CPF - Central Pacific Financial: Dividend Is Attractive But Earnings Outlook Is Worrisome

2023-07-28 12:37:44 ET

Summary

• I have slashed my earnings estimate as I’ve reduced both my margin and loan growth estimates for the year following the first half’s disappointing results.
• CPF is offering a dividend yield of 5.8%. Despite the earnings outlook, the dividend payout appears safe.
• The year-end target price suggests a moderately-high upside from the current market price.
• CPF has large unrealized losses on its securities portfolio.

Earnings of Central Pacific Financial Corp. ( CPF ) will likely decline this year because of the downtrend of the margin. On the other hand, subdued loan growth will likely support earnings. Overall, I’m expecting the company to report earnings of $2.24 per share for 2023, down 16% year-over-year. Compared to my last report on the company, I’ve significantly reduced my earnings estimate as I’ve decreased both my loan growth and margin estimates. The year-end target price suggests a high upside from the current market price. Further, Central Pacific is offering an attractive dividend yield. Therefore, I’m maintaining a buy rating on Central Pacific Financial Corp.

Changes in the Deposit Mix are Likely to Pressurize the Margin

The net interest margin declined further in the second quarter of 2023, which was worse than my expectation. The first half’s downtrend is especially disappointing because the existing balance sheet is asset sensitive, which means that the net interest income is positively correlated to interest rates. The management’s rate-sensitivity analysis given in the 10-Q Filing shows the correlation.

The decline is attributable to a continued deterioration of the deposit mix. The chart below shows how time deposits (light red bar) have grown while non-interest-bearing deposits (light green) have dipped over the quarters.

There is still room for further deterioration because non-interest-bearing deposits currently make up 29.5% of total deposits, which is still higher than the level of 27.5% at the end of December 2016. The ongoing up-rate cycle (I’m expecting another 25 basis points rate hike in September) will provide depositors the incentive to switch their funds away from zero and low-interest paying accounts to higher-yielding accounts.

As a result, I’m expecting the margin to dip by a further ten basis points in the second half of 2023. Compared to my last report on the company, I’ve reduced my margin estimate because the deposit mix trend has been worse than I previously anticipated.

Hawaii’s Economy Gives Hope that Loan Growth Could Turn Positive

Central Pacific’s loan growth also disappointed me in the second quarter of 2023. The loan portfolio dipped by 0.7% during the quarter. Going forward, I’m expecting a better performance because most of Hawaii’s economy seems strong. The state’s unemployment rate has dipped this year and the coincident economic activity index has improved, which bodes well for overall loan growth.

However, there are obvious signs of a slowdown as well. Real-estate loans make up 77% of Central Pacific Financial’s total loans; therefore, the condition of this industry will play a pivotal role in the company’s loan growth. As seen below, payrolls in the real-estate segment have been on a downtrend so far this year, which gives a negative signal regarding the health of this industry.

Within the real-estate segment, residential mortgages are likely to suffer from high interest rates which will make homes less affordable. Further, the house price index is still very high in a historical context despite the recent easing of prices. The residential mortgage segment makes up 35% of total loans.

Considering these factors, I'm expecting loan growth to improve to 1.0% in each of the last two quarters of 2023. The following table shows my balance sheet estimates.

In my last report, I projected earnings of $2.66 per share for 2023. I’ve slashed my earnings estimate as I’ve decreased my loan growth and margin estimates.

Unrealized Losses Bear Monitoring

Gross unrealized losses on the available-for-sale securities portfolio totaled $122.5 million at the end of June, which is a sizable 26% of the total equity balance. As the up-rate cycle hasn’t ended yet, there is a good chance that these unrealized losses will increase in the second half of 2023. I’m not expecting Central Pacific Financial to sell its securities; nevertheless, the risk remains that these unrealized losses could turn into realized losses and hurt the earnings per share.

Apart from the unrealized losses, the company’s risk level is low. Uninsured deposits are well covered; therefore, the deposit book doesn’t carry much risk. Total available sources of liquidity as a percentage of uninsured and uncollateralized deposits was 128%, as mentioned in the 10-Q filing. Further, none of the asset quality ratios are problematic, so the loan portfolio’s credit risk also appears manageable.

CPF Offering a High Dividend Yield of 5.8%

Central Pacific Financial is offering a high dividend yield of 5.8% at the current quarterly dividend rate of $0.26 per share. The earnings and dividend estimates suggest a payout ratio of 46% for 2023, which is the same as the last five-year average. Therefore, my earnings outlook is not a threat to the dividend payout.

Further, the existing capital level is comfortable; therefore, it’s highly improbable that the company will cut its dividend to shore up its capital. Central Pacific Bank reported a total risk-based capital ratio of 13.5%, which is significantly above the minimum regulatory requirement of 10.0%.

Maintaining a Buy Rating

I’m using the peer average price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples to value Central Pacific Financial. Peers are trading at an average P/TB ratio of 1.1 and an average P/E ratio of 9.5, as shown below.

Multiplying the average P/E multiple with the forecast earnings per share of $2.24 gives a target price of $21.2 for the end of 2023. This price target implies a 17.6% upside from the July 27 closing price. The following table shows the sensitivity of the target price to the P/E ratio.

Equally weighting the target prices from the two valuation methods gives a combined target price of $20.2 , which implies a 12.0% upside from the current market price. Adding the forward dividend yield gives a total expected return of 17.8%. Hence, I’m maintaining a buy rating on Central Pacific Financial.

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