1st Source Corporation (SRCE) is South Bend, IN headquartered an $8 billion community bank. The bank operates community banking and specialty finance segments. For community banking, 78% is C&I loans and the rest is consumer loans. For the specialty finance segment, the bank has a national footprint and can underwrite leases on construction machinery, business and personal aircraft, automobile leasing and truck rental/leasing. Community banking accounts for 53% of the loan portfolio and specialty finance accounts for the remaining 47%. 1st Source operates 79 banking centers, 99 24-hour ATMs, 9 trust and advisory locations with $5.1 billion in assets under management, and 10 insurance offices. The bank’s diversification into fee income has historically led to ROA above the industry average.
From the perspective of deposit composition, the bank has recently made efforts to improve the basic deposit in the composition of funding. The deposit base has grown to ~87% of the deposit base from just 75% 5 years ago. The improvement in the cost of funding is a significant improvement for the bank. In FY21, DDAs accounted for 29% of total deposits, and savings and money market accounts accounted for 54%.
1st Source Corporation reported net income of $118.5 million for fiscal 2021, compared to $81.4 million for the prior year. Earnings per share were $4.70 versus $3.17 a year earlier. Revenue for the year increased to $341.0 million from $294.5 million in fiscal 2020. During the fourth quarter, 1st Source Corporation reported ROA and ROE of 1.4% and 11.5%, respectively. The efficiency ratio is 56.6% and the net interest income/income is 70.7%. NIM is 3.09% and the Tier 1 capital ratio is 15.5%
From a profitability perspective, reported ROA has been consistently above 1% for the past several years, particularly in FY20 when NPLs increased significantly. Financial results were impressive in FY20, with the bank managing to post ROA above 1%; provisioning increased significantly and NPLs also increased to over 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 strong for the bank. Even in the worst year of the pandemic, NPLs only rose 110 basis points. As a significant portion of the bank’s portfolio is travel-related, the loan loss is expected to be high. The bank saw significant improvement in NPL reduction in FY21, and as the world returns to normal, investors should expect to see more normalized NPLs. The impressive nature is that the bank managed to deliver a consecutive return on investment of more than 1% in fiscal years 20 and 21, which shows the resilience of the business model and the effectiveness of fee diversification to generate income .
As mentioned previously, the bank’s ability to generate a constant ROA, greater than 1%, is the result of the practice of wealth advice and the insurance offer. Commission revenue represented more than 30% of total revenue for FY21 and is a significant improvement for revenue diversification.
The share price is attractive at 10.5x P/E and 1.5x P/TBV. Mortgage income is only 15% of the fee mix and the diversification of fee income is sufficient to offset declining mortgage expense generation.
From a risk perspective, as the bank approaches $10 billion in total assets over the next few years, growth could slow unless the bank engages in acquisitions to generate value. Although the bank has not engaged in mergers and acquisitions in the past 10 years, inorganic growth was part of the growth strategy 10 years ago. Investors should be careful of transactions that are not well structured.
From a compensation perspective, the bank is on a solid organic growth trajectory. Since 2014, the bank has grown the book value to 7% CAGR on an organic basis.
In summary, stocks 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 in the mid to high single digits. The stable fee mix and diversified loan portfolio give us confidence that dividends are likely to be safe and growing. The bank’s response to COVID-19 has shown the management team’s ability to lead the bank through one of the worst crises in recent history. We appreciate the risk/reward dynamic and consider investment risk to be limited. The bank will benefit from a rising rate environment.