Merchants Bancorp: Low Valuation Warrants Further Research

Investment Thesis

Merchants Bancorp (NASDAQ:MBIN) better known as Merchants Bank of Indiana, is headquartered in Carmel, Indiana and primarily focuses on mortgage warehousing and retail banking. The company’s performance speaks for itself, as last year it was recognized by S&P Global Market Intelligence as the #1 best-performing US public bank and has assets of over $11 billion. Merchants Bank has also been named by Fortune Magazine as one of the fastest-growing companies in the country, as well as in the Indianapolis area.

In addition, it is the sixth-largest Indianapolis area bank and has been recognized by the Indiana Chamber of Commerce’s Best Places to Work Program for seven years in a row. This speaks somewhat to the quality of management, which is a topic that must be expanded upon later.

For one of the best-performing public US banks, the valuation is curiously low and does not seem to match up with the financial performance. The stock has a P/E ratio of around 5 and currently trades below book value. With an average return on equity of over 18% and incredible growth over the last six years, the stock should, in theory, be trading at much more of a premium. So, what gives?

Introduction – Carmel, Indiana

Being a native of Indiana, I am somewhat familiar with Carmel, Indiana, the city in which Merchants Bancorp is headquartered. The city is home to more than 40 corporate headquarters and many more regional offices, with many large companies’ national headquarters such as Allegion (ALLE), CNO Financial Group (CNO), Midcontinent Independent System Operator, and Delta Faucet. If you have spent any time in Carmel, you may remember the place as the city of many roundabouts, the home to one of the largest farmers markets in the state, or perhaps the bustling Carmel Arts & Design District.

To put it bluntly, Carmel is one of the richest cities in Indiana. The smaller areas surrounding Indianapolis are more quiet, relaxed areas with suburbs which attract wealthy people and support a growing population which has benefited Merchants Bancorp in recent years. In places like Carmel, Indiana, unemployment is very low, poverty is scarcely found, and wages are rising, supporting an upper-middle class that is expanding.

In a study which analyzed nearly 500 cities and considered annual household income, property values, percentage of homes without a mortgage, and average credit limits, the results were of no surprise to me;

Carmel is ranked as the second richest city and Fishers ranks fifth among municipalities with a population of at least 65,000. Nationally, Carmel ranked 22nd and Fishers is ranked 58th among the 475 richest cities in the study. Data shows that 82.94% of people who live in Indiana’s wealthiest cities have a bachelor’s degree or higher.”

Source: carmelindianainfo.com

One thing that I found quite interesting were the demographic trends in these areas. In data from the previously cited study, the most common age group among the richest cities in Indiana was 25 to 44 years old, with an average of 20% of people with the highest income belonging to this age group. This likely means that current trends are sustainable, and there is not a ‘demographic cliff’ which the population of Carmel, Indiana will experience any time soon. The residents are on average highly educated, high-income earners, and young people looking to raise a family. I cannot think of a better place for a bank to operate.

Quality of Management

Following my initial research into Merchants Bancorp, one thing that stood out to me was the high quality of the management team. Michael Petrie, the Chairman has served as a Director at the company since 2002, and has previously served as the Chairman and President of Merchants Capital (formerly PR Mortgage & Investments), a multi-family finance company which he co-founded in the year 1990. Mr. Petrie is incredibly active in the mortgage banking industry and in the community, sitting on the Board of Directors for over six associations including the Indiana Affordable Housing Council and the Indianapolis Chamber of Commerce.

Most impressive to me as a Hoosier was the fact that Mr. Petrie was awarded the “Sagamore of the Wabash” award in 2004. This award is without a doubt the highest honor an Indiana governor can bestow, and is only given to those who demonstrate a distinguished service to the state or to the governor. Among those who have received this award have been astronauts, presidents, ambassadors, artists/musicians, and citizens who have been recognized as contributing greatly to the Hoosier state. This speaks volumes as to the quality of person Mr. Petrie is, and this is a major green flag for me in terms of assessing the management team at the company.

The CEO of Merchants Bancorp, Michael Dunlap, also has a decorated history and was responsible for establishing the warehouse lending platform and Merchants Mortgage. Mr. Dunlap has over 30 years of mortgage banking experience, and prior to joining the company in 2009, he served as the Chief Financial Officer of National City Mortgage (now a part of PNC Bank). He is also a graduate of the Kelley School of Business, which is nationally recognized as one of the top business schools in the United States.

Going through and researching other members of the management team here is a great place to start if you would like to learn more about the company. Many members of the management team have decades of experience in their respective industries, and this lends credibility along with the company’s observable financial history.

Mortgage Market Troubles?

While the stock performance of Merchants Bancorp has been very good over the last several years, 2022 was a year of correction for the company.

This is undoubtedly due to the macro environment of rising interest rates and a decline in demand for mortgages compared to 2021. While I do not have much experience analyzing bank stocks, I did write-up two companies related to the housing market/mortgages earlier this year: Green Brick Partners (GRBK) and AGNC Investment Corp. (AGNC).

These two companies have had mixed results since my original publications, but both are currently beating the S&P 500 when accounting for total returns (Green Brick is up nicely, AGNC’s book value has been crushed but dividends are helping the stock beat the market).

There is, however, a glimmer of hope for the mortgage market. Homebuilder sentiment just hit a new 12-month low, but the declines month-over-month were the least significant of this entire time period. This suggests that the housing and mortgage markets could be turning the corner soon, even though rates are still much higher compared to 2020 and 2021. All-cash purchases of homes are becoming more popular, but as rates top out and gradually come down, mortgage demand should swing back up. Just as recently as December 20th, 2022, front page news was made when it was announced that the bond king Bill Gross had bought some of the largest mortgage REITs, including AGNC Investment Corp.

Certainly the economy is slowing down and ultimately we’ve got a recession… if interest rates keep going up then we’ve got more than that… if the Fed continues to raise rates, the ability to equitize some of your housing, which is moving down in price, is going to be severely limiting. That will serve as a caution in the housing market”

Source: Bill Gross buys Annaly Capital, AGNC

This caution in the housing/mortgage market, which is related to interest rates, is likely why companies in this space are trading at such cheap valuations. While it is impossible to predict exactly what the Fed is going to do, many investors are sifting through the debris to find value in stocks related to housing and mortgages. Merchants Bancorp is an example of an interesting, small bank stock with exposure to a great market. Over the next few years, it is my opinion that the microeconomics will trump macroeconomics, but with so much uncertainty and my limited experience analyzing bank stocks, plus exposure to the sector already, I am holding off on buying shares in Merchants Bancorp at this moment. With more research, however, I may be interested in starting a position some time in 2023.

Earnings Growth and Dividends, Nice ROE

Financial performance has been quite good for Merchants Bancorp over the years. Since 2016, the bank’s net interest income has gone from $54 million to $278 million as of 2021. The company has an average net interest margin of around 2.5%, but in good times for mortgage demand such as in 2020, the NIM was closer to 3%.

Return on equity has averaged out at over 18% consistently, but a risk is that percentage could fall below 16%, as the most recent quarter showed a drop with trends that mirror 2018’s financial performance. In 2020 and 2021, the company’s ROE was over 23% but this was due to an unsustainable market environment, so it is not assumed that Merchants Bancorp can achieve that high return on equity in the near term.

Still, these are not bad numbers in the slightest. The growth is impressive, and earnings per share have gone from $0.98 in 2016 to a whopping $4.76 as of 2021. This year’s EPS is estimated to be similar and should come in around the same range or slightly lower than last year’s, despite the slowdown in mortgage demand. Growth in earnings is expected over the next two years, albeit not as dramatic as the last several.

Merchants Bancorp does pay a dividend, but it is small at 1.14%. The company has, however, steadily increased the dividend over the years. Trends in the dividend are good and stable. This, to me, shows that the company could eventually become a great dividend stock and attract a shareholder base surrounding this.

Another thing I should mention is I have read online that Merchants Bancorp’s management has a high level of insider ownership. Over the last twelve months, there was only one individual insider sale at a share price of $28.00, which coincides with the near-term top in the stock after the massive rally which took place from July 14th to August 9th, 2022. A high level of insider ownership is always good to see, as management appears to be aligned with shareholders and wants to create value over the long term.

Conclusion

Merchants Bancorp is an interesting small bank stock with exposure to a great market in Carmel, Indiana. The company has shown impressive growth over the last six years and boasts a high ROE, a P/E ratio of 5, and currently trades below book value. Why is the stock seemingly so cheap? For what reason, I am at a loss. The company seems great with a quality management team and high levels of insider ownership. It seems to me that exposure to the mortgage market could be seen as a risk and reason to stay away during this time of rising interest rates and a potential economic slowdown in 2023. ROE also could trend lower to around 16%, as the recent quarter showed a trend back towards similar financial performance seen in 2018. However, the company is forecasted to grow earnings over the next two years and has been increasing the dividend in a sustainable manner. For this reason, I could see potential that Merchants Bancorp could attract a shareholder base focused on dividend growth for future years. At this moment, I am really on the fence with the stock and recommend a rating of Hold until more research can be done. While I so far have little experience analyzing bank stocks, I intend to do a lot more research and sit on the sidelines until the stock presents with an attractive buying opportunity, likely in 2023.