Ryan Herron
As far as managing what is within their control, I can’t find much fault with Preferred Bank (NASDAQ:PFBC) since my last update on this smallish ($5B in assets) California bank. Rate leverage has been very strong, operating leverage has been very strong, and credit quality has likewise been quite good. But, banks being out of favor, the shares have done only a little better than the average regional bank since my last update, falling about 5% – beating the market by around 10%, as well as peers like East West (EWBC), Hope Bancorp (HOPE), and Pacific Preferred (PPBI), while underperforming Cathay General (CATY) by a few points.
Macro headwinds remain real, and I don’t expect the Street to stop worrying about this issue for at least another quarter or two. Preferred still has some leverage to further rate hikes, but the bank is already seeing demand destruction for loans and I don’t see much sustainable operating leverage with loan growth. Long term, I still think this is a good bank and I think the valuation is attractive, but this could be stagnant money until the Street is ready to look past the coming slowdown.
Rate And Operating Leverage Drive Strong Growth
Preferred Bank had one of the better quarters I’ve seen from a bank, as the company coupled strong rate leverage to excellent operating leverage (with strong credit quality also on board).
Revenue rose 37% year over year and 17% quarter over quarter, which screens out very strong compared to the bank’s peer group. Net interest income drove that growth, rising 40% yoy and 18% qoq, as the bank’s net interest margin rose more than a point (up 101bp yoy and 60bp qoq to 4.37%); Preferred’s spread leverage was well ahead of average this quarter, with the average smaller bank seeing around 45bp yoy of NIM improvement. Net interest income is a trivial contributor to revenue ($2M out of $69M), but declined 20% yoy and 16% qoq.
Operating expenses rose 13% yoy and 1.5% qoq, which puts Preferred in the enviable position of below-average expense growth on well above-average revenue growth. That, then, drove the efficiency ratio down more than five points yoy to 25.2% – one of the lowest I know in the space. Pre-provision profits rose 47% yoy and 23% qoq, and Preferred’s small securities portfolio meant minimal tangible book value erosion from mark-to-market losses, with tangible book value per share up about 3% sequentially.
Spread Leverage Still A Driver, But Soft Loan Growth Bears Watching
Preferred reported 2% sequential end-of-period loan growth after adjusting for PPP loans. On balance, that was a little soft compared to its peers, though average loan growth (up 2.8%) was more in line. Commercial real estate lending was still pretty strong, with the 4% growth rate in Q3’22 about double the average. C&I lending, though, was down slightly in what was otherwise a good quarter for commercial loan demand, and the 1% qoq decline in construction lending was likewise anomalous in a quarter where 4% growth was more the norm.
Management did say that they were seeing more caution and conservatism on the part of its customers, leading to lower loan inquiries, and management also said that their top priority has shifted to maintaining credit quality into what they expect will be a recession.
While loan growth is slowing, Preferred is leveraging higher interest rates into higher loan yields. Average loan yields improved 91bp yoy and 83bp qoq to 5.75%, well ahead of peers both in terms of yoy/qoq improvement (where 45bp was closer to the norm) and absolute yield (where the average is closer to 4.5% or 4.6%). Preferred isn’t sacrificing quality to chase yield, though, as reserving looks reasonable and trailing credit metrics like non-performing loans (0.12%) and charge-offs (net recoveries in the quarter) are good.
Deposit costs were a concern of mine going into this year, but Preferred has managed these costs relatively well. Deposits rose 1% qoq on an end-of-period basis and a little more than 1% on an average balance basis, though non-interest-bearing deposits were down about 3% (qoq, eop basis), which was worse than average.
Deposit costs did increase, rising 41bp yoy and qoq to 0.77%, with both higher growth rates and a higher overall level of interest expense than peers (average deposit costs were closer to 0.30%). Preferred does suffer from a weaker non-interest-bearing deposit position relative to many peers (around 25% of deposits versus a peer average in the low-to-mid-30%’s), but the bank’s cumulative interest-bearing deposit beta is nevertheless about average (24%) and the cumulative total deposit beta is likewise quite good at less than 20%.
Weaker loan demand should help ease some of the deposit cost pressure Preferred would otherwise see. Deposit costs are going to continue to rise from here (the exit-rate for September was close to 1% for deposits), but if loan growth is more muted, the bank won’t have to compete/pay as aggressively for deposits.
The Outlook
I do see some risks to 2023 earnings expectations at this point; Preferred has done very well in 2022 and the bank still has strong asset sensitivity (with at least one more Fed rate hike likely on the way), but if the rate hikes seen so far are starting to diminish loan demand, I have to think that another hike is going to further depress demand. The lingering benefit of rate hikes should still lead to earnings growth, but a bigger slowdown could drive harsher revisions in the future.
Longer term, I still expect high single-digit core earnings growth from Preferred as the bank continues to selectively expand its lending operations into new metro areas (like its expansion into Houston, Texas). I also see the bank potentially leveraging M&A activity in its footprint to add some producing loan officers, but I don’t expect an aggressive effort to expand the business.
The Bottom Line
Long-term core earnings growth in the neighborhood of 8% can support a double-digit annualized total return from here, which is relatively attractive. Likewise, the shares look undervalued below $90 on the basis of both P/TBV (driven by near-term ROTCE) and P/E (with a forward multiple of 9.6x).
There are many undervalued banks out there today, and investors should be prepared for this sentiment overhang to last for a few more quarters. I also don’t discount the risk of further cuts to earnings expectations in 2023/24 on a slower-growing (if not briefly shrinking) economy. Still, for investors who can be patient, the valuation is attractive here and now, and those who wish to wait should at least consider giving Preferred a spot on a watchlist.
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