Eagle Bancorp Still Offers Rate Leverage, But Growth Will Be More Challenging (EGBN)

Despite higher funding costs and more economic uncertainty, there was still progress for Eagle Bancorp (NASDAQ:EGBN) on multiple fronts in 2022. Not only was the company’s performance generally better than expected (versus the start of the year), with more consistent loan growth and good rate leverage, but the company also largely resolved significant outstanding legal issues. Going into 2023, though, challenges remain – while Eagle is still meaningfully rate-sensitive, the Washington property market isn’t looking as strong and loan growth, as well as effectively funding that growth, looks to be more challenging.

If long-term core earnings growth in the neighborhood of 4% to 5% is still a valid assumption, Eagle shares look modestly undervalued today. A healthier D.C.-area real estate market would be helpful, as would a greater shift toward in-office work, but I would also note that the bank has been active in returning capital to shareholders, and I would expect that to continue if the bank cannot find sufficiently attractive lending opportunities over the next year or two.

Rate Leverage Continues To Drive Performance

Eagle had a good quarter on balance, as the bank continued to benefit from its above-average rate leverage (a largely variable-rate commercial loan portfolio) and strong operating leverage. Expenses were higher than expected, mitigating pre-provision profit growth, and the bank did get a boost from a lower tax rate, but I’m not going to look askance at a pre-provision beat.

Revenue rose a little less than 4% from the prior year and about 2% from the prior quarter, good for a 6% beat (or about $0.14/share) relative to sell-side expectations. Net interest income rose almost 10% year over year and 2% quarter over quarter, with net interest margin driving the growth. Net interest margin improved 59bp yoy and 12bp qoq to 3.14%, while earning assets declined about 2% sequentially.

Non-interest income has never been a big contributor to Eagle’s earnings, and that remains the case (at around 6% of revenue). Non-interest income fell 45% yoy and was basically flat with the prior quarter on a core basis. The biggest driver of the year-over-year decrease was a sharp decline in gains on loan sales.

Operating expenses declined 1% yoy and 7.5% qoq, with legal expenses down 15% yoy and up 9% qoq (close to 7% of total expenses). The efficiency ratio of 42.8% still compares quite favorably to most peer banks, though I would expect higher wages and FDIC insurance costs to create some pressures in 2023.

Pre-provision profits rose 7% yoy, but declined 2% qoq on the higher opex. Pre-provision profits were about $0.08/share higher than I expected, and much of the rest of Eagle’s outperformance (relative to sell-side EPS expectations) came from a lower tax rate.

Loan Growth, Deposit Costs, And Credit Quality Looking More Challenging

Eagle reported a little more than 1% sequential growth in loans on an average balance basis and better than 4% growth on an end-of-period basis, and the bank did okay relative to smaller banks in the fourth quarter. C&I lending grew 5%, a strong relative result, while CRE lending grew close to 6%, well above system-wide growth in the quarter.

With a meaningful skew to variable-rate lending, Eagle remains quite asset-sensitive (meaning that net interest income goes up with higher rates), with strong loan rate leverage. Loan yields grew 142bp yoy and 77bp qoq to 5.87%, one of the higher loan yields of the banks I’ve written up so far (which is typical for Eagle).

On the deposit side, average deposits declined almost 4% qoq (down less than 1% end of period), with non-interest-bearing deposits up more than 2% qoq on an average balance basis and up 7.6% on an end-of-period basis. Deposit costs rose 141bp yoy and 80bp qoq (to 1.65%), with interest-bearing deposit costs up 241bp yoy and 108bp qoq to 2.79%, a high rate of change relative to most banks. Indeed, Eagle’s cumulative deposit beta is now 33%, well above the low-to-mid-20%’s that seems likely to be the typical result this quarter.

Credit quality looked fine, with net charge-offs, non-performing assets, and non-performing loans all at low levels. I’d suggest interested readers peruse the 10-K when it comes out with an eye toward the criticized loan numbers – this metric improved in 2022, but a criticized loan ratio of 8.5% (all “non-pass” loans) is still fairly high.

On that subject, management sounded some cautious notes about the Washington, D.C. office market. Eagle’s office portfolio is $841M (or around 17% of the CRE portfolio), with about 20% of that in the central business district. While the average loan-to-value ratio of 53% looks fine, management noted much higher vacancies in Class B properties versus Class A, and Eagle has typically focused on “B” credits. Vacancies are being driven by work-from-home, but a slowing economy is an added concern going into 2023 and could explain the higher ratio of loans in the “watch” category.

Management did say, though, that they still see opportunities for lending in high-quality CRE and C&I, and with more and more banks getting more cautious on lending, I could see Eagle possibly picking up share in Class A lending in 2023-2024. Deposit costs are likely to head higher, but the bank does remain highly asset-sensitive with likely two more Fed rate hikes left to go.

The Outlook

I believe Eagle is past its legal issues – a shareholder lawsuit was settled in 2021, the company settled with the SEC and Federal Reserve in August of 2022, and the SEC announced in October of 2022 that it had concluded its investigation of CFO Charles Livingston and was not recommending any enforcement action. As is often the case in such settlements, the bank formally didn’t admit to or deny the SEC’s allegations (essentially making false statements and disclosures about related-party transactions engaged in by the former CEO), but agreed to pay over $13M (including a $10M civil penalty) and agreed not to violate these rules in the future.

Looking at the business prospects, I do have concerns around weaker CRE loan demand in the metro D.C. area in 2023, but it’s worth noting that the presence of the federal government (and many corporations that do business with the government) typically means that the D.C. CRE market is more stable than other metro office markets. So while I think growth is a risk, I’m not quite as concerned about credit quality relative to other office-driven CRE markets.

I expect further rate leverage in 2023, as I don’t believe the Fed is done raising rates, but securing funding at good rates will be more challenging – the loan/deposit ratio is close to 90%, and while the bank has sticky non-interest-bearing deposits, I believe costs remain a threat. I also don’t see a lot of opportunity to drive meaningfully better operating leverage; legal expenses should decline but Eagle runs a tight ship already.

I’m expecting weaker core earnings in FY’23 and FY’24, pushing medium-term core earnings growth into the low single-digits (I expect a meaningful rebound in 2025), but I think long-term core growth in the 4% to 5% range is still attainable, and that still supports a fair value in the low-$50’s. I get a broadly similar result on the basis of near-term ROTCE-driven P/TBV (1.4x multiple supporting a $50 fair value) and P/E (using a 10.5x multiple on my ’23 estimate).

The Bottom Line

I do believe that investors can reasonably expect a total long-term annualized return in the low-to-mid-teens, with near-term undervaluation more in the 5%-10% range. I do think sentiment remains a risk as the economy slows further and I don’t expect the Fed to ease up until 2024. When I last wrote about Eagle, I thought the valuation was okay, and the shares have since modestly outperformed the peer group.

On the other hand, this is a bank with a trailing tangible book value growth rate above 10%, a good deposit base, and a good history of writing profitable commercial loans to smaller commercial customers in the D.C. area. While I do expect more intense competition in the D.C. area (from newcomers like Pinnacle (PNFP) and the like), I think this is a reasonable prospect today and a more interesting one should the price retreat to the low-$40s.