United Bankshares: Credit Costs Likely To Undermine Acquisition Benefits (NASDAQ:UBSI)

Earnings of United Bankshares, Inc. (NASDAQ: UBSI) declined by 36% from the last quarter of 2019 to $0.40 per share in the first quarter of 2020. A surge in provision expense due to the COVID-19 pandemic and the resultant lockdown was the major contributor to the earnings decline. Earnings will likely decline on a year-over-year basis in the remainder of the year due to above-normal provision expense. Additionally, one-time merger expenses will pressurize earnings this year. On the other hand, a growth in earning assets on the back of the acquisition of Carolina Financial will likely limit the earnings decline. Moreover, the Paycheck Protection Program and growth in mortgage banking will help support net income. Overall, I’m expecting earnings per share to decline by 31% year over year to $1.77 in 2020. There is a risk of an earnings surprise in the year ahead because the impact of COVID-19 on credit costs is uncertain. The price upside implied by the year-end target price is not high enough to compensate for the elevated level of risk. Consequently, I’m adopting a Neutral rating on UBSI.

Increase in Provisions for Loan Losses Likely in the Year Ahead

UBSI’s provision expense increased to $27 million in the first quarter from $6 million in the last quarter of 2019. The allowance for loan losses was 1.12% of total loans at the end of the first quarter, which seems quite low when compared to an allowance to total loans ratio of 1.11% in 2013. In my opinion, the allowances amid a pandemic should be much higher than the past. As mentioned in the first quarter’s 10-Q filing, management assumed a 10-15% decline in GDP in the second quarter of 2020 to determine the provisions for loan losses. Additionally, it assumed an economic recovery in the third quarter of 2020 with GDP stabilizing in 2021. I believe the assumed recovery trend is too optimistic; hence, I’m expecting UBSI to materially increase its allowances in the last three quarters of the year. As a result, I’m expecting the provision expense to remain above last year’s level in the year ahead. For the full year, I’m expecting UBSI to post provision expense of $58 million, up from $21 million in 2019.

Carolina Financial Acquisition and Paycheck Protection Program to Drive Revenues

UBSI completed the acquisition of Carolina Financial (CARO) in May, according to a press release. CARO had $3.2 billion in net loans as of December 31, 2019, as mentioned in its 10-K filing; hence, the acquisition will likely boost UBSI’s loans by 23% in the second quarter. In addition to the acquisition, the bank’s loans will receive a boost from growth in mortgages as well. According to news reports, the demand for mortgages is high due to low interest rates. UBSI retains only a portion of the mortgages it originates, while the rest are originated for sale. Therefore, most of the benefits from the growth in mortgage banking will likely reflect in non-interest income.

Moreover, UBSI’s participation in the Paycheck Protection Program, or PPP, will drive revenues in the second half of the year. As mentioned in the first quarter’s earnings release, the company funded $900 million worth of loans under PPP in the first half of April. I’m expecting a majority of the PPP loans to get forgiven in the third quarter of the year, at which time UBSI will book the unamortized fees on the loans. Assuming a margin of 2.75% on the loans, I’m expecting PPP to add $25 million to net interest income in the third quarter.

Considering the factors mentioned above, I’m expecting UBSI to end the year with loans of $17.2 billion, up 26% from the end of last year. The following table shows my estimates for loans and other balance sheet items.

UBSI’s net interest margin, or NIM, will likely contract in the last three quarters of the year, which will partially offset the impact of loan growth on net interest income. A simulation conducted by the management shows that UBSI’s NIM is modestly sensitive to interest rate changes. The results of the simulation disclosed in the first quarter’s 10-Q filing show that a 200bps decline in interest rates can reduce net interest income by 1.22% over twelve months. Considering this rate sensitivity, I’m expecting NIM to decline by 8bps in the second quarter and by 20bps in the full year. The following table shows my estimate for NIM, excluding the impact of one-time fees under PPP.

United Bankshares Net Interest Margin

Expecting a 31% Decline in Earnings per Share

The elevated provision expense and NIM contraction will likely pressurize earnings in the year ahead. Furthermore, one-time merger-related expenses will lift non-interest expenses and pressurize earnings this year. On the other hand, an increase in non-interest income due to strength in mortgage banking will likely support earnings. Additionally, the acquisition of CARO will boost revenues. Overall, I’m expecting net income to decline by 18% year over year and earnings per share to decline by 31% year over year in 2020. I’m assuming that the acquisition will increase the shares outstanding by around 25 million shares. The following table shows my income statement estimates.

United Bankshares Income Forecast

Year-end Target Price Suggests a 24% Upside from Current Market Price

UBSI has traded at an average price-to-book ratio, or P/B, of 1.18 since 2016, as shown in the table below.

United Bankshares Historical Price to Book

Multiplying this P/B multiple with the forecast book value per share of $26.9 gives a target price of $31.8 for December 2020. This target implies a 23.6% upside from UBSI’s July 8 closing price, as shown in the table below. The table also shows the sensitivity of UBSI’s target price to different levels of the P/B multiple.

United Bankshares Valuation Sensitivity

Apart from the potential price upside, UBSI also offers a decent dividend yield of 5.5%. The yield is based on the expectation that the bank will maintain its quarterly dividend at the current level of $0.35 per share. Despite the expected earnings decline, I’m not expecting a dividend cut, because the earnings and dividend estimates suggest a payout ratio of 78%, which is manageable. Additionally, UBSI’s capital position is currently very comfortable, which will minimize the need for a dividend cut. The company reported a CET1 ratio of 12.3% as of March 31, 2020, versus the minimum regulatory requirement of 6.5%.

Risks Likely to Overshadow Attractive Valuation

The severity and duration of the COVID-19 pandemic are still uncertain, which increases the risk of an earnings surprise this year. If the pandemic lasts longer than expected, then provisions expense can exceed its estimate and hurt earnings for the year. According to news reports, the United States created a new record for daily new COVID-19 cases on July 8. The recent surge in cases has increased the risk of another dip in economic activity before a COVID-19 vaccine becomes widely available. The price upside implied by the year-end target price is not high enough to compensate for UBSI’s elevated level of risk. Consequently, I’m adopting a Neutral rating on UBSI.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is not financial advice. Investors are expected to conduct their own due diligence, and consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.

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