National Bankshares Appears Pricey – National Bankshares, Inc. (NASDAQ:NKSH)

National Bankshares’ (NKSH) earnings are expected to decline next year due to a compression in net interest margin and constrained growth in non-interest expense. The loans portfolio, which had declined in the third quarter, is expected to recover in 2020. This recovery will offset some of the negative impact of lower net interest margin on the bottom line.

Loan Growth to Recover Next Year

NKSH is a community bank based in Southwest Virginia; therefore, its earning assets growth depends on Virginia’s economy. Uncertainty related to trade tensions and global economic slowdown has already started hurting the US economy, but Virginia’s economy is still showing strength relative to the rest of the nation. The state’s unemployment rate has declined much sharply in recent months than the national average, as shown in the chart below.

Data by YCharts

Loans declined in the third quarter by 1% on a linked quarter basis. I expect some improvement in loan growth next year because of the relative strength of Virginia’s economy. Moreover, a decline in prepayments and re-financing activity once the Fed starts holding rates steady is likely to buoy the loan book. As a result, I’m expecting loans to decline by 0.5% in 4QFY19, which is a lower rate than the decline in 3QFY19. I’m expecting the loan book to return to an upwards trend in 2020, posting a low growth of 1.0% year over year.

The table below shows my 2020 estimates for loans and other key balance sheet items. I’m expecting deposit growth to outpace loan growth in line with the recent trend, which will eliminate the need to increase expensive borrowings.

National Bankshares Balance Sheet Forecast

Improvement in Deposit Mix to Provide Some Relief to Margin

The company’s yields are expected to continue to decline in the coming months due to a lagged effect of the three rate cuts by the Fed this year. As a result of the reduction in average yields on earning assets, NKSH’s net interest margin, NIM, is expected to come under pressure in the coming quarters.

The detrimental effect of declining yields on NIM is expected to be partly offset by deposit re-pricing. Moreover, NKSH’s deposit mix continued to improve in the third quarter, which will offer further relief in a declining interest rate scenario. The proportion of non-interest bearing deposits increased to 20.4% by the end of September 2019, up from 19.0% at the end of June 2019, and 18.6% at the end of December 2018.

Based on the above-mentioned factors, I’m expecting NKSH’s NIM to dip by 3bps in 4QFY19, and then 2bps in each of the first and second quarters of 2020. For full-year 2020, I’m expecting average NIM to be 6bps below the average NIM for 2019.

National Bankshares Net Interest Income

Net Interest Income Compression to Drag Earnings

The NIM contraction is expected to undermine loan growth, thereby leading to a decline in net interest income. This decline, along with a low (1.4%) increase in non-interest expense, is expected to lead to a reduction in the bottom line. As shown in the table below, I’m expecting NKSH’s earnings to dip 5.1% to $15.9 million in 2020, or $2.45 per share.

National Bankshares Income Forecast

Dividend Expected to be Maintained

I’m expecting NKSH to maintain its semi-annual dividend in 2020 at the current level of $0.72 per share. This estimate will lead to full-year dividend of $1.44, implying a forward dividend yield of 3.2%. Despite the prospects of earnings decline, I think there is very little chance of a dividend cut as the dividend and earning estimates suggest a payout ratio of 58.8% for 2020, which is only slightly above the company’s five-year average of 53%. Moreover, the company’s dividends face very little threat from regulatory requirements as NKSH’s Tier I Capital to Risk Weighted Assets ratio was reported at 22.48% at the end of September 2019, which is far above the regulatory requirement of 8.50%.

Retained Earnings to Increase Equity by 4%

NKSH’s equity book value is expected to grow 3.8% next year mostly due to retained earnings. The company’s current share buyback program can reduce equity book value in the coming months, but I have not incorporated the plan in my estimates as the current market price is much above the price that the management appears to regard as attractive. As mentioned in the 3QFY19 10-Q filing, the company bought shares at an average price of $33 in the third quarter. This means that the management deems a price in mid-$30s to be attractive, which is far below the stock’s current market price of $45.7.

I’m expecting the equity book value growth to lead to book value per share of $29.9 at the end of December 2020.

Target Price Implies Potential for Capital Depreciation

I’m using the historical price to book ratio, P/B, to value NKSH. The company has traded at an average P/B multiple of 1.42 in the past, as shown in the table below.

National Bankshares Historical Price to Book

Multiplying the average P/B ratio with the forecast book value per share of $29.99 gives a target price of $42.6 for December 2020. This price target implies a 6.7% downside from NKSH’s November 20 closing price. The table below shows sensitivity of the target price to P/B ratio.

National Bankshares Valuation Sensitivity

Conclusion: Adopting Neutral Stance

As the one-year ahead target price is below NKSH’s current market price, I believe the stock price can decline in the months ahead. Based on the single-digit price downside, I’m maintaining a neutral rating on the stock. My previous rating on the stock was also neutral. While NKSH is currently not trading at an attractive price, I believe the stock price can become attractive if it dips to $38.7, which is an entry point that is 10% below the target price. I recommend buying at or below this entry point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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