Prepared by Stephanie, Analyst at BAD BEAT Investing

We are penning a lot of reviews of operational performance in the financial sector the last few weeks, with a focus on some interesting regional banks. While we provide a solid overview of the critical metrics that you should be aware of, you should do your homework beyond our initial looks. That takes us to Prosperity Bancshares (NYSE:PB). This bank, along with many others, offers sizable upside in the next three to five years as the industry resets itself. You could buy now, and it will pay off down the road all things considered. We believe you should wait for a pull-back in the space. COVID-19 restrictions are coming back on pretty strong right now, and that will at least take the market down in several sessions in the coming weeks, in our opinion. Overall, COVID-19 has caused immense pain for consumers and business alike, and in response, the Fed has slashed rates next to zero, which has hurt banks’ ability to take in deposits and lend at higher rates, weighing on the net interest margins. As the sector normalizes in coming quarters, we think you need to take advantage if some of these names pull back. The bank reported earnings last month, which saw a big boost in the headline numbers thanks to a strategic merger with LegacyTexas Bank. Ultimately, we believe PB stock would be a good buy in the high $50 range, as the dividend is safe, has been raised, and, if it pulls back, would yield a healthy 3.5%.

Merger drove headline performance

EPS and revenues gained on the back of the big merger, but we also saw continued loan growth and deposit strength backing out the merger impact. That is a key strength. Of course, the headline changes were eyepopping but driven mostly by that merger.

With Q3 2020 revenues of $293 million, the bank put up a nice 57% increase in this metric year over year. The growth in revenues helped drive earnings power. Net income for Q3 2020 saw a massive increase thanks to the merger. Net income came in at $130.1 million, or $1.40 per share. This compares to a net income of $81.8 million, or $1.19 per share, for Q3 2019. That was a nice rise from a year ago, thanks to the new assets. Some of the earnings potential was hit by loan loss provisions. That said, we think 2021 will be even better based on the trends we are seeing for banks.

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Book value suggests the stock is pricey

The stock’s value proposition is impacted when we consider the equity price relative to book value. The bank’s stock is pricey at $62 relative to the book value per share at September 30, 2020. Book value per share as of September 30, 2020, was $65.20, compared with $64.19 to start the quarter. Thus, it appears we are trading at about book value. However, we are very pricey relative to tangible book. Tangible book was $29.46, up from $28.45 in Q2. A premium-to-tangible book is common, but this is over a 100% premium to tangible book. Thus, we think shares are still expensive, and you should wait for shares to fall back to the high $50s before considering a purchase, in our opinion.

You have to watch loans and deposits

Remember, growth in loans and deposits is key for any bank, small or large. That’s how you make money as a traditional bank. Of course, loans and deposits were impacted heavily by the merger. That said, we will present the overall impact to these key metrics, and then present the metrics if we backed out the merger impacts.

So, let us first take a look at loans. Loans at September 30, 2020, were $20.79 billion, an increase of $10.12 billion or 94.8%, compared with $10.67 billion at September 30, 2019. Linked quarter loans decreased $229.5 million or 1.1% from $21.03 billion at June 30, 2020. That decline is notable. One risk some may note is the loans to oil and gas companies it lends too. Thus, keep an eye on energy prices as this bank tends to be impacted a bit by them, given that its clients are often in this sector. What if we back out the loans from the merger? Excluding loans acquired in the merger and new production by the acquired lending operations since November 1, 2019, loans at September 30, 2020, grew $1.04 billion or 9.8% compared with September 30, 2019, which was positive, but decreased $135.5 million or 1.1% compared with June 30, 2020.

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What about deposits? Deposits at September 30, 2020, were $26.46 billion, an increase of $9.53 billion or 56.3%, compared with $16.93 billion at September 30, 2019. Linked quarter deposits increased $306.5 million or 1.2% from $26.15 billion at June 30, 2020. Excluding deposits assumed in the merger and new deposits generated at the acquired banking centers since November 1, 2019, deposits at September 30, 2020, grew $3.55 billion or 21.0% compared with September 30, 2019, and grew $326.6 million or 1.6% compared with June 30, 2020.

A look into asset quality metrics

We have to be aware that provisions for credit losses remain high. They were about flat from Q2 2020. In Q3, there was a provision for credit losses of $10.1 million, compared with a provision of $1.1 million for Q3 2019 and a provision of $10.0 million for Q2 2020. These losses offset earnings power, despite the fact that earnings were so strong. Nonperforming assets totaled $69.5 million or 0.24% of quarterly average interest-earning assets at September 30, 2020, compared with $51.2 million or 0.26% of quarterly average interest-earning assets at September 30, 2019, and $77.9 million or 0.28% of quarterly average interest-earning assets at June 30, 2020. The merger suggests that asset quality improved. The allowance for credit losses on loans was $323.6 million or 1.56% of total loans at September 30, 2020, compared to $324.2 million or 1.54% of total loans at June 30, 2020, and $87.1 million or 0.82% of total loans at September 30, 2019. These results were mixed. On the one hand, we like that provisions were about flat from Q2, and it was a positive that nonperforming assets as a percentage of the total on hand declined. The allowance for credit losses as a percentage increase, though. The bank recognized an increase in allowance for credit losses on loans of $108.7 million, of which $102.5 million was related to LegacyTexas. This does not mean the merger was problematic but merely reflects the transition of the portfolio and off-balance sheet credit exposures. However, we see 2021 as an improving operational climate for banks, including Prosperity.

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Final thoughts

The merger brought in a ton of new assets. Investors should be aware of lending to oil and gas companies and the associated risks. As energy has rebounded in recent weeks, so has this stock, in addition to rallying on the back of improving rates on bonds. Banks have gotten a boost in general on this. When we look at loans, deposits, and asset quality, we see now glaring issues. The dividend was recently raised which we like, and if shares pull back a good 10%, the yield will be attractive at 3.5%. While there is an improving book value, the stock is expensive relative and tangible book. We think you should wait to buy here.

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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.



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