Provident Financial (PFS): Higher provisioning is likely to undermine strong revenue growth

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Benefit of Provident Financial Services Inc. (NYSE: SPF) will most likely weaken this year due to higher provisioning for expected loan losses in an environment of higher interest rates. On the other hand, decent loan growth and a slight expansion in margins will likely support the bottom line. Overall, I expect Provident Financial to report earnings of $2.04 per share for 2022, down 7% year-over-year. The year-end target price suggests a slight upside from the current market price. Based on the expected total return, I maintain a Buy rating on Provident Financial Services.

Strong pipelines and labor markets signal continued loan growth

Management mentioned on the first quarter conference call that its pipelines remained healthy at around $1.4 billion at the end of the first quarter. Therefore, it is safe to assume that loan growth must have remained robust through the second quarter. To put the pipeline amount into perspective, $1.4 billion represents 14% of outstanding loans at the end of March.

Management was positive about continued strong loan growth through 2022, as mentioned on the conference call. Given the strength of regional labor markets, management’s objective appears achievable. Provident Financial operates in New York, New Jersey and Pennsylvania. All three states have worse labor markets than the national average, but they’re still doing extremely well historically.

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Data by Y-Charts

However, the anticipated change in interest rates should dampen loan growth. The Federal Reserve projects interest rates will peak later this year or next. Therefore, customers with non-urgent borrowing needs may want to postpone their borrowing plans until the end of next year.

Overall, I expect the loan portfolio to grow by 2.3% in the last nine months of 2022, which will lead to loan growth of 3.2% for the entire year. Meanwhile, other balance sheet items will likely grow more or less in line with lending for the last nine months of 2022. The following table shows my balance sheet estimates.

EX17 EX18 FY19 FY20 FY21 FY22E
Financial situation
Net loans 7,266 7,195 7,277 9,721 9,501 9,804
Net loan growth 4.7% (1.0)% 1.1% 33.6% (2.3)% 3.2%
Other productive assets 1,567 1,600 1,487 1,745 2,736 2,681
Deposits 6,714 6,830 7,103 9,838 11,234 11,624
Loans and sub-debts 1,743 1,442 1,125 1,210 671 460
Common equity 1,299 1,359 1,414 1,620 1,697 1,678
Book value per share ($) 20.1 20.9 21.8 21.1 22.2 22.1
Tangible BVPS ($) 13.6 14.5 15.1 15.0 16.1 16.0

Source: SEC Filings, Author’s Estimates

(In millions of dollars, unless otherwise indicated)

The composition of deposits is poorly positioned for rate hikes

The composition of deposits at Provident Financial Services is not conducive to rising interest rates. Indeed, deposits that are quickly repriced represent an overwhelming majority of total deposits. Savings, Negotiated Withdrawal Order (“NOW”) and Money Market accounts accounted for 69.3% of total deposits at the end of March 2022.

However, due to excess liquidity in the banking sector, banks currently have greater than normal pricing power with respect to deposits. Therefore, there is a good chance that Provident Financial will be able to contain its deposit costs despite the frequent price revision. Management also mentioned on the conference call that the overall deposit beta is only 23%, which is quite low. (A deposit beta of 23% means that every hundred basis point increase in rates could increase the average cost of deposits by just 23 basis points.)

Management’s interest rate sensitivity analysis shows that the sensitivity of the net interest margin to increases in interest rates is moderate to low. According to the results of the analysis, a 200 basis point hike could increase net interest income by only 3.3% year over year, as mentioned in the first quarter 10-Q filing.

Pensions Financial services Sensitivity to interest rates

Filing 1Q 2022 10-Q

Given these factors, I expect the margin to increase by 18 basis points in the last nine months of 2022, compared to 3.02% in the first quarter of the year.

Higher provision charge leading to lower profits

As mentioned on the conference call, Provident Financial relies on Moody’s U.S. baseline forecast to determine the provisioning needed for expected loan losses. In July, Moody’s revised down its GDP growth estimates for 2022 and 2023, as mentioned in its last report. This downward revision is partly explained by the evolution of interest rates. Due to Moody’s revised base forecast, it is very likely that Provident Financial will significantly increase its provisioning for the remainder of the year. In addition, the anticipated loan additions discussed above will require additional provisions for expected loan losses.

Overall, I expect the provisioning charge to be slightly higher than normal for the last three quarters of 2022. I expect Provident Financial to report a net provisioning charge of 0.18% of total loans in 2022. In comparison, the net provision charge has averaged 0.13% of total loans over the past five years.

Expect revenue to drop 7%

Anticipated growth in provisioning expenses will likely be the main contributor to lower earnings this year. On the other hand, decent loan growth and margin expansion will likely support the bottom line. Overall, I expect Provident Financial to report earnings of $2.04 per share for 2022, down 7% year-over-year.

The company is due to report second quarter results on July 29, 2022. I expect Provident Financial to report earnings of $0.50 per share for the quarter. The following table shows my income statement estimates for the full year.

EX17 EX18 FY19 FY20 FY21 FY22E
income statement
Net interest income 278 301 298 313 366 394
Allowance for loan losses 6 24 13 30 (24) 18
Non-interest income 56 59 64 72 87 86
Non-interest charges 188 192 202 228 250 255
Net income – Common Sh. 94 118 113 97 168 155
BPA – Diluted ($) 1.45 1.82 1.74 1.39 2.19 2.04

Source: SEC filings, earnings releases, author’s estimates

(In millions of dollars, unless otherwise indicated)

In my last report on Provident Financial, I estimated earnings at $1.91 per share for 2022. I increased my earnings estimate as I slightly changed all income statement line items. The difference in earnings estimates is not attributable to any major factor.

Actual earnings may differ materially from estimates due to the risks and uncertainties associated with inflation and, therefore, the timing and magnitude of interest rate increases. Also, the threat of a recession may increase the provisioning of expected loan losses beyond my expectations. The new Omicron sub-variant should also be watched.

Maintaining a Buy rating due to a decent expected total return

Provident Financial offers a dividend yield of 4.1% at the current quarterly dividend rate of $0.24 per share. Earnings and dividend estimates suggest a payout ratio of 47% for 2022, which is below the five-year average of 56%. Despite the possibility of a dividend hike, I have not factored any dividend changes into my investment thesis to remain on the safe side.

I use historical price/tangible accounting (“P/TB”) and price/earnings (“P/E”) multiples to value Provident Financial. The stock has traded at an average P/TB ratio of 1.48 in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
T. Book value per share ($) 14.5 15.1 15.0 16.1
Average market price ($) 25.9 25.1 15.6 22.8
Historical P/TB 1.79x 1.66x 1.04x 1.42x 1.48x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/TB multiple by the expected tangible book value per share of $16.0 yields a target price of $23.6 for the end of 2022. This price target implies an upside of 2.0% compared to the closing price on July 22. The following table shows the sensitivity of the target price to the P/TB ratio.

Multiple P/TB 1.28x 1.38x 1.48x 1.58x 1.68x
TBVPS – Dec 2022 ($) 16.0 16.0 16.0 16.0 16.0
Target price ($) 20.4 22.0 23.6 25.2 26.8
Market price ($) 23.2 23.2 23.2 23.2 23.2
Up/(down) (11.8)% (4.9)% 2.0% 8.8% 15.7%
Source: Author’s estimates

The stock has traded at an average P/E ratio of around 12.6x in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
Earnings per share ($) 1.82 1.74 1.39 2.19
Average market price ($) 25.9 25.1 15.6 22.8
Historical PER 14.3x 14.4x 11.2x 10.4x 12.6x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/E multiple by the expected earnings per share of $2.04 yields a price target of $25.7 for the end of 2022. This price target implies a 10.7% upside from at the July 22 closing price. The following table shows the sensitivity of the target price to the P/E ratio.

Multiple P/E 10.6x 11.6x 12.6x 13.6x 14.6x
EPS – 2022 ($) 2.04 2.04 2.04 2.04 2.04
Target price ($) 21.6 23.6 25.7 27.7 29.8
Market price ($) 23.2 23.2 23.2 23.2 23.2
Up/(down) (6.9)% 1.9% 10.7% 19.5% 28.4%
Source: Author’s estimates

An equal weighting of the target prices from the two valuation methods gives a target price of $24.7, implying a 6.3% upside from the current market price. Adding the forward dividend yield gives an expected total return of 10.5%. Therefore, I maintain a buy rating on Provident Financial Services.

About Daisy Rawson

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