Associated Banc-Corp: Convincing Skeptics Through Good Execution (NYSE:ASB)

For many years, Associated Banc-Corp (NYSE:ASB) was basically an also-ran bank with an okay deposit base, but a poor record relative to peers in terms of net interest margin, efficiency ratio, PPNR growth and margin, and credit quality. New management has brought in new strategies, though, and Associated Banc-Corp (“Associated”) is starting to build credibility around the idea that this new approach will drive sustainably better results over the long term.

I’d describe valuation today as more “okay” than compelling, as long-term growth on the high-end of the mid-single digits supports a mid-$20s fair value. That said, as the company executes, it will argue for lower discount rates and outperformance could be reinvested in the growth of the business, leading to a long-term compounding effect that makes today’s valuation look quite a bit more compelling.

Good Core Results

Associated posted strong third quarter results, particularly on a core pre-provision basis. Core EPS beat expectations by about $0.03, which seems to be an oddly common margin of outperformance this quarter.

Revenue rose 27% year over year and 14% quarter over quarter, beating expectations by around 4% on a core adjusted basis. Net interest income rose around 43% yoy and 22% qoq on an FTE basis, beating expectations by around $0.09/share. While wider spreads absolutely made a major positive difference, as net interest margin expanded 75 bp yoy and 42 bp qoq to 3.13%, beating by 24 bp. Associated had one of the best volume growth performances of the banks I’ve analyzed so far, as average earning assets rose 9% yoy and 5% qoq.

Fee income fell 15% yoy and 12% qoq, hurt by a sharp decline in mortgage banking income, as well as declines in the wealth management business. Relative to expectations, Associated missed by about $0.025/share here.

Operating expenses rose 8% yoy and 4% qoq, missing slightly in absolute terms, but outperforming by about 200 bp on an efficiency ratio basis. Pre-provision profits jumped 65% yoy and 29% qoq, beating expectations by about $0.06/share. Higher provisioning expense clawed back a little more than $0.03/share.

Robust Balance Sheet Growth As Growth Initiatives Are Ahead Of Schedule

Associated announced some significant strategic shifts a year ago that were aimed at growing the company’s commercial and consumer lending operations by expanding core middle-market C&I lending and entering into asset-backed/equipment finance lending and indirect auto lending. Since that time, the company has exceeded expectations with growth in these businesses.

Overall, loans rose 18% yoy and 5% qoq in end-of-period terms and 13% yoy and 7% qoq in average balance terms, with the former coming in well ahead of most banks this quarter. Consumer lending outpaced commercial lending (growing 6% qoq versus 4% qoq), but both were strong.

C&I lending was in line with industry trends with 2% qoq growth while asset-backed lending grew 33% sequentially off a low base. CRE was also strong, growing 5%, despite reports elsewhere of growing caution among CRE borrowers. Auto lending jumped another 32% sequentially (to over $1.1 billion) while mortgage loans increased by about 4%.

Loan yields aren’t exceptional at 4.06%, but Associated saw a very large improvement here (up 114 bp yoy and 90 bp qoq), as higher-yielding categories like asset-backed lending grow.

I really like these growth initiatives. Middle-market lending has been driven in part by the hiring of new relationship managers (loan officers) from rival banks, and management seems to be working toward making Associated a desirable place to work for productive managers. Asset-backed lending and indirect auto lending certainly carry some risks, but I see the former as a strong growth category while the latter benefits by many banks exiting the space in recent years.

It’s going to take time to see how these initiatives really play out. It’s far too soon to get any meaningful feedback on Associated’s underwriting quality, and it wouldn’t be unprecedented by any means to see some time down the road (three to five years) that the bank misestimated the risks and has to pay the price in terms of higher charge-offs. In the meantime, though, these are markets that can support significant growth, and Associated won’t have to worry about headwinds like elevated payoffs.

One other concern to monitor is the cost of this growth. Associated actually did pretty well with its deposits, as non-interest-bearing deposits rose 2% qoq (while most banks are seeing contraction), and total deposit costs are still attractive at 36 bp (up 25 bp yoy and 30 bp qoq). Unfortunately, the loan/deposit ratio is now in the 90%s, and the bank is having to take on higher-cost funding like FHLB advances (up 133% yoy and 16% qoq, with a yield of 2.51%). It’s still profitable for Associated to pursue loan growth with these funding sources, and the bank still has above-average asset sensitivity, but there will be more of a drag on spreads and profit growth as the deposit beta rises.

The Outlook

Given the pedigree of senior management (the new CEO and CFO are from Huntington (HBAN)) and the focus on hiring quality relationship managers from other banks, I’m not overly concerned that these new lending initiatives will lead to elevated credit costs, but I also am using a somewhat higher discount rate for now to reflect the uncertainty and risk.

I do see some risks to lending categories like mortgages and C&I lending in 2023 as higher rates work into the economy, but I think the opportunities to take share in middle-market, asset-backed, and indirect auto lending can still drive differentiated (mid-to-high single-digit) loan growth and strong double-digit pre-provision profit growth.

I’m looking for core earnings growth in the high-single digits over the next five years, slowing to a long-term core earnings growth rate around 6%. With that, I believe the company can and will put its legacy of sub-optimal returns (ROE, ROTCE, et al.) behind it, but there’s still a lot left to prove here.

The Bottom Line

Sentiment is an issue for all bank stocks now, and Associated has the added burden of convincing this Street that this new growth strategy is prudent and attainable. So far so good, I would say, but it is still early in the process. Discounted core earnings, ROTCE-driven P/TBV, and P/E support a fair value in the mid-$20s, a decent return from here, but there is rerating potential if and when the bank can convert more skeptics to believers.