PFBC - Peak Margins Complicates The Valuation Case For Preferred Bank

Summary

• Preferred posted strong net interest income growth in the fourth quarter, but higher operating expenses took a bite and deposit costs are rising rapidly.
• With Preferred seeing significant outflows of no-cost deposits, it's possible that the bank is at or near a peak for net interest margin, and operating costs are rising.
• I think Preferred could still see double-digit pre-provision profit growth in 2023, but a reversal in 2024 will likely drop the two-year growth rate to a very lackluster low-single-digit level.
• Preferred's stock price seems to already be discounting minimal growth over the next two years (up in '23, down in '24), but sentiment will temper bargain-hunting until the Fed eases off rate hikes.

Although the Fed isn't done hiking rates yet, many banks are already at or near peak net interest margins, as fast-rising deposit/funding costs are likely to outpace yields on earning assets like loans. Add in weaker operating leverage due to higher wage and FDIC insurance costs, and it's not too hard to understand why investors are still nervous about this sector.

All of this is relevant to Preferred Bank ( PFBC ) going into 2023, as this Los Angeles-based commercial lending is facing weakening loan demand (at least among higher-quality borrowers), a high loan/deposit ratio, and the prospect of further low-cost deposit outflows and higher funding costs, and more pressure on operating leverage in 2023. Trading at less than 9x what I believe should be a bearish trough earnings estimate over the next two years, the valuation is appealing, but it may be tough to surmount growing concerns about weakening profit momentum in 2023 and into 2024.

Good Results On Balance In The Fourth Quarter

Like most banks I've looked at so far, Preferred Bank posted stronger-than-expected net interest income in the fourth quarter, helped by robust loan yields and ongoing growth in the loan book. This revenue outperformance was tempered by higher operating expenses, though, and a more cautious outlook on near-term conditions.

Revenue rose 49% year over year and more than 11% quarter over quarter, beating sell-side expectations by about 4% (or $0.15/share). Net interest income jumped 50% yoy and 11% qoq, fueled by higher loan yields that drove net interest margin 147bp higher year over year and 38bp higher from the third quarter (to 4.75%), as well as almost 2% qoq growth in earning assets. Non-interest income is a trivial part of Preferred's business mix but did grow 15% sequentially.

Operating expenses rose about 35% yoy and 15% qoq and came in higher than expected this quarter, continuing a common trend across the banking sector as banks absorb higher wage, occupancy, and insurance costs. Pre-provision profits rose almost 55% yoy and 10% qoq, though, which is still a comparatively good result and better than the Street expected.

Funding Costs Are Spiking, Limiting Leverage To Loan Growth And Higher Rates

One of the concerns I had about the bank sector going into this next phase of the cycle was what would happen to the flood of low-cost deposits that banks took in during the pandemic and the quarters that followed. Now that rates are heading higher, those deposits are moving out in search of better offerings.

Preferred saw overall deposits grow about 2% sequentially, but non-interest-bearing deposits dropped about 11% on an end-of-period basis. Having to replace no-cost deposits with more expensive sources of funding (and/or seeing depositors move money to higher-yielding savings or CDs), Preferred saw deposit costs jump 137bp yoy and 91bp qoq to 1.68%, with the cost of interest-bearing deposits rising 173bp yoy and 110bp qoq to 2.14%, while non-interest-bearing deposits fell to just over 21% of total deposits (generally 30% and higher is considered good).

Growth in loan yields is more than keeping pace for now, as loan yields rose 206bp yoy and 119bp qoq to 6.94%. With most of Preferred's lending tied to the Prime rate, Preferred benefits earlier from rate hikes (and there is likely 50bp of rate hikes left to come), but they also lack that strong core of sticky low-cost deposits.

Preferred's cumulative deposit beta is now at around 33%, one of the highest out there among the banks I follow closely, and it's going to head higher still. While I did expect Preferred to see a higher-than-average deposit beta, and my thesis on banks throughout 2022 was that deposit betas in this next phase of the cycle were going to be higher than many managements and analysts expected, this pace is ahead of what I expected.

Management has not specifically called out a peak for net interest margin, and the next rate hike (or hikes) from the Fed could delay it, but I think we're close to that peak and net interest margin is unlikely to expand significantly from here.

On top of that, the overall lending environment is getting more challenging. Quality borrowers are pulling back on expansion plans and using the cash they have on hand, and Preferred management noted competitors in its core markets are willing to get more aggressive on lending terms to make loans. Getting aggressive on lending when the economy is slowing is usually a bad plan for the long term, and while I think it's smart for Preferred to pull back, it does mean weaker prospects for loan growth - I think loan growth could fall into the low-single-digit in 2023.

The Outlook

Not much about the prospective numbers for Preferred in 2023 and 2024 looks all that good. Net interest income should grow in 2023, possibly by double digits, but net interest margin should start contracting. Meanwhile, operating costs are going to be higher in 2023, and as an already-efficient bank, there's not a lot Preferred can do to offset that. Provisioning, too, is likely to head higher as the credit environment deteriorates.

The good news is that there should be pre-provision growth in 2023 (double-digit growth seems attainable), but even that good news is tempered by the reality that 2024 will likely be a down year and two-year growth between 2022 and 2024 could be in the very low-single-digit depending upon how the economy and rate cycle play out.

I do expect a rebound in 2025 and long-term core earnings growth in excess of 6%, and discounting those core earnings back to today does give me a robust fair value (close to $90). Likewise, even if I use depressed 2024 estimates (what I hope will prove to be bearish assumptions), I get a fair value in the low $70s.

The Bottom Line

I think the market is already pricing in quite a bit of oncoming pressure on Preferred's operations. The trouble with sentiment, though, is that it takes that light at the end of the tunnel to get institutional investors interested in bargain-hunting, and I think it will take the Fed signaling an end to hikes before that happens. Accordingly, while I do think today's price likely undervalues the future earning streams of Preferred, it's hard to be bullish in the face of what is likely to be more challenging quarterly reports.

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