Earnings of Webster Financial Corporation (NYSE:WBS) increased by 43% in the second quarter on a linked-quarter basis to $0.57 per share. The recovery was mostly attributable to a lower provision expense in the quarter. Provision expense will likely continue to decline in the second half of 2020 because economic factors will likely ease in the remainder of the year. However, portfolio-specific factors will likely keep provision expense above-normal. Overall, I’m expecting provision expense in the year ahead to decline compared to the first half of the year but increase compared to the corresponding period last year. Apart from lower credit costs, earnings will also receive support from fees under the Paycheck Protection Program. Moreover, deposit services fees will likely recover in the year ahead as economic activity picks up, which will likely further support the bottom line. Overall, I’m expecting earnings to increase by 57% in the second half of the year compared to the first half. For the full year, I’m expecting WBS to report earnings of $2.47 per share, down 39% year over year. The June 2021 target price suggests a high upside from the current market price; hence, I’m adopting a bullish rating on WBS.
Paycheck Protection Program to Drive Net Interest Income
As mentioned in the second quarter’s investor presentation, WBS funded $1.4 billion worth of loans under the Paycheck Protection Program, PPP. Assuming fees of 3% and funding cost of 0.35%, PPP will add an estimated $37 million to net interest income over the life of the PPP loans. I’m expecting most of the PPP loans to get forgiven before year-end; hence, I’m expecting WBS to book most of the PPP impact this year.
Excluding the impact of PPP, the net interest margin, or NIM, is likely to trend downwards in the second half of the year. WBS’s NIM declined by 19bps in the second quarter following the 150bps federal funds rate cuts in March. I believe NIM has already taken most of the hit from the interest rate cuts because most of WBS’s loan portfolio is floating rate based. As mentioned in the presentation, floating and periodic loans represented 71% of total loans at the end of the last quarter. Moreover, around $2 billion of loans are at floors, which will mitigate the further impact of the interest rate cut on average portfolio yield. Moreover, WBS improved its deposit mix in the second quarter, which will further support NIM. Non-interest based deposits made up 23.5% of total deposits at the end of June 2020, up from 19.9% of total deposits at the end of March 2020.
According to the results of management’s interest-rate sensitivity analysis disclosed in the presentation, a 50bps decline in long-end interest rates can reduce pre-provision net revenue by 3.3% over 12 months. Considering the factors mentioned above, I’m expecting NIM to decline by 8bps in the third quarter, as shown below.
Loans will likely decline in the year ahead due to the forgiveness of PPP loans. Excluding the impact of PPP, loans are likely to grow at a low rate in the remainder of the year. Low interest rates will likely drive residential and home equity loan segments. Overall, I’m expecting WBS to end the year with a loan balance of $20.2 billion, down 6% from the end of June 2020, and up 1.7% from the end of 2019. The following table shows my estimates for loans and other balance sheet items.
Easing of Economic Factors to Let Provision Expense Decline in the Year Ahead
WBS reported a provision expense of $40 million in the second quarter, down from $76 million in the first quarter of 2020. Economic factors were mostly responsible for pushing up provision expense in the first half of the year. As mentioned in the second quarter’s conference call, to determine the provisioning requirement, the management assumed that the unemployment rate peaked at 14% in the second quarter and would trend downwards going forwards. Further, the management assumed that the unemployment rate would decline to 9.5% in the fourth quarter of 2020 and hover at an average of 9.3% for 2021. Moreover, the management assumed that GDP would decline by 5.6% in 2020 and annualized year-over-year GDP growth would not turn positive until mid-2021. These economic forecasts currently appear reasonable; therefore, economic factors will likely have little effect on provision expense in the year ahead.
However, portfolio-specific factors will likely keep the provision expense above-normal in the remainder of the year. As mentioned in the presentation, WBS allowed payment modifications on 11% of total loans. While the modification did not impact provision expense in the second quarter, further deterioration in the operating environment can turn these modified loans delinquent and push up the provision expense. Further, WBS has high exposure to COVID-19-sensitive industries, including hotels, travel, and restaurants, which made up 11.8% of total loans at the end of the last quarter, as mentioned in the presentation. Additionally, the risky equipment finance segment made up 2.9% of total loans. These vulnerable segments can magnify the impact of any further worsening of the pandemic on provision expense.
Considering the factors mentioned above, I’m expecting WBS to report a provision expense of $176 million in 2020, up from $38 million in 2019.
Expecting Full Year Earnings to Decline by 39%
The dip in provision expense and fees from PPP will likely increase earnings in the second half of the year compared to the first half. Additionally, deposit service fees and health savings account fees will likely recover in the year ahead as economic activity gradually improves. Further, WBS reported a decline in non-interest income in the second quarter due to a one-time adjustment of $6.5 million related to customer derivatives. The non-recurrence of this adjustment will let non-interest income recover in the year ahead from the dip in the second quarter.
Considering the factors mentioned above, I’m expecting earnings in the second half of the year to increase by 57% compared to the first half. For the full year, I’m expecting WBS to report earnings of $2.47 per share, down 39% from last year. The following table shows my income statement estimates.
Actual earnings may differ materially from the estimates because future earnings will depend heavily on provision expense, which is difficult to forecast. The uncertainties related to the depth and duration of the COVID-19 pandemic can cause a negative surprise in provision expense in the year ahead. Additionally, WBS’s high exposure to COVID-19-sensitive industries makes the provision expense highly susceptible to the pandemic. These risks make WBS unsuitable for low-risk tolerant investors.
WBS is Offering a High Upside and Attractive Dividend Yield
I’m using the historical price-to-book multiple (P/B) to value WBS. The stock traded at an average P/B multiple of 0.99x in the first half of 2020. Multiplying the average P/B ratio with the June 2021 forecast book value per share of $35.1 gives a target price of $34.9 for the mid of next year. This target price implies an upside of 23% from WBS’s August 8 closing price. The following table shows the sensitivity of the target price to the P/B multiple.
Apart from the price upside, WBS is also offering an attractive dividend yield of 5.7%, assuming the company maintains its quarterly dividend at the current level of $0.4 per share. The earnings and dividend estimates suggest a payout ratio of 65%, which is manageable. Hence, I’m not expecting a dividend cut.
Based on the high price upside and attractive dividend yield, I’m adopting a bullish rating on WBS. Please note that WBS is currently carrying a high level of risk due to the pandemic and the company’s exposure to vulnerable industries. Investors should consider their risk tolerance before making any investment decision on WBS.
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.