1st Source: Balanced Bank With Attractive Fee Income Mix (NASDAQ:SRCE)

Overview

1st Source Corporation (SRCE) is South Bend, IN headquartered $8 billion community bank. The bank operates community banking and specialty finance segments. For the community bank services, 78% is C&I lending and the rest is consumer lending. For the specialty finance segment, the bank has a national footprint and can underwrite leases on construction machinery, corporate and personal aircraft, auto rental, and truck rental/leasing. Community banking accounts for 53% of the loan book and specialty finance represents the rest of 47%. 1st Source operates 79 banking centers, 99 24-hour ATMs, 9 trust and advisory locations with $5.1 billion assets under management, and 10 insurance offices. The bank’s diversification into fee income has consistently driven higher than industry average ROA historically.

From a deposit mix perspective, the bank has recently worked to improve the core deposit in the funding mix. The core deposit has increased to ~87% of the deposit base, vs. only 75% 5 years ago. The improvement in funding cost is a significant improvement for the bank. As of FY21, DDA accounted for 29% of the total deposit and saving & money market accounts represented 54%.

Review of Operations

1st Source Corporation reported a net income of $118.5 million for the fiscal year 2021 as compared to $81.4 million for the prior year. Earnings per share were $4.70 versus $3.17 for the prior year. Revenues for the year increased to $341.0 million from $294.5 million for the fiscal year 2020. During Q4, 1st Source Corporation reported ROA and ROE of 1.4% and 11.5%, respectively. The efficiency ratio is 56.6% and Net interest income/Revenue is 70.7%. NIM is 3.09% and Tier 1 Capital Ratio is 15.5%

From a profitability perspective, reported ROA has been consistently above 1% during the past few years, especially during the FY20, when NPL increased significantly. The financial results were impressive in FY20 as the bank managed to report above 1% in ROA; provisioning increased significantly and NPL also increased to above 1% in FY20; the negative provisioning in FY21 indicates a reversal of credit losses in FY20, which is a good sign as the actual loan loss is not as severe.

Credit quality is robust for the bank. Even during the worst year in the pandemic, NPL increased only to 110 basis points. As a significant amount of the bank’s portfolio is travel-related, the loan loss is expected to be high. The bank saw significant improvement in reduction in NPL in FY21 and as the world returns to normal, investors should expect to see more normalized NPL. The impressive nature was that the bank managed to deliver consecutive 1%+ ROA during FY20 and FY21, which shows the resilience of the business model and the effectiveness in fee diversification to generate revenues.

As mentioned previously, the bank’s ability to generate consistent, above 1% ROA is a result of the wealth advisory practice and the insurance offering. Fee income accounted for 30%+ in total income for FY21 and is a significant improvement for revenue diversification.

Valuation

Stock is attractively priced at 10.5x P/E and 1.5x P/TBV. Mortgage income only accounts for 15% of the fee mix and the diversification of fee income is enough to compensate for a declining mortgage fee generation.

Risk/Reward

From a risk perspective, as the bank approaches $10 billion in total assets in the next few years, the growth may slow down unless the bank engages in acquisitions to drive value. While the bank has not engaged in M&A during the past 10 years, inorganic growth was a part of the growth strategy 10 years ago. Investors should watch out for deals that are not structured well.

From a reward perspective, the bank has a solid organic growth trajectory. Since 2014, the bank has grown the book value at 7% CAGR on an organic basis.

Conclusion

To sum up, the shares are attractively priced at 10.5x P/E and 1.5x P/TBV. The bank has been a consistent dividend payer and will continue to grow at a mid-to-high single digit. The stable fee mix and the diversified lending portfolio provide us with the comfort that dividends will likely be safe and growing. The bank’s response to COVID-19 has shown the management team’s ability to run the bank during one of the worst crises in recent history. We like the risk/reward dynamic and view the investment risk as limited. The bank will benefit from a rising rate environment.