In July 2020, Preferred Bank (NASDAQ:PFBC) piqued my interest when the bank provided additional clarity on one of the larger loans that suddenly became non-performing. And almost exactly a year ago, I argued that moving to the sidelines made sense as the shares returned over 70%. We’re now a year and three days later and Preferred Bank is trading at almost exactly the same stock price as it was in May 2021. Sure, the stock price has peaked near $82, but the recent stock price drop makes this bank more attractive thanks to its strong loan book and its very strong and conservative underwriting policy.
Net interest income continues to rise
During the first quarter, PFBC recorded an incremental deposit inflow of nearly $100 million and the cash received was immediately used to expand the loan book. In addition to investing the new deposits, Preferred Bank slightly reduced its cash position (-6%) and the amount of securities for sale (-4.5%), resulting in an increase in the loan book by almost $175 million. USD led.
This helped increase interest income and net interest income. Total interest income increased a little over 5% to $55 million, while total interest expense actually decreased from $6.8 million to $5 million despite a higher amount of deposits serving as a funding source.
Net interest income increased more than 10% from $45.3 million to $50 million. Meanwhile, total noninterest net expense fell to just under $14 million from $14.3 million, which helped push pretax income to just over $36 million (before accounting for changes in loan loss provisions). That’s an important and impressive improvement from the company’s $31 million in the first quarter of 2021.
While the bank recorded a provision for loan losses in Q1 2021, it reported a $0.25 million release in Q1 of the current fiscal year. This is interesting as it is evidence of the improvement in the loan book despite the recent expansion.
The bottom line shows net income of just over $26 million and divided by average share count of 14.77 million shares, earnings per share for the first quarter was approximately $1.76 per share. This means that the quarterly dividend of 43 cents per share is very well covered, since the payout ratio is almost 25%. The remainder of the qualifying profit is retained on the balance sheet to keep the equity ratio sufficiently strong: the equity portion of the balance sheet grows as the balance sheet expands. Of the $95 million in additional assets on the balance sheet, approximately $8.5 million was covered by an increase in equity.
I appreciate that PFBC maintains a liquid balance sheet. Although more cash was diverted to the “riskier” loan book, the bank still had nearly $1 billion in cash on the balance sheet with an additional $444 million in securities. That means just over $1.4 billion of the $6.14 billion asset base has been invested in assets that are liquid and should be relatively safe. Holding 23% of assets in these liquid positions is quite encouraging.
As you can see above, the nearly $4.6 billion in loans consists mostly of real estate-related loans. Approximately $351 million was spent on home loan originations while the home mortgage portfolio grew to just over $2.9 billion. Of that amount, about $540 million is classified as residential mortgages, meaning the balance sheet includes nearly $2.4 billion in commercial real estate.
Preferred Bank does an absolutely amazing job of keeping track of their loan portfolio. As you can see in the above image, only $2.15 million of loans are in the unaccrued column, while the total amount of delinquent loans is only $8.5 million. That is less than 0.2% of the total loan portfolio. And most past due loans are barely past due.
The focus on credit quality was also mentioned on the quarterly conference call. CEO Li Yu mentioned (emphasis mine):
Looking ahead, we are very encouraged by the new loan applications received so far. Although these applications will be are subject to higher drawing standardswe believe that the second quarter results could be quite positive. […] the underwriting standard is higher due to various stress tests and the value situation in the face of inflation and rate increases, and we also always keep in mind that there will be a recession after inflation. That’s why at Preferred Bank we’ve always tried to be mindful that good and bad loans come at good times. So, we have to be extremely careful now.
In the meantime, the bank clearly wants to keep growing and is looking at new locations for new branches, but it sounds like there’s absolutely no compromise on credit quality.
And that means I might try to go long Preferred Bank. In 2020 I tried to go long by writing put options and perhaps that remains a very valid strategy in the current market. Unfortunately, the options at this bank are quite illiquid and there is generally a large bid/ask spread. So in order to try to write some (out of the money) put options, I may need to place some limit orders hoping they will be hit.
At multiples of 9.5 times earnings, Preferred Bank doesn’t seem expensive. And the roughly 70% premium to tangible book value is likely due to the bank’s strong earnings profile and robust loan portfolio, with very few loans classified as past due or unaccrued.
I’m in no hurry, but PFBC’s performance is a very pleasant surprise.