Preferred bank runs on rate leverage, but the street isn’t all that interested (PFBC)

Ryan Heron

As far as the management of what is under their control is concerned, I cannot find much fault with Preferred bank (NASDAQ: CBFP) since my last update on this small Californian bank ($5 billion in assets). Rate leverage was very strong, operating leverage has been very strong and the credit quality has also been quite good. But, with banks out of favor, stocks have only done slightly better than the average regional bank since my last update, falling around 5% – beating the market by around 10%, as well as peers like is West (EWBC), Hope Bancorp (HOPE), and favorite pacific (PPBI), while underperforming Cathay General (CATY) by a few points.

The macro headwinds remain real, and I don’t expect the street to stop worrying about this issue for at least another quarter or two. The preference still has some leverage for further rate hikes, but the bank is already seeing loan demand destruction and I don’t see much sustainable operating leverage with loan growth. Long term I still think it’s a good bank and I think the valuation is attractive but it could be stagnant money until the street is ready to look past the coming downturn .

Rate and operating leverage drive strong growth

Preferred Bank had one of the best quarters I’ve seen from a bank, as the company combined strong rate leverage with excellent operating leverage (with strong credit quality on board as well).

Revenue was up 37% year over year and 17% quarter over quarter, which is very strong compared to the bank’s peer group. Net interest income fueled this growth, increasing 40% yoy and 18% yoy, as the bank’s net interest margin increased by more than one point (up 101 bps in yoy and 60 bps yoy to 4.37%); Preferred’s spread leverage was well above average this quarter, with the average small bank seeing an improvement in NIM of around 45 basis points year-over-year. Net interest income is a negligible contributor to revenue ($2 million of $69 million), but it was down 20% year-over-year and 16% year-over-year.

Operating expenses grew 13% year-over-year and 1.5% year-over-year, putting Preferred in the enviable position of below-average expense growth on well-above-average revenue growth. mean. So that brought the efficiency rate down more than five points year-over-year to 25.2% – one of the lowest I’ve seen in the space. Pre-provision earnings increased 47% year-on-year and 23% year-on-year, and Preferred’s small holding of securities resulted in minimal erosion of tangible book value due to market value losses, with book value tangible per share up approximately 3% sequentially.

Spread leverage remains a driver, but soft loan growth worth watching

Preferred had sequential loan growth at the end of the period of 2% after adjusting for PPP loans. Overall, it was a bit weak compared to its peers, although average loan growth (up 2.8%) was more in line. Commercial real estate loans were still quite strong, with a growth rate of 4% in the third quarter of 2022, about double the average. C&I loans, however, fell slightly in what was otherwise a good quarter for commercial loan demand, and the 1% qoq decline in construction loans was also abnormal in a quarter where a 4% growth was more the norm.

Management said it was seeing more caution and conservatism from its customers, leading to lower loan applications, and management also said its top priority had shifted to maintaining the credit quality in what it expects to be a recession.

As loan growth slows, Preferred is taking advantage of higher interest rates to earn higher loan yields. Average loan yields improved 91 bps yoy and 83 bps qq to 5.75%, well above their peers in terms of yoy/qq improvement (where 45 bps was higher). close to the norm) and absolute return (where the average is closer to 4.5% or 4.6%) . The preference doesn’t sacrifice quality to chase yield, however, as reserves look reasonable and lagging credit metrics like non-performing loans (0.12%) and write-offs (net recoveries during the quarter) look good.

Filing costs were a concern for me at the start of this year, but Preferred managed those costs relatively well. Deposits increased by 1% on a quarterly basis at the end of the period and by just over 1% on an average balance basis, although non-interest bearing deposits were down by around 3% (on on a quarterly basis, at the end of the period), which was worse than average .

Deposit costs rose, rising 41 bps yoy and qq to 0.77%, with both higher growth rates and a higher overall level of interest expense than peers (the average deposit costs were closer to 0.30%). Preferred suffers from a weaker exposure to non-interest bearing deposits compared to many peers (around 25% of deposits compared to an average of peers in the low to mid 30% range), but the cumulative beta of deposits bearing Bank interest is nevertheless average (24%) and the cumulative total deposit beta is also quite good at less than 20%.

Weaker loan demand should help ease some of the pressure on deposit costs that Preferred would otherwise see. Deposit costs will continue to rise from here (exit rate for September was close to 1% for deposits), but if loan growth is more subdued, the bank won’t have to compete/pay just as aggressively for deposits.

Perspectives

I see some risks to 2023 earnings expectations at this point; The preference has done very well in 2022 and the bank still has strong asset sensitivity (with at least one more Fed rate hike likely on the way), but if the rate hikes seen so far start to decrease the demand for loans, I have to think that another increase will further depress demand. Continued benefit from rate hikes should still lead to earnings growth, but a deeper slowdown could lead to more severe revisions going forward.

Longer term, I still expect high single-digit core earnings growth from Preferred as the bank continues to selectively expand its lending operations into new metro areas (such as its Houston expansion, in Texas). I also see the bank leveraging M&A activity in its footprint to add producing loan officers, but I don’t expect an aggressive push to grow the business.

The essential

Long-term core earnings growth of around 8% can support a double-digit annualized total return from here, which is relatively attractive. Similarly, stocks look undervalued below $90 based on both P/TBV (driven by short-term ROTCE) and P/E (with a 9.6x forward multiple).

There are many undervalued banks today, and investors should expect this excess sentiment to last for a few more quarters. I also don’t discount the risk of further earnings forecast cuts in 2023/24 on a slower growing (if not briefly contracting) economy. Still, for investors who can be patient, the valuation is attractive here and now, and those willing to wait should at least consider giving Preferred a spot on a watch list.