Plenty of Heat in Banknorth
By Evan Momios, CFA
Over the last two years, Banknorth Group (BNK ) has dramatically improved its growth prospects by expanding in demographically attractive markets. All the while, it has continued to report record profits. The multistate banking and financial services holding company is well-positioned to benefit from an economic pickup in its home market of New England and the integration of recently completed acquisitions.
We at Standard & Poor's believe Banknorth -- with its strong asset quality, 345 retail offices, nearly 500 ATMs, about 160,000 Internet banking customers, a top-40 insurance agency network, and an $8 billion money-management firm -- has built an attractive franchise. In light of its brightening prospects, Standard & Poor's has assigned the stock its highest investment ranking of 5 STARS (buy).
Prior to its acquisitions of Andover Bancorp and MetroWest Bank in the fall of 2001, Banknorth was viewed as a community bank with limited growth potential. With already strong market shares in Northern New England, it had to seek growth opportunities in new markets. The acquisitions extended Banknorth's branch-office network in the more vibrant communities of Greater Boston and marked the beginning of its aggressive expansion in the more attractive regions of Southern New England.
In mid-2002, Banknorth moved to bolster its growth by acquiring Ipswich Bancshares, which added eight branches to its Massachusetts franchise, for a total of 115 offices. In August, it purchased Bancorp Connecticut, adding seven branches in the state. Banknorth capped off 2002 with the acquisition of Massachusetts-based Warren Bancorp in December.
Banknorth has continued its acquisitive ways in 2003. In mid-February, it completed the purchase of American Financial Holdings in a move that quadrupled the size of its Connecticut franchise and made Banknorth the state's fifth-largest depository institution. About half of its loans and deposits are now located in Massachusetts and Connecticut, the state with the nation's second-highest per capita income.
S&P expects that Banknorth's assets, including American Financial Holdings, will total more than $26.5 billion as of the end of 2003's first quarter, up sharply from $18.1 billion on June 30, 2001. Management envisions assets growing to $30 billion to $40 billion in the next three years. Based on that assumption, S&P thinks Banknorth can achieve average annual growth rates of as much as 15% -- although growth of over 8% to 10% a year would likely require additional acquisitions.
Banknorth targets a top-three market share position (in terms of deposits) in all of its markets. That means it's likely to focus future acquisition activity in Southern New England. According to data provided by the Federal Deposit Insurance Corp., as of June 30, 2002 (the latest available) Connecticut is a $64.1 billion in deposits market. Banknorth has a top-three market share only in Hartford County, a $21 billion market. In Massachusetts, Banknorth is the fourth-largest retail bank, with a market share of less than 4% and a strong presence in Essex County, a $13.1 billion market, and in Worcester, a $2.3 billion market and New England's second-largest city.
Historically, management has pursued acquisitions that can add to earnings per share within one year. Banknorth has used cash and equity to finance acquisitions, but it has also repurchased a total of 18.5 million shares in the last three years. As of September 30, 2002, management had authorization to repurchase up to 7 million shares. Although we do not view share buybacks as the main reason to invest in Banknorth, we appreciate management's assertion that they'll buy back stock when they cannot identify reasonable acquisition opportunities.
Acquiring smaller thrifts enables Banknorth to realize operating cost savings via systems integration and the centralization of duplicate functions. Thrifts are primarily focused on mortgage-lending operations and often don't have a full menu of banking products for their clients. Banknorth can offer a wider range of products and services including insurance, investment planning, and investment management. As a result it's able to generate greater revenues per client compared to a thrift.
NOT MANY NONPERFORMERS.
In 2002, revenue equaled $1.1 billion, vs. $920 million in 2001 and $807 million a year earlier. Noninterest income accounted for 26% of total revenue and was well diversified among deposit service charges, trust and investment management fees, insurance brokerage fees, and merchant and electronic banking fees. Mortgage banking fees, which have boosted the results of many community banks in recent years, accounted for less than 1% of total revenue.
Banknorth's loan portfolio is well-balanced between commercial and retail loans. At yearend 2002, retail loans, including residential mortgages, and consumer loans and leases, represented 45% of the total, while commercial real estate loans and business loans and leases accounted for the balance. Nonperforming loans accounted for 0.28% of total assets, their lowest level in the last eight quarters. Net charge-offs, or loans that are no longer likely to be collected and are written off as bad debt expense, minus recoveries of payments previously charged off, were 0.27% of average loans in 2002's fourth quarter. That number has remained between 0.26% and 0.44% in the last eight quarters. The allowance for loan losses at yearend 2002 represented 1.45% of total loan, or more than 310% of nonperforming loans.
Excluding special charges, Banknorth posted operating EPS of $2.06 in 2002, vs. $1.75 in 2001. In 2003, S&P projects that figure to rise 8%, to $2.22. The shares recently traded at 10 times our operating EPS estimate, compared to 12 times for its industry peers, and at 1 times our projected five-year EPS growth rate of 10%, vs. 1.1 times for the peer group. In the last five years the shares have traded on average at a prospective price-earnings multiple of 12.5 which would imply a stock price of $28. Further, our three-stage dividend discount valuation model estimates the stock's intrinsic value in the range of $27 to $30.
We have therefore established a 12-month price target of $29, which implies potential capital appreciation potential of around 25% from the stock's recent quote of approximately $23.
Evan Momios is an equity analyst following commercial regional banks for Standard & Poor's