PFBC - Preferred Bank: Low Cap High Return

2023-09-06 16:00:02 ET

Summary

• Preferred Bank is a small bank that was not heavily impacted by interest rate spikes in early 2023.
• PFBC offers a solid investment opportunity with potential for growth and a well-managed management team.
• The bank targets a promising Chinese-American market and has shown growth in deposits, indicating potential for further expansion.

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Investment Thesis

With a market cap of only $902.34M, Preferred Bank ( PFBC ) is without a doubt a small bank; however, unlike its counterparts, the bank did not suffer a huge blow from the interest rate spikes of early 2023.

PFBC offers an attractive investment to those looking for a solid return on a stock that isn’t on the radar of many. Although shares were down 39.7% from the end of February 2023, their lowest of the year, they climbed back up to 5.23% down from the end of February 2023. This bounce back shows the potential PFBC holds as an investment. Many may argue that the return on this stock is nearing its peak and an investment now would not serve any rational purpose; however, with the sheer room for growth and the well-oiled management of PFBC, this discounted stock is a prospect for a great return.

Company Overview

Preferred Bank is a low-cap financial institution serving a select market in the US. The company offers multiple commercial banking products and services to a wide range of consumers including small to mid-sized businesses, business owners, entrepreneurs, and a base of high-net-worth individuals. With roughly $6.5 billion in total assets, the bank does business in savings, checking, individual retirement and money market deposit accounts. They engage in fixed-rate and fixed-maturity retail as well as non-retail certificates of deposit. The bank also provides a wide range of loans including real estate mortgage loans, commercial loans with working capital lines of credit, term loans for capital expenditures, SBA loans, and more. Incorporated in 1991, and headquartered in Los Angeles, California, the bank is able to provide wealthy business services to high-wealth individuals located in the West/Pacific region. They also pride themselves in their remote services such as deposit captures, treasury management, and internet and mobile banking services, to name a few.

Catalysts

Multiple catalysts support the reasoning behind an intelligent investment towards PFBC. Firstly, if we simply look at how it stands with its competition, it is clear that PFBC can hold its ground, just as it did in the recent turbulence from the interest rate spikes. Most smaller, regional banks similar to Preferred Bank suffered massive blows earlier this year, Silicon Valley Bank and Credit Suisse to name a few. Those banks were forced to sell their held-to-maturity bonds at a loss due to the Federal Reserve raising interest rates. Consumers fled and ultimately, these banks collapsed, however, this was not the case at all for Preferred Bank and they suffered a drop in share price of 39.7%. A substantial dip nonetheless, but its ability to climb back up to where it is today showcases the safety it provides in an investment, even in a time of crisis.

What helped Preferred Bank stay on its feet? To dig deeper, we can look at their balance sheet . The bank held only $20 million in held-to-maturity securities, compared to Silicon Valley's $91 billion.

On top of that, Preferred Bank only saw a loss of $2 million off of their held-to-maturity securities, compared to Silicon Valley’s $15 billion loss. This $2 million loss was offset entirely by the $140 million the bank had in annual earnings the year before. But how does this prove PFBC to be a strong investment? By seeing the success they had in a time of crisis, it can be concluded that the management played it smart. They knew the risks small banks faced with interest rate fluctuations; thus, they ensured that 85% of the bank’s loans were variable interest rates and they made sure to only hold $20 million in held-to-maturity securities, the bank was prepared for the storm that was brewing.

It was inevitable that they would get hit by the interest rate storm, just as every other bank did, including large institutions such as Bank of America and JP Morgan Chase. They did take a blow, but it was a blow that was able to be handled almost immediately. If we look at their current share price, it is still 10.11% below its original price at the end of February of this year, before the crisis hit the industry. The upside on this isn’t substantial and a few more catalysts give us reason to believe that PFBC is a great investment.

Looking at the market the bank operates in, we can already see a promising consumer base. The bank targets a Chinese-American market which it is able to actively serve with a headquarters in California. To put the promise of this community into perspective, we can look at the bank’s deposits. They saw deposits expand from $4.44 billion to $5.56 billion from 2020-2022. A drop of $5.41 billion in the first quarter of 2023 can be noted; however, as the second quarter of 2023 came to an end, deposits had jumped up to $5.59 billion, showing growth on a larger scale. To many, this can be a confusing number as a significant amount of the bank's deposits are uninsured: a whopping 39.9% after the most recent quarter. The reasoning behind this may be the fact that consumers crave the variable interest rates the bank offers, or in the more likely case, they trust the management. However, the bank has 41.2% liquidity coverage, completely mitigating any possible risk.

As mentioned, the bank is extremely well managed. The company bought back $17.5 million worth of shares in 2021 and a substantial $32 million in 2022. Although an accurate amount is not listed for 2023 thus far, we can use the 281,000 shares they purchased back in the first six months of 2023 and multiply it by the share price to calculate an estimate of $17.8 million in 2023 thus far. This makes it clear that management is committed to buying back shares showing their trust and maintaining of the company. It also goes without saying that management has done an excellent job of growing the company over the past few years and this is shown by the net interest income. This figure has grown 62% from 2020-2022 ($148.2 million to $240 million). In addition to this net income has increased from $69.3 million in 2020 to $128.8 million in 2022, a nice 86% increase. This growth has and will continue to grow in 2023 and onwards. Comparing the end of the second quarter of 2022 to 2023 will show a jump from a 3.77% net income margin to a 4.58% net income margin as well.

Valuation

We can calculate the total intrinsic value of Preferred Bank and its’ intrinsic value per share to value the company. By taking their average P/E ratio over the past 5 years (10.11) and multiplying it by their 2022 total earnings ($128.8m), we will get our total intrinsic value, $1.302b. We can then divide this by the total diluted shares (14.6m) to get our intrinsic value per share or our target price per share. This value ends up being $89.19, which shows that the current price is significantly discounted. This provides us with an immediate upside of roughly 41.66%. This value is a very attractive entry price and with the chances of the share price decreasing even more, the upside is even more attractive.

Risk

Based on the small size of the bank, many would argue that the bank would face a similar fate in a time of crisis (when inflation occurs and interest rates spike) to other small banks such as Silicon Valley Bank. However, the bank only holds $20m in held-to-maturity securities, compared to Silicon Valley’s $91b. Yes, b as in billion. Additionally, Preferred Bank only lost $2 million off of their held-to-maturity securities, compared to Silicon Valley’s $15 billion loss. This $2 million loss was very small when we look at the bigger picture. The bank had $140 million in annual earnings the year before; thus, this loss was offset without barely making a dent. This risk was properly mitigated and it is showcased by simply seeing their success in a time of crisis. The management behind the company was extremely smart and forward-thinking. They knew the risks of interest rate fluctuations on smaller banks and wanted to mitigate their risks.

If the bank were to lose a substantial amount in their held-to-maturity securities, although this would never occur due to the small size of their securities, they would be clear of any harm. This is because of the Federal Reserve's new Bank Term Funding Program. This program would completely insure the bank, fully mitigating this risk. Again, this would be a very rare occurrence as the bank has such a low value of HTM securities and collects large earnings to compensate for any loss.

An inevitable risk banks face is uninsured deposits. As mentioned in the catalysts, if we look at the bank's most recent earnings call , Li Yu, the company’s Chairman and CEO, clearly stated that the bank’s liquidity coverage offsets their uninsured deposits as of June 30, 2023. The bank held 39.9% of uninsured deposits while having 41.2% in liquidity coverage .

Conclusion

Over the past 100 years, purchasing an expanding and consistently profitable company’s stock at a price lower than its intrinsic value during turbulence in the market has proven to be a foolproof way to earn returns in the market. This method is supported by many notorious investors including Warren Buffett, Benjamin Graham, Joel Greenblatt, and many, many more. Although the banking industry has taken a hit this year, ultimately causing many banks to either collapse or see a dip in their share price, the forward-looking management, appealing financials, and smartly invested securities held by Preferred Bank offer investors a confident buy and an opportunity not visible to many.

Purchasing shares of PFBC at its current price would be a smart choice as it could provide a short-term upside of roughly 41%, currently making this company a buy. With the increasing growth of the company moving forward, this return could be even higher. The return could reach 86.18% in the next few years with continued growth and continuous decline in the market with more interest rate fluctuations. This would give us an intrinsic value per share of $118.71 (a 10% increase on the current intrinsic value annually for 3 years). If the market declines, so would PFBC simply because financial institutions often fluctuate in correspondence with the market. In conclusion, PFBC is a great buy and a no-brainer investment for those interested in a small-cap company with a discounted price and attractive upside.

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