Analyst Research
Cathay General Bancorp CATY
by Michael Kon, CFA
Analyst Note 04-27-2007
Cathay General Bancorp's first-quarter results, announced Thursday, met our expectations. Despite some industrywide upheavals, the bank managed to increase net income and assets in the quarter while maintaining good credit quality. We are sticking to our fair value estimate. Cathay's net interest margin declined 50 basis points, to 3.83%, compared with 4.33% in the year-ago quarter. Despite this sharp decline, net interest income grew 12% from last year, thanks to solid growth in earning assets. Fee income also contributed its share, growing 16% from the prior-year period. The efficiency ratio, though higher by 237 basis points, was still a very enviable 38%. Credit quality remained solid, with no significant additions to nonperforming loans and negligible net charge-offs.
Thesis 04-12-2007
Cathay General Bancorp has historically produced solid returns on assets and equity in a competitive niche market. We like the bank's strategy and geographic positioning and would be investors at the appropriate price.
In 1962, Cathay General became the first bank in Southern California to cater to the ethnic Chinese-American community. The bank has since expanded into other cities with high concentrations of Asian-Americans, such as San Francisco and New York, tapping this growing and financially attractive demographic. Because Cathay's retail customers typically earn and save more than average Americans, serving them produces higher-than-average income per customer and lower loan losses.
Cathay General stands out in this niche market for its growth and efficiency. The bank has posted average annual internal asset growth near 12% since 1999, and in 2003, it doubled its assets by teaming up with California-based GBC Bancorp. What separates Cathay General, however, is its highly efficient operating strategy. Lower-cost commercial loans represent greater than 80% of the bank's portfolio, helping produce an efficiency ratio of 38% in 2006(non-ethnic peers run closer to 55%). Cost controls mean an unusually large portion of revenue is dropping directly into shareholders' pockets.
An interesting characteristic of the Asian-focused banks is the unusually low percentage of core deposits (total deposits less jumbo CDs). The bank's average customer saves a good deal, but tends to be financially savvy and doesn't park funds in noninterest-bearing accounts. As a result, core deposits represent only about 55% of the deposit base at Cathay General, while most banks rely on a core base above 75%. Still, while jumbo deposits are price-sensitive at a typical bank, the ethnic client base is very loyal and will generally not move deposits to reach for yield. So even though core deposits are low, the bank's cost of funds remains below the peer average, and we believe most deposits tend to be sticky.
Stable funding helps net interest income, but the lack of fee revenue makes us wary. The higher savings rate means overdraft fees are rare, and insurance and trust services are not typically in high demand. While many domestic banks have been reducing reliance on interest rates in recent years, this is not an option for the Asian-focused banks. Therefore, Cathay General must closely and acutely manage its exposure to interest rate risk.
We like the bank's record and expect more success as its customer base grows.
Valuation
We think Cathay is worth $40 per share. We expect assets to grow 12% annually, on average, through 2011. This growth will come mainly from acquisitions and favorable trends in the population segment the bank is targeting. Since the bank has been historically weak in generating fee income, we expect growth in noninterest revenue to track growth in total assets, averaging 12% over the next five years. We applaud the bank's strategy of increasing loans while shrinking the securities portfolio. This has enabled Cathay General to expand the net interest margin in a tough interest environment, from 3.2% in 2003 to 4.2% in 2006. We don't think the bank has much more room for margin expansion; thus, we expect the net interest margin to remain at about 4.2% over the next five years. We expect that the efficiency ratio will hover around 36% over the next five years, and that credit-quality metrics will remain in line with historical norms. Our analysis uses a 10.5% cost of equity assumption.
Risk
Cathay General's loan portfolio is geographically concentrated in the California market, and any downturn in the California economy could damage the bank's performance. In addition, most of the bank's loan originations are real estate related, which means collateral values would be hurt by falling property prices. Cathay General also faces intense competition, even in its niche market, from banks like East West Bancorp EWBC and UCBH Holdings UCBH, both of which operate in similar markets.
See Previous Analyst Reports
Close Competitors TTM Sales $Mil Market Cap $Mil
Cathay General Bancorp 301 1,752
* Bank of America 73,023 229,117
* East West Bancorp 402 2,470
* UnionBanCal 2,710 8,758
* UCBH Holdings 311 1,820
* Wells Fargo 35,691 121,090
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 12-31-2006
Strategy
Cathay General differentiates itself from peers by focusing on one segment of the population: Chinese-Americans. While California is still its main market, the bank has expanded, through acquisitions of banks with similar population segment focus, to states such as New York, Illinois, and Washington.
Management & Stewardship
Chairman, CEO, and president Dunson Cheng has been with Cathay General in some capacity for more than 20 years. We believe a great deal of the bank's success is attributable to his leadership and connections in the Chinese community. Cheng owns about 2.7% of the bank, which is enough to align his interests with those of outside shareholders, in our opinion. But in 2005, Cheng received 664,694 options, amounting to 1.3% of outstanding shares and valued at more than $8 million, in addition to his $1.8 million in cash compensation. We believe this is an excessive package, even considering the bank's strong financial performance. Overall, Cathay General's option issuance is not excessive, but we are disappointed that Cheng received 54% of the options granted in 2005. The 11-member board serves staggered three-year terms, and director compensation does not include stock options or restricted stock. However, we like that 13 directors and executive officers beneficially own 11.6% of the bank's outstanding stock on a combined basis.
Profile
Cathay General is a California-based regional bank primarily serving the Chinese-American community. With more than 45 branches and three international representative offices, the bank provides traditional loan and deposit products and international trade-related services to individuals and small to midsize businesses. The bank has more than $7 billion in assets.
Growth
We expect assets and noninterest income to grow by 12%, on average, over the next five years. We think this growth will mainly come from acquisitions of other banks that focus on the Chinese-American segment.
Profitability
The bank's return on equity has averaged 14% over the past five years. We expect it to average 16% over the next five years, mainly thanks to an increase in the net interest margin to 4.2% from the historical average of 3.9%.
Financial Health
Given that net charge-offs have averaged only 0.09% of gross loans over the past five years and the equity/asset ratio remains conservatively above 10%, we think the bank's financial health is good.
