Description

Background

CATY is a regional mid-cap bank with 69 branches in nine states.  Its branch network is mostly located in California and New York (47 and 10, respectively). It also has offices in Beijing, Shanghai, Hong Kong, and Taipei. 

It just closed HSBC’s west coast retail business in February, adding $646mm in loans, $575mm in deposits, and 10 branches in California.

As of 1Q22, the bank has around $21B in total assets, $20B in earning assets, and $18B in deposits.  About $17B, or 85% of earning assets are loans.  The loan book consists of 48% Commercial Real Estate, 30% Residential Mortgage, 18% Commercial and Industrial, and 4% Construction.  PPP is immaterial.

Why Does This Opportunity Exist?

Inflation in the US is at a new 40-year high.  Market participants increasingly view the possibility of the Fed tightening causing a recession as high.  Credit issues can emerge in a recession.  As such, bank stocks, including CATY, have sold off.  Recent price weakness is due to market sentiment/macro concerns and not related to anything company-specific in my opinion.

Investment Thesis

A higher interest rate environment will serve as a tailwind to earnings.  CATY is a beneficiary due to asset sensitivity and its unusually high exposure to net interest income (NII).  I believe the current stock price ($39.2) represents an asymmetric opportunity to invest in a well-capitalized bank with a differentiated strategy and above-average profitability. The macro risk can be hedged.

Differentiated Strategy and Above-Average Profitability

The bank has its roots in serving the Chinese-American niche and targets growth specifically in geographies with large Chinese-American communities, hence the CA and NY concentration.

Chinese-Americans tend to have higher income, more college graduates, and higher savings rates relative to typical Americans - therefore they are desirable clients for community banks. 

Furthermore, many first-generation immigrants prefer to deal with bankers that speak the same language either because of language barriers or personal preferences.  They are also “sticky” customers due to mild switching costs and inertia. Also, competition is less fierce in this niche than in generic banking.  

I believe this differentiation provided CATY with a cost advantage as evidenced by its superior efficiency. Since 2016, CATY’s efficiency ratio has ranged from 44% to 48%.  Adding back amortization in low-income housing and OREO lowers the adjusted efficiency ratio to a range of 37 - 40%.  Community banks’ efficiency ratio, according to the FDIC, ranged from 61% to 66% over the same time period.

The table below compares CATY with its $15-25B asset peer medians of two key profitability measures: 5-year cumulative changes in tangible book value plus dividends, and 5-year average return on assets. CATY outperforms in both measures.

Asset Quality

Despite covid-19 and recent macro volatility, credit quality at CATY has been solid. Net charge-offs were 9 and 11 bps of loans in 2020 and 2021 respectively.  During 2008 - 2021, median net charge-offs have been very modest at 10 bps of loans. It's worth noting that the adoption of CECL made the analysis of loan provisions not meaningful.

Recall that 48% of loans are CRE. The weighted avg loan-to-value ratio (LTV) is 51% as of 1Q22.  Only 3% of CRE loans have LTV > 70%.  Given the conservative LTV profile, I do not expect a recession would severely damage the bank’s earnings power or capital levels.  That said, I do expect charge-offs to ramp up in a normalized scenario.

Rising Interest Rates Benefit

CATY is an asset-senstive bank.  According to company disclosures, as of 2021 year-end, a +100 bps scenario would increase net interest income by 9.43%, and 19.63% in a +200 bps scenario. This translates roughly into a $0.74 and $1.55 EPS benefit, respectively. Although this is just management’s internal modeling, this will be directionally correct and I expect the upper range of its NIM guidance of 3.4% will be exceeded.

Additionally, CATY has an unusually high mix of net interest income to net revenue.  Typically, non-interest income is around 20% of net revenue for community banks whereas only 7 - 8% of CATY’s revenue comes from non-interest income. Therefore, CATY is very well-positioned for rising NII even among spread-lending focused banks.

Earnings and Valuation

Base case price target of $56.8 (45% upside from $39.2) is based on 12x normalized earnings.

Bear case price target of $36.5 is based on 10x trough EPS ~ 7% downside (2021 EPS adjusted for amortization of low-income housing and energy partnership; normalized NCO at 20 bps of loans).

Upside to Base Case

The NIM guidance is based on 2.25% Fed Funds Rate.  It is almost certain this will be exceeded.

Efficiency ratio is 350 bps lower than my assumption and should continue to trend down because of larger scale and higher revenue.

Key Risks

Historically bank stocks price tend to react favorably to rising short-term rates as the increase is usually driven by a strong economy.  However, this cycle is unlike the one in 2004 or 2017.  US GDP is already slowing; high energy prices are squeezing consumers; China's GDP is also slowing given lockdowns and real estate problems; Europe is also facing high inflation; it does seem a recession is very likely.  

This recession risk can be mitigated by shorting a basket of bank stocks with lower profitability (i.e. less than 1% ROA) and/or high noninterest income to net revenue (i.e. capital market fees, mortgage banking income).

Another risk is exposure to mortgage-backed securities (MBS) which is facing extension risk. CATY has $873.5mm of MBS at fair value as of 1Q22.  Although manageable, there is not enough disclosure to estimate what the impact will be and this could lead to negative earnings surprise.

Catalyst

NIM expansion; earnings growth