Cathay Bancorp’s (CATY) earnings are expected to decline this year on the back of normalization of non-interest based income and growth in expenses. Increase in provisions for loan losses due to normalization and issues related to China is also expected to have a limited negative impact on the bottom-line. On the other hand, some support is expected from continued growth in net interest income. Overall, I’m expecting CATY’s earnings to decline by 2% year over year to $3.40 per share. This estimate is below the forecast given in my previous report (i.e. $3.48), which is partly why I have reduced my target price on the stock to $40.3 from $42.2. Another reason for the reduction in price target is a higher estimate for the new accounting standard for credit losses. As a consequence of the reduction in target price, and the resultant decrease in potential price upside, I’m downgrading CATY to neutral from the previous rating of bullish.
Chinese Links to Have Limited Impact on Provisions Charge
CATY’s earnings have benefited from reversals of provisions over the past few years. Going forward, I’m expecting this benefit to end as credit quality is expected to normalize in the overall banking industry. Asset quality in the economy had been at such an unusually good level in the past couple of years that it was unsustainable. In addition, the adoption of the new accounting standard called Current Expected Credit Losses, or CECL, can increase provisions depending on economic outlook. There are also some threats from the company’s exposure to borrowers related to China due to trade tensions and the Coronavirus outbreak. However, this threat is likely to remain limited because CATY does not have a large exposure to borrowers that could be adversely affected from their Chinese links. As mentioned in the fourth quarter conference call, only 2% of CATY’s total loans are vulnerable to trade tariffs on Chinese goods. In light of the various factors affecting provisions for credit losses, I’m expecting CATY to post nil provisions charge in 2020 as opposed to negative $7 million in 2019.
Operating Expenses and Income to Pressurize Earnings
CATY’s non-interest income was unusually high in 2019 due to certain one-off items, including gain of $1.5 million on the valuation of interest rate swap contracts. The non-recurrence of one-off items in 2020 is expected to return non-interest income to a normal level this year. Moreover, I believe there will be fewer opportunities to book gains on sale of equity securities as I expect some pressure on the stock market ahead of the presidential elections. In addition, there will be fewer opportunities to realize gains on sale of fixed rate securities and residential mortgages because I’m expecting interest rates to remain stable this year. Consequently, I’m expecting CATY’s non-interest income to decline by 26% year over year in 2020 to $33 million.
Apart from the dip in non-interest income, slight growth of non-interest expenses is also expected to pressurize earnings this year. Salary expense is expected to be the major driver of non-interest expense growth as salaries are expected to increase due to inflationary pressures in a tight job market. On the other hand, cut back in discretionary items such as marketing is expected to offset some of the impact of higher salary expense. As mentioned in the conference call, the management expects cost cutting efforts to lead to flattish growth in non-interest expense of up to 1% this year. My estimated growth, of 1.3%, is slightly higher than management’s guidance.
Net Interest Income Growth to Keep Earnings from Tanking
While changes in provisions, non-interest income, and non-interest expense are all likely to pressurize earnings this year, net interest income is likely to support the bottom-line. The expected increase in net interest income is largely attributable to prospects of continued loan growth, albeit at a lower rate than the historical trend. Due to headwinds from global economic slowdown, and the resultant impact on the US economy, GDP growth slowed to 2.1% annualized in the last quarter of 2019, according to recent reports. Further slowdown is expected due to uncertainties ahead of the 2020 presidential elections. Moreover, threats remain that the progress made in US-China trade talks can be reversed. I’m expecting CATY’s net loans to grow by 6.1%, which is at the lower end of management’s guidance of 6% to 7% given in the conference call. My estimates for CATY’s net loans and other key balance sheet items are shown in the table below.
The positive impact of loan growth on net interest income is expected to be partly offset by lower average net interest margin in 2020 compared to 2019. The dip in average expected net interest margin, NIM, is attributable to the 75bps cut in Fed funds rate in 2019.
Compared to the last quarter of 2019, NIM is expected to improve this year. Around $2.6 billion, or 34%, of relatively higher costing certificates of deposits, CDs, are scheduled to mature in the first quarter of 2020. These maturing CDs carry a cost of around 2.2% and the management expects to renew them at rates no higher than 1.8%, as mentioned in the conference call. The resultant reduction in average cost of CDs is expected to support NIM in the coming quarters. Overall, I’m expecting CATY’s NIM to be around 3.35% in 2020, which is at the lower end of management’s guided range of 3.35% to 3.45%. The following table shows my estimates for CATY’s average yield, cost, and NIM.
Earnings to Receive Support from Tax Credits
Further support for CATY’s bottom-line is expected to come from solar and low-income housing tax credits in 2020. Based on management’s guidance given in the conference call regarding the tax credits, I’m expecting CATY to record effective tax rate of 18.75% in 2020, as opposed to 20.1% in 2019.
In light of the support from taxes and net interest income, and pressure from provisions, non-interest income and non-interest expense, I’m expecting CATY’s earnings to decline by 2% year over year in 2020 to $3.40 per share. The following table summarizes my estimates for key income statement items.
Downgrading to Neutral Rating
Based on the earnings estimate and a payout ratio in line with historical trend, I’m expecting CATY to increase its quarterly dividend to $0.33 per share in the last quarter of 2020 compared to the current level of $0.31 per share. The full year dividend estimate implies dividend yield of 3.4%.
Based on the earnings, dividends, and CECL day-one impact estimates, I’m expecting CATY’s book value per share to increase by 2.9% in 2020 to $29.41 per share. This estimate is slightly below the previous estimate of $30.8 given in my last report on the stock. I have reduced my equity book value estimate due to a fall in earnings estimate, as well as higher anticipated CECL impact. Due to the fall in book value, my target price is now $40.3, as opposed to $42.2 given in the previous report.
The new target price is based on a justified price to book ratio of 1.37, which is the average for the past seven years as shown below.
Multiplying the average P/B ratio with the forecast book value per share of $29.4 gives a target price of $40.3 for December 2020. The target price implies a 9.7% upside from CATY’s February 12 closing price. The following table shows sensitivity of the target price to P/B ratio.
As the target price implies a single-digit price upside, I’m adopting a neutral rating on the stock. My previous rating on the stock was bullish due to a higher target price, as mentioned above. Due to the single-digit price upside implied by the new target price, I believe it is appropriate to stay sidelined for now and invest only if the stock price dips to an attractive enough level.
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