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Earnings of Lakeland Bancorp, Inc (LBAI) decreased to $0.24 per share in the first quarter, down 34% from the last quarter of 2019. A surge in provisions for credit losses amid the COVID-19 pandemic was the chief contributor to the earnings decline. Earnings will likely recover from the first quarter in the year ahead because of a sequential decline in provision expense. However, the future earnings will likely decline on a year-over-year basis because the provision expense will remain above-normal. Additionally, the net interest margin will slightly decrease following the interest rate cuts earlier this year, which will pressurize earnings. However, the stickiness of yields and the upcoming maturity of expensive deposits will mitigate the impact of interest rate cuts on margin. Further, loan growth under the Paycheck Protection Program will support the bottom-line. Overall, I’m expecting earnings to decline by 6% year over year to $1.29 per share in 2020. There is a chance that actual earnings will miss estimates because the impact of COVID-19 on provisions for credit losses is uncertain. Additionally, the delay in the adoption of the new accounting standard for credit losses, CECL, has compounded the uncertainty related to provisions. The December 2020 target price suggests a high upside from the current market price; nevertheless, I’m adopting a neutral rating on LBAI because of the risks and uncertainties.

Provision Expense to Remain Above-Normal

LBAI’s provision expense surged to $9 million in the first quarter from $1 million in the last quarter of 2019. As mentioned in the first quarter’s 10-Q filing, LBAI chose to delay the adoption of the new accounting standard for credit losses, called CECL; therefore, the company used the incurred loss model to determine provisioning requirements. The provision expense in the first quarter made up 17 basis points of total loans, which is unusually high in historical perspective; hence, the loan loss provisioning appears to be large enough to provide some cover for the economic downturn in the quarters ahead. As a result, I’m expecting provision expense to decline sequentially in the remaining three quarters of the year. However, the provision expense will likely remain above normal in the year ahead. I’m expecting LBAI’s equipment finance portfolio to experience some problems because of the slowdown in business activity across several industries, which will likely drive provisions. As mentioned in the filing, equipment finance made up 2.2% of total loans as of March 31, 2020.

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As mentioned in the first quarter’s earnings release, LBAI received applications for payment deferrals on approximately $745 million of commercial loans and $54 million of mortgage and consumer loans due to the pandemic. The deferral requests make up 15% of total loans, which shows the extent of the problems in the portfolio. If the debt serviceability of borrowers worsens any further, then these payment deferrals can turn into troubled debt restructuring (TDR) which will push up provision expense. I’m expecting a small proportion of these payment deferrals to increase TDRs. Considering these factors, I’m expecting provision expense to increase to $14 million in 2020, from $2 million in 2019.

Loan Mix, Deposit Repricing to Ease Margin Pressure

The 150 basis point reduction in the federal funds rate will pressurize the average yield on earning assets in the second quarter. However, the loan portfolio’s concentration in long-term real estate loans will likely make average yield sticky and resistant to downward pressure. As mentioned in the 10-Q filing, real estate loans made up 89% of total loans as of March 31, 2020. Additionally, the maturity of expensive certificates of deposits (CDs) this year will ease some of the pressure on net interest margin (NIM) from the interest rate cuts. As mentioned in the last 10-K filing, around 82% of total CDs, representing 13.5% of total deposits, will mature in 2020.

According to the results of a simulation conducted by the management, a 100 basis point reduction in interest rates can increase net interest income by 1.4% over twelve months, which shows NIM’s rate-sensitivity. The following table from the 10-Q filing shows the results of the simulation.Lakeland Bancorp Rate Sensitivity

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Considering the factors mentioned above, I’m expecting NIM to decline by just 4bps in the second quarter and by 17bps in the full year. The following table shows my estimates for yield, cost, and NIM.

Lakeland Bancorp Net Interest Margin

LBAI’s participation in the Paycheck Protection Program (PPP) will offset the adverse impact of NIM decline on net interest income. As mentioned in the earnings release, LBAI has funded $350 million of loans under PPP that will drive loan growth in the second quarter. I’m expecting PPP to be the major cause of loan growth in the second quarter; therefore, I’m expecting the loan balance to increase by 7% quarter over quarter in the second quarter. A majority of the PPP loans will likely get forgiven in the third quarter; hence, I’m expecting loans to decline by $342 million in the third quarter. Further, I’m expecting LBAI to end the year with a loan balance of $5.4 billion, up 5.2% from the end of 2019. The following table shows my estimates for loans and other balance sheet items.

Lakeland Bancorp Balance Sheet Forecast

Expecting Earnings of $1.29 per Share in 2020

LBAI’s earnings for the full year will likely decline from last year due to a surge in provision expense and dip in NIM. The company’s participation in PPP will likely limit the earnings decline. Overall, I’m expecting earnings to decline by 6% year over year to $1.29 per share in 2020. The following table shows my estimates for the income statement items.

Lakeland Bancorp Income Forecast

Actual earnings may differ materially from the estimates because the impact of COVID-19 on provision expense is uncertain. If the severity and duration of the pandemic exceed my expectations, then the actual provision expense can surpass its estimate. Moreover, LBAI has not yet adopted CECL; therefore, the impact of the new accounting standard on future provisioning (beyond the first day of adoption) is difficult to predict. Additionally, the fees that LBAI will book under PPP are uncertain because the timing of the booking will depend on when the loans will get forgiven. The risks and uncertainties will likely keep the stock price depressed.

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Risks Warrant a Neutral Rating Despite Attractive Valuation

To value LBAI, I’m using its historical price-to-tangible-book multiple (P/TB) which averaged 1.43x in 2019. Multiplying the P/TB ratio with the forecast tangible book value per share of $12.0 gives a target price of $17.2 for December 2020. This price target implies an upside of 58% from LBAI’s June 19 closing price. The table below shows the sensitivity of the target price to the P/TB ratio.

Lakeland Bancorp Valuation Sensitivity

Apart from the price upside, LBAI is also offering a dividend yield of 4.6%, assuming the company maintains its quarterly dividend at the current level of $0.125 per share in the remainder of 2020. There is very little threat of a dividend cut because the earnings and dividend estimates suggest a payout ratio of 39% for 2020, which is more or less in line with LBAI’s historical payout. The company’s five-year average payout ratio is 36%.

As discussed above, LBAI’s stock price is likely to remain depressed in the near-term due to the high level of risks and uncertainties. In my opinion, the risks will overshadow the attractive valuation in the next two to three months. Therefore, I’m adopting a neutral rating on LBAI.

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 consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.