I have been looking at some of the hundreds of regional banks in the US lately as some of those banks appear to be attractively priced. During my due diligence phase (which is ongoing), I encountered one case where I would have avoided the shares based on the financial statements, but initiated exposure after the conference call as the bank’s management team clearly explained the details of the income statement and the element I had a big issue with. Since the call, I have increased my exposure to Preferred Bank (PFBC) by writing out of the money put options.
Upon seeing the financial results, I had a lot of issues and outright worries
In the second quarter of the year, Preferred Bank saw its interest income decrease by approximately $3.5M compared to the first quarter. That was inevitable given the constant pressure on the interest rates, but as the interest expenses decreased by almost $4M, Preferred Bank actually reported a 1% increase in the net interest income, which increased to $42.2M from $41.8M.
Source: quarterly report
The total non-interest income remained negligible at $1.4M while the total non-interest expenses decreased from $15.2M to $14.3M thanks to a lower payroll. This means the pre-tax income before loan loss provisions was approximately $28M.
Of course, we cannot ignore the loan loss provisions as the COVID-19 pandemic will have an impact on the loan book of every bank out there. The loan loss provision increase from $5.3M to $7.5M was perhaps expected, and the pre-tax income after taking the loan loss provision into consideration was $21.8M, resulting in a net income of $15.3M or $1.03/share. This brings the H1 net income to $2.12, indicating Preferred Bank is trading at less than 10X its net income despite seeing a four-fold increase in the loan loss provisions.
I was unsure what caused the initial 6% share price decrease, until I found this well-hidden sentence in the press release:
Source: Company press release
So the non-performing loans impacted in the quarter as they increased from $2.1M to $26.4M (up $24.3M). Fine, accidents happen on a $4B loan book. But I was flabbergasted as to why Preferred Bank thought it would get away with a loan loss provision of $7.5M while it confirms about $24M of its loans were in default. And this wasn’t just a blip, as shown on this slide from a May presentation. The non-accrual loans reached the highest level since the end of 2018.
Source: Company presentation
So while I liked the net income and net interest income performance, I was very surprised to see a relatively low loan loss provision considering loans worth more than three times the provision were officially classified as a non-performing loan.
The conference call removed all those issues, and Preferred Bank could be a “buy” now
Perhaps this was a good test case showing investors should listen in on the conference call wherein the management discusses the financial results. One of the analysts on the call enquired about the very question I was struggling with. From the Seeking Alpha conference call transcript (the emphasis is mine):
The non-classified loans are mainly classified top [ph] of the loans, which we have recently downgraded to classified non-accrual. That’s why, the first loan actually is fully secured by real estate. And during the past couple of months is the borrower trying to sell, to dispose the properties and pay back the loan. However, the sell was not so successful because of the COVID-19 pandemic, it has been delayed. We’re continuously working with the borrower, try to resolve the problem. And the second one, we have further downgraded because of the borrower filed Chapter 11 recently. And the cash flow was negatively affected by COVID-19 pandemic at the very beginning. And also, the third one is related to one of our small loan, around $1.4 million in our New York area and the loan is also fully secured. And the borrower’s working with the Bank for refinancing and provide additional collateral to cover the risk.
Later in the conference call the CFO confirmed the book value of the first and third loans are $16.8M and $1.1M and that the bank expects to recoup 100% of these loans as they are secured by real estate assets that are move valuable than the loan. The main issue was the second loan with a book value of $6.3M and reading between the lines it looks like Preferred Bank doesn’t have high hopes in recovering a chunk of this amount.
This sheds a whole new light on the income statement and now I fully understand why Preferred Bank only recorded a loan loss provision of $7.5M. This very likely consisted of a major impairment on the $6.3M loan the borrower defaulted on and a “normal” loan loss provision.
Additionally, the conference call also included this tidbit of information (the emphasis is once again mine):
I think going forward, we are going to have, as Mr. Yu mentioned, the CDs maturing, we have $426 million maturing during Q3 at an average rate of about 161. Those will come back on at an average rate of about 70 to 75 basis points. So, that will certainly help going forward.
Should Preferred Bank indeed be able to refinance the $426M in deposits at 0.75% (down from 1.61%), PFBC will save $3.6M per year in interest expenses. On an after-tax basis this could add as much as $0.19-0.20 per share to the net income on an annual basis.
Now the low level of loan loss provisions vs. the increase in non-performing loans has been cleared up, the quarterly dividend of $0.30 remains safe. The annual dividend of $1.20 represents a current dividend yield of approximately 3%.
That’s not great but Preferred Bank has a history of keeping the payout ratio relatively low in order to grow its balance sheet. From 2015 to 2019 the total amount of assets increased by roughly 80% to $4.6B while the amount of shareholders equity increased from $264M to $470M. And I don’t mind a low payout ratio as this means the bank retains most of its profits within the company which helps to keep the balance sheet resilient and paves the way for further loan growth.
After hearing the explanation behind the benign loan loss provision during the conference call, I became interested in initiating a long position in PFBC. I noticed the option premiums were very attractive and as the bank is currently trading at a premium to its book value of almost $33/share I elected to write a bunch of out of the money put options. I selected put options expiring in August and September with strike prices of $25 and $30 as those would be attractive levels to initiate a long position in Preferred Bank.
Source: interactive brokers screenshot
I’m also considering writing some longer-dated put options as a put option with a strike price of $30 expiring in December can be written for an option premium of approximately $2. This would reduce the average purchase price to $28 (or 0.85 times the book value) while pushing the dividend yield to 4.25%. And if PFBC expires above $30/share on Dec. 18, my return will have been in excess of 6% on an exposure of $3,000 per contract.
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p id=”a-disclosure” class=”p p5″>Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have no position in the common stock, but have written out of the money put options in an attempt to go long closer to the book value per share.
Source: Seeking Alpha