Arrow Financial Stock: Attractive value with lackluster earnings outlook (NASDAQ:AROW)

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Earnings of Arrow Financial Corporation (NASDAQ: NASDAQ: AROW) will likely remain somewhat stable this year. Economic strength in northeast New York will likely drive loan growth, which, in turn, will support the bottom line. On the other hand, loan growth will also increase provisioning charges, which will limit earnings growth. Meanwhile, the margin is likely to remain flat due to the combination of the fixed-rate heavy loan portfolio and the transaction deposit-heavy fund portfolio. Overall, I expect the company to report earnings of $3.07 per share, down 1% year over year. The year-end target price suggests a strong upside from the current market price. Therefore, I maintain a buy rating on Arrow Financial Corporation.

New York’s economic recovery to boost demand for credit

Arrow Financial’s loan portfolio continued to grow in the last quarter of 2021, but fell short of my expectations. The portfolio only grew by 0.5% at the end of December 2021 compared to the end of September 2021. Going forward, I expect loan growth to improve due to the economic recovery. Arrow Financial operates in northeast New York. The state lags other states in unemployment rates, according to official sources. New York reported an unemployment rate of 5.3% in January 2022, which was well above the national average. However, the GDP growth rate shows that the state is doing quite well. New York recorded economic growth of 2.3% in the third quarter of 2021, according to official sources.

Additionally, the bulk of the Paycheck Protection Program (“PPP”) wallet rebate is now behind us. Outstanding PPP loans increased from $130.9 million at the end of December 2020 to $48.8 million at the end of December 2021. Outstanding PPP loans represented only 1.8% of total loans at the end of the last trimestre. Therefore, the remaining discount will only have a small impact on the total size of the loan portfolio.

Arrow Financial recorded high-to-low double-digit loan growth before the pandemic. For 2022, I expect loan growth to improve, but not at the pre-pandemic rate. Overall, I expect the loan portfolio to grow by 6% by the end of December 2022 compared to the end of 2021. In my last report on Arrow Financial as well, I expected this that the loan portfolio grows by 6% in 2022. Although I have not changed my growth expectations for this year, my estimate of the average loan balance for 2022 is lower now because the starting point (December 31 2021) is lower. Arrow missed my estimate of my loan growth for the fourth quarter of 2021, which is why the actual loan balance as of December 31, 2021 is lower than my previous expectations.

Additionally, I expect deposits and other balance sheet items to grow primarily in line with loans. The following table shows my balance sheet estimates.

EX17 EX18 FY19 FY20 FY21 FY22E
Financial situation
Net loans 1,932 2,176 2,365 2,566 2,641 2,803
Net loan growth 11.3% 12.6% 8.7% 8.5% 2.9% 6.1%
Other productive assets 676 646 638 930 1,194 1,218
Deposits 2,245 2,346 2,616 3,235 3,550 3,768
Loans and sub-debts 245 354 231 88 70 67
Common Equity 250 270 302 334 371 403
Book value per share ($) 16.8 18.1 20.1 21.6 23.1 25.1
Tangible BVPS ($) 15.2 16.5 18.6 20.1 21.6 23.6

Source: SEC Filings, Author’s Estimates

(In millions of dollars, unless otherwise indicated)

Higher interest rates to barely affect the margin

Arrow Financial has more fixed rate loans than variable rate loans. Within the commercial and industrial (“C&I”) and commercial real estate (“CRE”) segments, variable rate loans represented only 37.6% of the portfolio, according to details given in the 10-K filing. Additionally, most residential mortgages are based on fixed rates in nature. Consequently, Arrow’s loan portfolio is not very sensitive to increases in interest rates.

In addition, a large portion of the deposit portfolio will be revalued soon after a rate hike. Interest-bearing checking accounts and savings deposits represented 71% of total deposits at the end of December 2021. This means that the cost of deposits is quite sensitive to changes in interest rates.

Management’s interest rate sensitivity analysis also shows that rate increases will have virtually no impact on net interest income in the first year. Even in the second year, the impact of an interest rate hike will be quite small. According to the results of the analysis presented in the 10-K file, a 200 basis point increase in the interest rate can increase net interest income by only 0.83% in the first year of the rate increase. The following table in Filing 10-K summarizes the results of management’s interest rate sensitivity analysis.

Arrow Financial Interest Rate Sensitivity

Filing 10-K 2021

Given these factors, I expect the margin to remain broadly stable in 2022, compared to 2.77% in the last quarter of 2021.

Provision standardization to undo revenue growth

After releasing some loan loss reserves in the first quarter of 2021, Arrow Financial recorded moderate net provision charges in the last three quarters of the year. Going forward, the provision charge will likely return to a more normal level as most excess reserve releases appear to be complete. Furthermore, increased provisioning is unlikely as current provisions easily cover the credit risk of the portfolio. Provisions represented 1.02% of total loans, while non-performing loans represented 0.44% of total loans at end-December 2021, as mentioned in the earnings release.

Given these factors, I expect 2022 provisioning to return to the pre-pandemic average. I expect provisioning expense to be around 0.11% of total loans in 2022. By comparison, provisioning expense averaged 0.12% of total loans from 2017 to 2019.

Expected earnings of $3.07 per share

Arrow Financial’s earnings are likely to remain nearly flat this year as loan growth will likely undo the normalization of provisions. Overall, I expect the company to report earnings of $3.07 per share in 2022, down just 1% year-over-year. The following table shows my income statement estimates.

EX17 EX18 FY19 FY20 FY21 FY22E
income statement
Net interest income 78 84 88 99 110 117
Allowance for loan losses 3 3 2 9 0 3
Non-interest income 28 29 29 33 32 31
Non-interest charges 63 65 67 71 78 82
Net income – Common Sh. 29 36 37 41 50 49
BPA – Diluted ($) 1.98 2.43 2.50 2.64 3.10 3.07

Source: SEC Filings, Author’s Estimates

(In millions of dollars, unless otherwise indicated)

Compared to the estimates given in my last report on Arrow Financial, I have reduced my earnings estimate primarily because loan growth exceeded my expectations in the fourth quarter of 2021. Although I have not changed my growth expectations for 2022, my average loan balance is lower because the starting point is lower.

Actual earnings may differ materially from estimates due to the risks and uncertainties associated with the COVID-19 pandemic and the timing of an interest rate hike.

High Price Rise Warrants Buy Rating

Arrow Financial offers a dividend yield of 3.1% at the current quarterly dividend rate of $0.27 per share. Earnings and dividend estimates suggest a payout ratio of 35% for 2022, which is below the five-year average of 41%. Although there is room for a dividend increase in the last three quarters of 2022, I do not expect an increase as Arrow only recently increased its dividend in the first quarter of 2022. A second dividend hike this year seems unlikely.

I use historical price/book tangible (“P/TB”) and price-earnings (“P/E”) multiples to value Arrow Financial. The stock has traded at an average P/TB ratio of 1.80 in the past, as shown below.

EX17 EX18 FY19 FY20 FY21 Medium
T. Book value per share ($) 15.2 16.5 18.6 20.1 21.6
Average market price ($) 31.5 34.0 33.3 29.3 34.9
Historical P/TB 2.07x 2.06x 1.79x 1.46x 1.61x 1.80x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/TB multiple by the expected tangible book value per share of $23.60 yields a target price of $42.50 for the end of 2022. This price target implies an upside of 23.9% compared to the closing price on March 14. The following table shows the sensitivity of the target price to the P/TB ratio.

Multiple P/TB 1.60x 1.70x 1.80x 1.90x 2.00x
TBVPS – Dec 2022 ($) 23.6 23.6 23.6 23.6 23.6
Target price ($) 37.8 40.1 42.5 44.8 47.2
Market price ($) 34.3 34.3 34.3 34.3 34.3
Up/(down) 10.1% 17.0% 23.9% 30.7% 37.6%
Source: Author’s estimates

The stock has traded at an average P/E ratio of around 13.1 in the past, as shown below.

EX17 EX18 FY19 FY20 FY21 Medium
Earnings per share ($) 1.98 2.43 2.50 2.64 3.10
Average market price ($) 31.5 34.0 33.3 29.3 34.9
Historical PER 15.9x 14.0x 13.3x 11.1x 11.3x 13.1x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/E multiple by the expected earnings per share of $3.07 yields a price target of $40.20 for the end of 2022. This price target implies a 17.3% upside from at the closing price on March 14. The following table shows the sensitivity of the target price to the P/E ratio.

Multiple P/E 11.1x 12.1x 13.1x 14.1x 15.1x
EPS 2022 ($) 3.07 3.07 3.07 3.07 3.07
Target price ($) 34.1 37.2 40.2 43.3 46.4
Market price ($) 34.3 34.3 34.3 34.3 34.3
Up/(down) (0.6)% 8.3% 17.3% 26.2% 35.1%
Source: Author’s estimates

Equal weighting of target prices from both valuation methods gives a combined result target price of $41.40, implying a 20.6% upside from the current market price. Adding the forward dividend yield gives an expected total return of 23.6%. Therefore, I maintain a buy rating on Arrow Financial Corporation.

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