Earnings of National Bankshares (NASDAQ: NKSH) dipped by 17% quarter-over-quarter to $0.61 per share in the first quarter. The earnings decline was attributable to a hike in provision expense and dip in revenues. Earnings will likely decline further in the coming quarters because of an increase in provision expense on the back of a deterioration in the economy since the end of the first quarter. Moreover, the net interest margin will likely decline further following the interest rate cuts in March. On the other hand, moderate loan growth under the Paycheck Protection Program in the second quarter will likely limit earnings decline. Overall, I’m expecting earnings to decline by 10% year-over-year to $2.38 per share in 2020. The provision expense is difficult to predict due to the uncertainties related to COVID-19; therefore, there is a chance of a negative earnings surprise in the year ahead. The December 2020 target price suggests a high upside from the current market price. Nevertheless, I’m adopting a neutral rating on NKSH due to the risks and uncertainties.

Provision Expense Likely to Increase in Coming Quarters

NKSH booked a provision expense of $479 thousand in the first quarter of 2020, up from $200 thousand in the first quarter of 2019. The allowance for loan losses stood at 0.99% of total loans as of March 31, 2020, down from 1.02% at the end of March 2019. Further, the allowance-to-loans ratio averaged 1.27% for the years 2013 to 2018, which is much higher than the first quarter’s ratio. As a result, the current allowance appears to be too low for a pandemic, which will likely lead to higher provision expense in the coming quarters.

As mentioned in the first quarter’s 10-Q filing, the management considered economic factors, including unemployment, bankruptcies, and residential vacancy rates up till March 2020 to determine the provisions for the first quarter. The considerable deterioration in unemployment since the end of the first quarter will likely push up allowances in the remaining three quarters of the year.

In addition to basing the allowance for loan losses upon data analysis, NKSH has an option to increase the allowance based upon management’s judgment. As mentioned in the 10-Q filing, the company’s policy permits an unallocated surplus of up to 5% in excess of the calculated requirement. In order to incorporate the expected credit losses from the pandemic, the management booked as much unallocated surplus as possible in the first quarter. Nevertheless, the surplus allowance will most probably be insufficient to cover the pandemic-driven impairments in the last three quarters of this year. Hence, the provision expense will likely increase from the first quarter. Considering these factors, I’m expecting NKSH to book a provision expense of $1.6 million in 2020, up from $0.1 million in 2019.

Downward Stickiness of Costs to Hurt Net Interest Income

The 150bps cut in federal funds rate will likely squeeze the net interest margin, NIM, in the remainder of the year. NKSH’s NIM is fairly rate-sensitive because its funding cost is downward sticky. The company has a high proportion of low-costing deposits in its deposit mix, which gives the overall funding cost limited room to decline. According to details given in the 10-Q filing, low-costing deposits, including demand and savings deposits, made up 89% of total deposits as of March 31, 2020.

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A rate-sensitivity analysis conducted by the management shows that NIM was fairly sensitive to interest rate changes as of March 31, 2020. The following table from the 10-Q filing gives the results of the simulation.

From the above table, I can decipher that a 100bps interest rate cut can reduce net income by a mid to high single-digit percentage. Considering the factors mentioned above, I’m expecting NIM to decline by 11bps in the second quarter, and by 15bps in the full year. The following table shows my estimates for yield, cost, and NIM.National Bankshares Net Interest Margin

NKSH’s participation in the Paycheck Protection Program, PPP, will partially offset the adverse effect of NIM compression on net interest income. As mentioned in the 10-Q filing, NKSH funded $48.2 million of loans under PPP in April. Consequently, I’m expecting loans to increase by 6.5% sequentially in the second quarter, and then decline by 6% in the third quarter when the loans will get forgiven. Loan growth other than PPP will likely remain lackluster due to the COVID-19 related uncertainties and economic downturn. The heightened unemployment will dampen credit demand for consumer real estate, while the slowdown in business activity will curtail demand for commercial real estate. The consumer and commercial real estate segments are NKSH’s major areas of focus as altogether they made up around 74% of total loans as of the end of the first quarter. Based on these factors, I’m expecting loans to stand at $727 million at the end of the year, almost unchanged from the end of 2019. The following table shows my balance sheet estimates.

National Bankshares Balance Sheet Forecast

Expecting Earnings to Decline by 10%

The increase in provision expense will likely be the major contributor to an earnings decline in the year ahead. Additionally, the NIM compression will pressurize earnings, which will be partially offset by loan growth through the PPP. Overall, I’m expecting earnings to decline by 10% year-over-year to $2.38 per share. The following table shows my income statement estimates.

National Bankshares Income Forecast

Actual earnings can differ materially from estimates because provision expense is very difficult to predict amid the COVID-19 pandemic. The uncertainties related to the severity and duration of the pandemic make provision expense difficult to predict.

Risks Justify a Large Discount to the Fair Value

I’m using the historical price-to-tangible-book ratio, P/TB, to value NKSH. The company has traded at an average P/TB multiple of 1.48 in the past, as shown in the table below.National Bankshares Historical tangible Book Value Per Shares Multiplying the average P/TB ratio with the forecast tangible book value per share of $28.4 gives a target price of $42.1 for December 2020. This price target implies a 48.6% upside from NKSH’s July 2 closing price. The table below shows the sensitivity of the target price to the P/TB ratio.National Bankshares Valuation Sensitivity

Apart from the price upside, NKSH is also offering a dividend yield of 4.7%, assuming the company maintains its semi-annual dividend at the current level of $0.67 per share. As discussed previously, NKSH is carrying a high level of risk due to the COVID-19 pandemic. The risks justify a substantial discount to the target price; hence, I’m adopting a neutral rating on NKSH.

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.

Additional disclosure: Disclaimer: This article is not financial advice. Investors are expected to consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.