A Compelling Case for Cathay General
We are optimistic about Cathay General Bancorp's (CATY: $34) focus on the Chinese-American community, and on the expected growth rates in this market. According to the U.S. Census Bureau, this population segment is expected to grow by about 8% to 10% over the decade ending 2010, vs. 3% to 5% for the total U.S. population.
We believe the company will be able to prosper in a highly competitive environment due to a strong customer base and solid positioning in this market. In the coming years, we see continued strong earnings growth, combined with stringent credit quality standards. We also like Cathay General's practice of selective acquisitions of smaller Chinese-American community banks which find themselves overburdened by the cost of regulatory compliance.
One more point in Cathay General's favor, in our view: The shares are currently trading at a compelling valuation. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).
Cathay General is the holding company for Cathay Bank, a California state-chartered bank with 46 branches in seven states, and representative offices in Hong Kong, Shanghai, and Taipai. Founded as a savings and loan institution in Los Angeles in 1962, Cathay General has evolved into a commercial lender, with only about 22% of loans currently made to individuals. Further growth opportunities are in financing pan-Pacific trade with China, Taiwan, and Hong Kong.
The company conducts substantially the same business operations as a typical bank: it accepts checking, savings, and time deposits, and makes commercial, real estate, personal, home improvement, automobile, and other installment and term loans. Services also include letters of credit, wire transfers, spot and forward contracts, and other customary bank services.
As of Mar. 31, 2007, Cathay General had assets of $8.7 billion, which includes $5.9 billion in loans (gross of reserves for loan losses), and $2.1 billion in interest-earning securities, backed by deposits of $5.7 million and other borrowings of $1.9 billion.
Gross loans were up nearly 18% from $5 billion at Mar. 31, 2006, primarily due to the acquisitions of Great Eastern Bank and New Asia Bancorp in March, 2006, and May, 2006, respectively. Cathay General's loan portfolio was dominated by commercial real estate (57% of the total).
Growing From California Roots
Due to the acquisitions, nonperforming loans at Mar. 31, 2007, amounted to $32.7 million (0.55% of gross loans held for investment), vs. $17.2 million (0.34%) at Mar. 31, 2006. The allowance for loan losses at Mar. 31, 2007, totaled $65.3 million (1.11% of total loans and 200% of nonperforming loans), vs. $61.7 million (1.23% and 358%) a year earlier.
Deposits totaled $5.7 billion at Mar. 31, 2007, up 13.9% from $5 billion at Mar. 31, 2006. Deposits were apportioned as follows: jumbo (over $100,000) time deposits, 46%; time deposits under $100,000, 18%; non-interest-bearing demand, 14%; money market, 12%; savings, 6%; and NOW deposits, 4%. The deposits-to-loans ratio has fallen to 97.1% at Mar. 31, 2007, from 100.4% a year earlier, a negative development that we estimate resulted from the two mergers completed in 2006.
Cathay has expanded from its roots in Southern California through acquisitions. In October, 2003, the bank completed a merger with GBC Bancorp, and simultaneously changed its name to Cathay General Bancorp, from Cathay Bancorp.
In May, 2006, Cathay General completed its acquisition of Great Eastern Bank (GEB), a New York City-based bank with five branches and approximately $330 million in assets. This transaction doubled Cathay General's New York loans and deposits, and the addition of five GEB offices raised Cathay General's New York City presence to nine offices.
In October, 2006, Cathay General completed the acquisition of Chicago-based New Asia Bancorp, for $23.5 million in cash and stock. In March, 2007, Cathay General purchased United Heritage Bank of Edison (UHBE), based in New Jersey, for $9.4 million in cash. At Dec. 31, 2006, UHBE had assets of $60 million, deposits of $55 million, and loans of $40 million. This is Cathay General's first New Jersey location.
In 2007, we anticipate that the addition of new branches in Ontario, California, Dallas, Texas, and Washington, plus the integration of Great Eastern Bank, New Asia Bancorp, and United Heritage Bank, will drive 10.5% total loan growth, with deposits increasing 8.5%. For 2007, we expect non-interest income to grow 19%, and total 7.8% of revenues. Non-interest expenses are forecast to be 37.6% of revenues, down from 37.9% in 2006. We expect net income to advance 9.9%, and project earnings per share (EPS) of $2.47, up 8.8% from $2.27 in 2006.
For 2008, we expect loan growth to moderate, to 8.5%, with deposit growth matching that level. We project non-interest income to rise 9.5%, and account for 7.7% of total revenues. Non-interest expense is estimated to be 37.0% of revenues. We forecast net income growth of 7.9%, leading to EPS of $2.67, up 8.1%.
Furthermore, we think Cathay is well-positioned if the currently inverted yield curve should begin to normalize to a steeper level later in 2007 or in 2008. Since Cathay generated only 7% of revenues from non-interest income in 2006, this means that the remaining 93% was based on borrowing and lending spreads, which have narrowed since the Federal Reserve began raising short-term interest rate targets in July 2004. For comparison, the average regional bank collects about 35% of total revenues from non-interest income, often from insurance brokerage services, deposit charges, and credit card issuance.
In 2007, we expect non-interest income to rise to 8% of revenues, up from 7% in 2006, still a relatively low level. If lending and borrowing margins widen, we think Cathay's earnings could benefit at a rate greater than peers.
We think investors may be discounting Cathay General vs. peers East-West Bancorp (EWBC) and UCBH Holdings (UCBH) due to concerns over corporate governance, deposit growth, and credit quality. In our view, these concerns are manageable. Therefore, we think the discount is overly large.
Trend to M&A
To arrive at our 12-month target price for CATY, we compare the stock with East-West and UCBH, as well as with other banks of similar size, expected growth rates, and geographical base, such as City National (CYN). East-West currently trades at 15.8 times our 2007 EPS estimate, UCBH trades at 15.6 times, and City National at 15.3 times. In our target price calculations for these three banks, we have estimated that they could trade at an average of 17.4 times.
We think that valuations in the regional banking industry have been supported by mergers and acquisitions activity, a trend which we think will continue in 2007. Recent acquisitions of midcap regional banks have occurred with price-to-forward earnings per share multiples in the high teens. Using a target multiple of 16.6 times our 2007 EPS estimate of $2.47 for Cathay General, we derive our target price of $41.
We believe that Cathay General's corporate governance policies are generally sound, but that there is room for improvement. Positive factors, in our view, are that the board is controlled by a majority of independent outsiders, the compensation committee is comprised solely of independent outside directors, there is a single class capital structure in place, and all stock-based incentive plans have been approved by shareholders. In addition, the company has not restated financial results for any period in at least the last two years.
Risks to the Recommendation
However, we view a number of the company's corporate governance policies unfavorably. Most of these issues, in our opinion, have to do with takeover defenses and with board composition issues that would hinder a hostile takeover, should one occur. The major negative factors, in our view, are that the board of directors is classified, shareholders do not have cumulative voting rights in director elections, and the board is authorized to increase or decrease the size of the board without shareholder approval. In addition, the company has a poison pill in place, which was not approved by shareholders, and a supermajority of shareholders is required to amend certain provisions of the bylaws.
Risks to our recommendation and target price, in our view, include the following:
•A continuing flat or inverted yield curve further increasing the cost of attracting and maintaining the level of deposits, while at the same time constraining loan yields. Cathay's earnings are dependent on its ability to maintain a favorable differential or spread between the yield on its interest-earning assets and the rates paid on its deposits and other interest-bearing liabilities.
•Acquisition integrations and the possibility of overpaying for future acquisitions. In addition, there is a risk of incorrectly assessing the asset quality of a bank acquired in a particular transaction.
•Competition in the Chinese-American banking market from peers East-West and UCBH, and much larger banks such as HSBC (HBC), Bank of America (BAC), and Wells Fargo (WFC: Hold; $35).
•A U.S. or Chinese economic slowdown adversely affecting loan growth and credit quality.