First Bancshares Has To Prove It Can Leverage Recent M&A, But Valuation Isn't Demanding

It may be a common way for banks to grow, smaller banks in particular, but growth by M&A is controversial with investors and the banks that do it often take a hit to valuation. That would potentially explain at least some of the underperformance at First Bancshares (NASDAQ:FBMS) since my last update, as well as over the last five years, but I’d also note an usually low earning asset beta that has limited net interest margin expansion during this rate cycle.

Heading into 2023 First Bancshares has a new acquisition to digest (Heritage Southeast) and the bank now finds itself operating in the very competitive Atlanta market. While I understand management’s desire to expand operations in growth markets like Florida and Georgia, running headlong into very competitive markets is a risk. I do believe that First Bancshares is undervalued if core earnings growth of around 7% is a valid assumption, but management needs to show that it can deliver on this more aggressive M&A plan.

Odd Results To Close The Year

First Bancshares closed the year with a modest miss at the EPS line and some unusual trends relative to larger regional banks that merit watching as 2023 develops.

Revenue rose 17% year over year, but declined almost 4% quarter over quarter, and sequential revenue declines have been rare outside of higher-growth banks this quarter (and First Bancshares doesn’t really qualify given low single-digit loan growth). Net interest income fell more than 2% quarter over quarter, with net interest margin up 23bp yoy and down 13bp qoq to 3.37% and earning assets up about 1%.

Non-interest income isn’t an especially large part of First Bancshares’ earnings, but declined about 10% sequentially.

Adjusted operating expenses rose 16% yoy and 5% qoq, with the efficiency ratio worsening by almost five points sequentially to 59.3%. Pre-provision profits declined 14% sequentially in a quarter where many banks posted healthy growth.

Challenging Balance Sheet Trends

First Bancshares isn’t asset-sensitive and that is compromising the bank’s earnings power in this period of higher rates. While the Fed funds rate climbed more than 400bp between the December 2021 and December 2022 quarters, First Bancshares’ realized loan yields were flat, and the bank’s cumulative loan beta is only about 9%.

While the bank still has attractive deposit costs, they are heading higher. Deposit costs rose 32bp yoy and 31bp qoq to just 0.51%, driving a very low cumulative deposit beta of 9%, but deposit costs are likely to head higher and the lack of leverage in earning assets (earning asset yields improved only 60bp yoy to 4.06%) is still a challenge.

I also see challenges from deposit outflow. This bank’s ratio of non-interest-bearing deposits to total deposits isn’t particularly special at 30%, and non-interest-bearing deposits shrank 8% qoq in the fourth quarter. On top of that, it’s typical for banks to see elevated deposit outflows after acquisitions, so the close of the Heritage deal could represent some downside risk there.

It’s not all terrible, though. A heavier skew of fixed-rate loans is a drag on margins when rates head higher, but yields eventually catch up and First Bancshares is putting higher-yielding loans onto the balance sheet now (though there is a longer-term risk of those loans being paid off early if rates fall again). Moreover, while overall loan growth was a little lackluster at 1.5% qoq, C&I and CRE loan growth of 3.6% and 2% weren’t bad relative to the broader banking sector.

Improving The Footprint, But At The Cost Of Increased Competition

When I last wrote about First Bancshares I thought it was a “when, not if” question that the bank would do more M&A, and they’ve been active since. I had expected management to target markets in or near the existing footprint, including Lafayette, Corpus Christi, Galveston, and Tampa, and while the Beach Bancorp deal did indeed bring them into Tampa (and grow their exposure to the Florida panhandle), the Heritage Southeast deal was more surprising.

Heritage was a more sizable deal ($207M deal value) and it brought the bank into markets like Atlanta and Savannah, Georgia and Jacksonville, Florida. Atlanta is a very popular market now and that’s part of the challenge I see – while there are attractive demographics here (in terms of population and household income growth), it’s a very crowded market and I think it may be more difficult for First Bancshares to stand out relative to other markets within their footprint that they could have targeted for growth.

First Bancshares didn’t overpay for Heritage, at least not based upon historical valuation norms for a bank with Heritage’s profitability, but there are aggressive rivals in that market (like Pinnacle (PNFP) and Synovus (SNV)) and I think attrition could be a greater risk given that competition.

The Outlook

I do see some near-term challenges for First Bancshares. The lack of asset sensitivity is a challenge, and it will take time for asset yields to catch up, and I’m concerned about rising deposit costs, even though the low deposit/loan ratio (below 70%) should take some of the pressure off. I also don’t see exceptional profitability here right now (as measured by pre-provision profits to earning assets), and that’s an area for improvement.

Even with those challenges, there’s still a place for commercial banks targeting smaller CRE lending, and there are good reasons that markets like Georgia and Florida are highly competitive (they’re attractive markets). I do think that First Bancshares can generate long-term core earnings growth on the low end of the high single-digits (around 7% to 7.5%), and that’s enough to support a mid-$30’s fair value on my discounted core earnings model.

Other approaches like ROTCE-driven P/TBV and P/E give me similar results, with the former giving me a 2.15x "fair” TBV multiple (a $38 fair value) and 10.5x my ’23 EPS estimate ($3.32, slightly below the Street average) giving me a $35 fair value.

The Bottom Line

A more accommodating Fed would be a good thing for First Bancshares at this point, and I do have some concerns that core pre-provision profits could lag ahead of more higher-rate loans coming onto the books. I likewise acknowledge the risk that I’m too bullish on loan growth and deposit retention, particularly in these new-to-FBMS markets. Those risks do seem amply priced into the shares, though, and I think this is a bank stock where good execution from management in 2023 could help drive rerating and a better share price.