Old Second Bancorp: High Interest Rate Sensitivity in Topline Drives Earnings (NASDAQ:OSBC)

Earnings of Old Second Bancorp, Inc. (NASDAQ: OSBC) will likely continue to grow this year on the back of significantly higher margins. Additionally, slowing loan growth should provide some support for bottom line earnings.Overall, I expect the company to report earnings $1.90 per share in 2023, up 31% from my estimated earnings of $1.45 per share in 2022. The December 2023 target price suggests a moderately high uplift from current market prices. Therefore, I have a Buy rating on Old Second Bancorp.

Rate hikes and high rate sensitivity to boost margins

Old Second Bancorp’s net interest margin surged 77 basis points in the third quarter following a 31 basis point increase in the second quarter of 2022. The strong margin expansion was partially due to an improved loan mix as management shifted funds away from lower yields. Securities to high-yield loans. As we noted in our 10th quarter filing, the average yield on securities in the third quarter was just 2.52%, while the average yield on loans was 4.93%.

Margin widening is also due to Federal Funds rate hikes and a heavy commercial loan portfolio that is easy to repricing. I expect another 75 basis points of Fed Funds rate hikes in the first half of 2023 before rates plateau in the second half of 2023. Yields are therefore likely to continue to rise this year, which will boost profit margins.

You will also benefit from a moderate balance of interest-free deposits. Interest-free deposits accounted for 39.7% of total deposits as of the end of September 2022.

Results from management’s interest rate simulation model show that a 200 basis point increase in interest rates, as noted in the 10-Q filings, could increase net interest income by a whopping 17.3%. Given these factors, we expect margins to increase by 20 basis points in the fourth quarter of 2022. We expect margins to increase another 20 basis points in 2023.

Slowing loan growth underpins earnings

Old Second Bancorp loans continued to grow strongly in the third quarter of 2022. His portfolio increased by 6.7% during the quarter. This is quite remarkable given the history of the company. Historically, the company’s organic loan growth has been in the high single digits to he mid single digits. I expect rising interest rates will force loan growth to return to this historic trend. Management also said on the conference call that it expects loan growth to slow in the fourth quarter compared to the third and second quarters. Nonetheless, management is positive about loan growth in the fourth quarter. That’s because the pipeline at the start of the quarter was better than the same period last year.

Old Second Bancorp operates primarily in Illinois, where the economy is not doing as well as in other regions. The state now has the second lowest unemployment rate among all states, according to official sources. In addition, economic activity in the state is in worse shape than in other parts of the country. As you can see below, Illinois’ economic activity trendline is flatter than the national average.

Taking these factors into account, we expect our loan portfolio to grow 3% in the fourth quarter of 2022, for full-year loan growth of 17%. In 2023, he expects his loan portfolio to grow by 3.5%. In addition, we expect deposits to grow in line with loans. The following table shows my balance sheet estimates.

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Revenue expected to surge 31% this year

Expected margin expansion could be the biggest earnings driver in 2023. On the other hand, the increase in operating costs due to inflation limits the increase in profits. Management said on a conference call that it is under wage pressure and has already raised wages significantly across its retail network.

In the meantime, we expect preparation costs to remain close to normal levels. We expect net preparation costs to account for about 0.1% of total lending in 2023, which is close to the 2017-2019 average.

Overall, Old Second Bancorp expects earnings of $1.45 per share in 2022, up 122% year over year. In 2023, we expect earnings to grow 31% to $1.90 per share. The following table shows my income statement estimates.

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My estimates are based on certain macroeconomic assumptions that may not materialize. Therefore, your actual earnings may differ significantly from my estimates.

Adoption of purchase evaluation

Old Second Bancorp offers a dividend yield of 1.2% at a current quarterly dividend rate of $0.05 per share. Earnings and dividend estimates suggest a payout ratio of 10.5% in 2022, which is in line with the five-year average of 8.7%. Therefore, we do not expect the dividend level to increase.

I value Old Second Bancorp using historical price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples. of the past 1.39 as shown below.

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Multiplying the average P/TB multiple by the projected tangible book value of $9.5 per share yields a target price of $13.2 at the end of 2023. This price target represents a 22.4% decline from the January 6 closing price. The following table shows the target price sensitivity to the P/TB ratio.

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As you can see below, the stock has historically traded at an average P/E of around 13.0x.

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Multiplying the average P/E multiple by the projected earnings of $1.90 yields a target price of $24.6 at the end of 2023. This target price represents a 44.8% increase from the January 6 closing price. The following table shows the sensitivity of the target price to the P/E ratio.

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Equally weighting the target prices from the two valuation methods yields a total Target price $18.9, which represents an increase of 11.2% from the current market price. Adding future dividend yields gives a total expected return of 12.4%. Therefore, I have a Buy rating on Old Second Bancorp.