2 Midwest Community Bank Stock Picks

NEW YORK ( TheStreet) -- There are plenty of community banks in the Midwest that are posting solid loan-growth numbers.

Stocks of strong community banks tend to trade at a significant premium to the largest U.S. banks, reflecting the prospect for continued earnings growth, in line with the loan growth as the Midwest economy continues to recover, while also reflecting investors' continued discomfort with the big banks, amid a regulatory and political onslaught.

FIG Partners analyst John Rodis covers 19 smaller regional banks, nearly all of which are located in the Midwest. At Friday's market close, the 19 stocks were trading at an average of 15.5 times his 2014 earnings estimates.

That's a pretty high valuation compared to the "big four" U.S. banks:
  • Shares of JPMorgan Chase (JPM) closed at $54.52 Friday and traded for 8.9 times the consensus 2014 earnings estimate of $6.10 a share, among analysts polled by Thomson Reuters.
  • Citigroup (C) closed at $51.32 Friday and traded for 9.2 times the consensus 2014 EPS estimate of $5.57.
  • Bank of America (JPM) closed at $14.45 Friday. The shares traded for 10.6 times the consensus 2014 EPS estimate of $1.37.
  • Wells Fargo (WFC) closed at $43.23 Friday and traded for 10.8 times the consensus 20143 EPS estimate of $4.02.

The valuations of the big four don't necessarily reflect their earnings power relative to each other. For several years, the strongest earnings report among the group has been Wells Fargo, however, the cheapest name to 2014 earnings estimates, JPMorgan Chase, has been the second-strongest when looking at returns on tangible common equity.

JPMorgan's valuation, and the low stock valuations for all of the largest U.S. banks, reflect the continued regulatory and political uncertainty, as the bar for capital strength keeps being raised, as the legacy mortgage mess continues to be worked through, and as other regulatory matters, including the Durbin Rule and the Volcker Rule, remain unsettled.

When discussing the lower valuations for large banks relative to community bank stocks, Rodis says, "There's not as much franchise value there, because of so much more complexity."

Many community banks also have a takeout premium baked-into their share prices. But there's no way Bank of America is going to be taken over.

Strong Loan Growth

"Loan growth was relatively strong and in most cases better than expected," according to Rodis, who last week summarized in a report the second-quarter performance for the banks he covers.

"The growth for most banks continues to be driven by commercial loans (C&I and CRE) and to a lesser degree by consumer loans including mortgages for some banks."

C&I loans are commercial and industrial loans not secured by real estate. This is a coveted loan type for all banks during this recovery cycle. CRE loans are commercial real estate loans, which many banks have shied away from during the recovery.

Only four of the 19 banks covered by Rodis saw sequential declines in net interest income during the second quarter. About half of the group saw net interest margins declining, but "the pace of decline appears to be slowing," Rodis wrote.

The release of loan loss reserves continues to pad earnings for many banks, and Rodis pointed out that among the banks he covers, six had ratios of loan loss reserves to total loans above 2% as of June 30, implying significant further releases of reserves.

2 Midwest Community Bank Stock Picks

Among the 19 banks covered by Rodis, all are rated "market perform" except for Lakeland Financial ( LKFN) of Warsaw, Ind., and Mercantile Bank ( MBWM) of Grand Rapids, Mich.

Rodis rates Lakeland Financial "outperform," with a price target of $35, implying 11% upside from Friday's closing price of $31.52. The shares trade for 13.1 times Rodis's 2014 earnings estimate of $2.40 a share. His 2013 EPS estimate for Lakeland is $2.26.

"Lakeland is a relatively high performing regional bank and the one thing that stands out for them is that they have grown earnings organically by just taking business from the bigger banks," Rodis says. "They have never done an acquisition and I don't expect them to."

Lakeland had $3.0 billion in total assets as of June 30. The bank's first-quarter return on average assets (ROA) 1.25% and its return on average tangible common equity (ROTCE) was 12.21%, according to Thomson Reuters Bank Insight.

During the second quarter, Lakeland grew its loan portfolio by over 3% from the first quarter to $2.33 billion. Commercial loans were up 5.5% quarter-over-quarter. The growth of total loans "was the best quarterly growth rate in a number of years and was above our estimate of +1.5%," Rodis wrote in note on July 25, following the bank's earnings announcement. "By market, the growth was driven by increased lending activity in South Bend, Elkhart and Fort Wayne. For the remainder of the year we are now modeling quarterly loan growth of 2.0-2.5% which is up from 1.0-1.5%."

In addition to the growth prospects, Lakeland pays a quarterly dividend of 19 cents a share, for a yield of 2.41%.

Rodis also rates Mercantile Bank Corp. "outperform," with a price target of $22, implying 18% upside from Friday's closing price of $18.70. The shares trade for 15.9 times Rodis's 2014 EPS estimate of $1.38. His 2013 EPS estimate is higher at $1.70, because the bank has been transferring money from loan loss reserves this year, rather than simply allowing reserves to draw down.

Mercantile Bank "is a bit of a turnaround story," according to Rodis. "Being in Michigan, they did see a rise in nonperforming assets, or NPAs as the economic environment slowed dramatically. NPAs are down 70-80% from peak levels."

A major feather in Mercantile Bank's cap is that it was able in 2012 to fully repay $31.6 million in federal bailout funds received through the Troubled Assets Relief Program, or TARP, without raising capital. "This management team has not diluted shareholders through this whole process," according to Rodis.

"They have a lot of capital and the balance sheet appears to be growing again," Rodis added. "They showed some decent loan growth during the quarter. I would expect them to continue growing organically, without acquisitions."

Mercantile Bank had $1.3 billion in total assets as of June 30. During the second quarter, "loan growth was better than expected with the portfolio increasing 3.5% Q/Q vs. our +0.5% estimate," Rodis wrote in a note on July 16. "This was MBWM's best quarterly growth rate since 2008. Origination activity improved to $76 Mil. from $50 Mil. last quarter," he wrote.

Mercantile Bank's first-quarter ROA was 1.18% and its ROTCE was 10.64%.

Mercantile pays a quarterly dividend of 12 cents a share, for a yield of 2.57%, based on Friday's market close.

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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