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The Preferred Bank Story

I research a lot of stocks. But I don’t write about most of them.

This is because most research leads to bland conclusions that aren’t really all that inspiring to write about.

For example, I spent a lot of time over the last two days learnign about Fastly.  I wrote 4 pages of notes.  I went through their investor day presentation, listened to the whole thing.  Went through their last couple conference calls.  Made a model.

But I’m not going to write about it.  There is not much to say.  At the end of the day, Fastly is going to be marginally profitable in 2026.  If the stock got down far enough (maybe $12) I might buy it.  But it would probably be for a trade.  Fastly trades at 13x their long-term goal operating income, which might happen before the end of the decade.  It’s a company worth following, but not exciting enough to write about.

To make an idea worth writing about you need some sort of tension.  Someone is right and someone is wrong.  Someone is missing something and here is what it is.

Otherwise, it is just Fastly should grow at blah, blah, blah and that gives us a positive operating earnings by blah, blah, blah and the discounted cash flow model says blah, blah, blah.

Boring.

Right now, a lot of my research is banks.  Which is essentially me doubling up on the boring-ness.  But there a few that make a good story.

There are two I plan to write about. Eastern Bankshares and Preferred Bank. This post is about Preferred Bank.

What makes Preferred a good story starts with it being a California bank. That puts it in the center of the crisis and a sorta-ish peer to other banks that have failed: SIVB and FRC.

Preferred operates in Los Angeles, Orange and SF counties.  They also have one branch in NY.  They are headquartered in Los Angeles.

Preferred was square in the headlights over the last couple months and you see that in the stock chart.

Top to bottom, Preferred’s stock price dropped 40%.

The other thing that makes Preferred a good story is that they exemplify a theory of mine.  That’s right, I have a theory.  It is unproven.  My theory is that all regional banks are not actually the same.

While the word “regional banks” has come to denote the group as a whole, essentially a Borg, it is my postulation that this characterization is missing in nuance.

It is just a theory.  It is not widely accepted.

Let’s look at Preferred.  Preferred is not the perfect, riskless, bank.  This isn’t a story about that.  It has risks.  But most are different risks than say, FRC or SIVB.  This is a story about how Preferred is very different than the two banks in California that failed.

THE BANK

Preferred was founded as a Chinese-American bank.  They have evolved past that, they say they serve the “mainstream markets” of their areas, but they still benefit from migration from China and other parts of East Asia and I suspect a lot of their lending is to this demographic.

Geographically Preferred was in the middle of the crisis.  That made those few days in March some tough days.  The CEO Li Yu gave a lesson learned in the Q1 press release.

Nevertheless, the bank had a good first quarter.  They had earnings of $38 million, EPS of $2.61 per share.  Earnings increased 46% YoY but were $1.5 million less than Q4.

In Q1 Preferred had an extremely high ROA of 2.41% and an ROE of 24.47%.  Their efficiency ratio in Q1 2023 was 26%.

While this performance was on the high-side of their historical results it was not that unusual.  Historically Preferred has been a very strong performer, especially since 2017.

Return on assets since 2017 has been above 1.5% and return on equity above 15%. 

Over the last 9 years Preferred has had an earnings CAGR of 22.5%.  That seems pretty, pretty good.  I’ve never quite been able to figure out banks in this respect.  Earnings CAGR is earnings CAGR right?  Yet banks that grow earnings by 20%+ for 10 years barely a get multiple above 10x.

Of course, I am comparing banks to the real world.  In the bank valuation world the market has rewarded Preferred’s performance with a generous multiple well above tangible book value – generally between 1.5x and 2x, with a P/E of in the lofty range of 12-15x!

Now before I run away gushing about the bank performance, Preferred hasn’t always been an outperformer. During the Great Financial Crisis (GFC) Preferred did very poorly. They are California based lender, which was ground zero of the housing crisis. But what made matters worse is that Preferred lent to single family home builders. Obviously when the housing market turned, being long land and new construction housing in California was a disaster.

This SeekingAlpha article has a good chart that illustrates what happened.

So take that for what you will. Either a harbinger of what may come or a lesson learned. They have made a point on past calls to say they keep construction loans below 10% nowadays. Though, as I will point out, their loan book is not without risk.

Preferred did seem to out-earn in 2022 and Q1 of this year. This is likely due to the interest rate lag (loans getting repriced right away while deposits reprice slower).  But even if you plug in their historic ROE of 16.5%, in 2022 Preferred would have had $7.13 EPS – which at even 10x earnings would still be a $70 stock.

My conclusion? Since the GFC, Preferred has done well. They have a 10 year track record of growth. They seem like a well-run bank. They’ve certainly been a growing one, as assets have expanded about 4x since then.

THE LOAN BOOK

But FRC and, to a lessor extent, SIVB, were also well-run banks.

What makes Preferred different?

The first and main difference are what Preferred’s assets are.  You get a hint that something else is going on when you look at their large net interest margin (NIM). 

Preferred’s NIM has expanded every quarter since Q1 2023.  It was 4.77% in Q1 2023.  That is a high NIM.  One of the highest.  Remember that big banks like Comerica and Fifth Third have NIMs in the 3s.  Keybanc is actually below 3%.

The big reason that Preferred has such strong NIM is that almost all their loans are variable rate loans.  From an analyst question on the Q1 call:

I just wanted to get an update on kind of the health of your variable rate borrowers given that you got 80%, 85% of your loans variable rate, you’ve seen loan yields up 300 basis points from the lows.

Being so levered to variable rates means that Preferred is largely benefiting from the Fed tightening.

This is a bank that should like higher rates.  If rates go up virtually their entire loan book reprices up.  Their deposits?  They will reprice higher too, but not nearly as much.

Think about it this way – banks are all talking about deposit betas. Analysts are fretting that deposit betas are now rising to 45 or 50. Everyone has been freaking out about that.

What this is really saying is that the deposits will reprice to 45% – 50% of the rise in the Fed Funds rate.  Which is a lot higher than what was being said a quarter ago. But for Preferred, their loan book is already repricing 80-85% of the Fed Funds rate. They have a loan book beta (I’m making this term up) of 80-85.

That is not to say that Preferred doesn’t have rate risk with the loan book.  It does.  But it’s the opposite risk.  If rates come down, those loans will price down immediately and deposits will likely be more sticky.

The other risk, which is also a real one, is that their gain is their customers loss. Their customers are hurting by paying high variable rate loans. Now Preferred says this isn’t a problem, that all their clients are dealing with the higher rates, but you have to wonder how much stress it is causing.

Regardless, this is a bank that is geared to higher rates. So you would think that when the Fed talked about raising rates further that would be good for Preferred.

Yet what did the stock do after Powell talked rates up this week?

It went straight down with all the other banks that are negatively correlated to higher rates.

Ok, so that’s the rate sensitivity of the loan book at a glance.  Now let’s look at the loan composition.

First the bad news.  Exhibit A: their loans are largely real estate.

Exhibit B: Of those $3.4b of real estate loans, $2.8b are commercial real estate.  And of that, Preferred has 10% of their loan book in office, or about $500mm.  This is quite a bit.

But just like all banks aren’t the same, all CRE is not the same and neither is all office CRE.  Where is Preferred’s office CRE?

First where they are not. They are not in downtown Los Angeles and only a very small amount is in downtown San Francisco.  They said they have one $8mm loan in SF which is not really made to anyone in the office-space maelstrom:

Of this amount, roughly $8 million is in the downtown area. We have faithfully have tried to avoid especially Los Angeles urban area for the past 20 years. And most of our office properties in the suburban area that in California, especially in Los Angeles, it’s a big, really suburban area. So there’s little communities everywhere and basically the property there is a lot more stable than the downtown area. And when we have the $8 million in downtown area is really in San Francisco that was leased and in the long-term lease to, I think, one of the famous university over there. It is very, very, how should I say, underwritten quite well is loan-to-value ratio probably less than 40% in any event.

Their office portfolio has an average LTV of 61% and average loan size of $4.1mm.  The largest 3 loans average about $40 million a piece.

Preferred went into a lot of detail on their top-4 office loans on the call:

The office building that is — one of the office building in the $50 million range is in one of the hottest areas in Los Angeles core, Culver City, which we have the creative and entertainment district, the first floor are all upscale — I mean they have upscale, good restaurants that do a bustling business. The second third floor is rented out to a new credit card type of company with LC support from a major bank. So that’s one. And also that we have a very rational, very reasonable sponsorship behind it.

The next largest one is in — is one of the buildings in Koreatown, the owner of that is rearranging the office building, making that office building near fully occupied and underwritten.

The owner of this office building is very, very, very substantial, very, very successful. And his credit in Los Angeles is it’s tough notch. Okay? Its cash flow is huge. So these are the top 2 as you have wanted to know, okay?

And I might explain the third one is in a very rich area of Newport Beach, where a group of people bought office building and my view, that group of people have dealt with us for many, many, many, many projects there. And a substantial group of people bought the office building and vacated everything and it’s going to demolish it and convert into apartments.

The fourth biggest office building is in the same category as the third.  It is being torn down to put up condos.

To sum that up: of the four biggest buildings, two of them are really construction loans where the office buildings are being torn down for condos.  One is a three story building in Culver City, a “hot” area of LA’s entertainment district with upscale restaurants and then offices above rented out to a credit card company.  And the last is in Koreatown and is fully occupied.

Just generally on how their credit is doing, Preferred said they “don’t have any nonaccrual or classified or even 30 to 89 days…in the office sector”.  There are no immediate credit concerns at least.

That doesn’t mean there won’t be though. The real risk with Preferred is credit risk – in a downturn. Banks are all about trade-offs and the trade-off Preferred makes is take rate for risk.

Preferred has reduced their exposure to construction loans since getting bowled over in the GFC. But they remain a heavy lender of real estate perm-loans.

Perm-loans are bridge loans made after construction. They are short term (3-5 years, thus the term mini-perm which is short for mini-permanent).

These are higher risk loans because they are being made to newly constructed buildings that are not yet occupied. There is no cash flow at the start.

Mini-perm loans are about 60% of Preferred’s book. In a true downturn, this is definitely a risk.

So it’s not that there isn’t risk with Preferred.  It is just that it is not at all the same risk as SIVB or FRC. And Preferred shouldn’t be trading in lock step with fed funds, as if it were a bank that had half their portfolio in mortgage-backed securities.

Speaking of securities.  Preferred is the opposite of the failed banks. While SIVB and FRC owned a lot of government securities, Preferred doesn’t own much at all:

Preferred has a grand total of $400mm of securities at fair value.  $40mm of embedded losses.  The entire value is less than 10% of their balance sheet.  They have more cash than securities.

Given the lack of securities, they really don’t lose any meaningful book value (real or marked) on rising rates.  Which is kind of the point here.  This bank has positioned themselves to rising rates.  Yet the stock is behaving like they aren’t.

DEPOSITS

On deposits, Preferred is like other banks. Deposits are the one place where all banks (other than the largest regionals – like PNC and the money center banks like BofA and JPM) are the same.  All banks are experiencing higher deposit costs, fewer non-interest bearing deposits, and more CDs.

Preferred’s non-interest bearing deposits declined in Q1 2023.  Their non-interest bearing deposits are below anywhere they have been in the last 10 years.

And that has impacted their cost of deposits.  Preferred’s cost of deposits rose to 2.49% in the first quarter.

Preferred said on the Q1 call that in March their cost of deposits was 2.63%.  That means average costs for January and February was 2.46%.  It looks like their Q4 2022 average rate was 1.66%.

The conclusion? Deposits costs are most definitely increasing.  But that March number is not crazy high.  And given their loan book, it is going to take a much larger rise in their deposits to really bite into their earnings.

Being in California, Preferred did lose some deposits during those few days in March after SIVB collapsed.  But they have already gained some of those back.  From their Q1 call:

During the 3 days in March, March 9, March 11 and March 12 and March 13, okay?  The 3 working days.  Preferred Bank also experienced deposits outflow.  The good news is we have a total of less than 10 accounts that pull the money out.  The bad news is that 3 of them is very precised.  For the quarter, our deposit reduced or decreased by 2.7%.  As of yesterday evening, which is April 18, we have our deposits increased 1%, back increased 1%.

FWIW they are still advertising for new accounts at pretty decent rates. But so is just about every other bank not named JP Morgan or Bank of America (though I read even that is changing). So I don’t really know if this is saying as much as some suggest:

SUMMING IT UP

There are two points I’m trying to make here.

First, there is more nuance to banks than is given credit for.  All banks have risk. But those risk are not all the same. Not every California bank should be lumped in with FRC and SIVB just because they are in California.  I was listening to the Michael Campbell show this weekend.  He had Jim Thorne on, who btw made a nice case for a continuing bull market.  But at one point Thorne and Campbell start talking about regional banks, and it was the usual: The banking crisis is not over… commercial office buildings with loans coming due… there will be defaults… all of this falls at the feet of the regional banks.  It was the usual refrain.

Everyone talks about “regional banks” as though they were some kind of monolithic entity that moves as one.  The Borg.

Yet here is a bank that a Raymond James analyst said was “one of the most rate-sensitive banks around”.   Like I said at the start, between 80-85% of their loan book is variable rate.  Is this really the same risk?

My second point is rather simple.   Preferred is a bank with a 10 year history (really more) of growing EPS and the last 9 years it has done that at a 22% CAGR.  A week or so ago you could buy Preferred at about 1x TBV and well under 10x PE. Today it is 1.1x TBV and still well under 10x PE.

In a world where tech is valued at well over 10x sales for a revenue CAGR that is equal to or less than Preferred, and even after considering the risks in office, the risks in deposits, the risks in California, that doesn’t seem like a bad price.