PFBC - Preferred Bank: Expect A Substantial Net Interest Margin Increase In Q3

Summary

• Preferred Bank is a California-based bank focusing on the local Chinese population.
• Its loan quality has been strong, and although there's an uptick in loans past due, Preferred Bank should be able to deal with it.
• I expect the EPS to exceed $2 in the current quarter, which paves the way for a higher dividend and additional share buybacks.

Introduction

I have been keeping an eye on Preferred Bank ( PFBC ) for over two years now. The share price was trading at roughly $40 when I published my first article and less than a year later when the stock was approaching $70 I lost my interest . I never lost track of this bank and I was happy to see Preferred Bank got through the first quarter without too much damage whereas other banks were hurting as their securities available for sale were suffering from the increasing interest rates.

The loan book is growing, and the net interest income should follow

Preferred Bank clearly noticed the impact of the increasing interest rates as this, in combination with an increased balance sheet size, caused the interest income to increase by almost a quarter to in excess of $62M. Additionally, the interest expenses were decreasing due to lower interest expenses on subordinated debt and time certificates while the interest expenses on normal savings accounts increased. As you can see below, the net interest income increased from $43.4M in Q2 last year to $56.4M in the most recent quarter. And although the bank was able to take back about $0.25M in loan loss provisions in the first quarter of the year, PFBC recorded a $2.9M provision.

While that weighed on the net interest income after taking loan loss provisions into account, the result was very clearly still much better than a year ago.

Generating a net interest margin still is the bank's main source of income. During the second quarter, it reported a non-interest income of $2.6M and a non-interest expense of $17.1M for a net non-interest expense of approximately $14.5M. This means two things: First of all, the bank is barely generating any income from non-interest activities, but on the other hand, a total non-interest expense of just $17M for the quarter is pretty low for a bank with in excess of $6B in assets.

The pre-tax income of Preferred Bank came in at almost $39M and after making the relevant tax payments, the net income was $28M, resulting in an EPS of $1.90. Looking at the H1 results, the EPS was $3.66, and while the Q1 result was boosted by a lack of loan loss provisions, if we would just focus on the net interest income you'll see the NII increased by about 12% on a QoQ basis. And that bodes well for the next few quarters as the interest margin should continue to expand. The bank is currently paying a dividend of just $0.43 per quarter (indicating a payout ratio of less than 25%) but on the Q2 conference call, management indicated it would 'obviously' increase the dividend soon.

Preferred Bank also was lucky it wasn't hit too hard by the increasing interest rates as the total amount of securities for sale on the balance sheet remained relatively limited. The income statement shows there was a loss of almost $36M on the securities available for sale, but this was more than compensated for by the retained earnings.

I'm also not too worried about seeing the loan loss provisions creeping up again. Looking at the breakdown of the loan book, we see a total of $10.6M of the loans is no longer on accrual status. While that's a decrease of about $4.2M compared to the end of 2021, the bank is seeing an increase in loans going past due. Whereas just one loan to the tune of $3,000 (not a typo) was past due as of the end of 2021, this increased to $8.2M with the majority of this number caused by residential mortgages that are between 1 and 2 months past due.

Investment thesis

While Preferred Bank experienced strong loan growth numbers in April and May, the pace slowed down in June and the bank expects it will be back at the loan origination level from 2021. We should see an uptick in the net interest income in the current quarter as the Preferred Bank management disclosed the average net interest margin in June was about 20 base points higher than the Q2 average and this effect should be fully visible in the current quarter.

As PFBC emphasized it is keeping an eye on loan quality and that it's doing a deep dive in all its loans, I don't expect to suddenly see large loan loss provisions, which means PFBC has a shot at reporting an EPS of $2 for the current quarter. If the quality of the balance sheet doesn't deteriorate (read: if the total amount of loans past due and non-accruing loans remains roughly stable), the stock doesn't appear to be too expensive anymore although it is still trading at a premium to the tangible book value of just over $41/share.

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