By Ann Heffron, CFA, CPA

OTC:CPKF

READ THE FULL CPKF RESEARCH REPORT

Chesapeake Financial's (OTC:CPKF) first quarter net earnings rose $0.4 million, or 13%, year over year to $3.4 million, while 2020's first quarter diluted EPS increased by $0.08, or 13%, to $0.68 from $0.60 posted a year ago. All data in this report have been adjusted for a 6-for-5 stock dividend, paid on October 15, 2019.

This was better than our estimate, which had called for essentially flat net earnings at $3.0 million and flat diluted EPS at $0.60 (off by $0.08).

The main factors behind the difference between actual results and our estimate were: (1) net interest income was $0.1 million more than we had estimated as the net interest margin of 3.79% was 9 basis points higher; (2) noninterest income was $1.0 million greater than anticipated as there were $1.2 million of securities gains (our estimate had been zero), which was partially offset by reduced merchant card income ($0.2 million below our estimate) and (3) compensation costs were $0.2 million less than estimated. These were offset by: (1) a provision for credit losses that came in $0.4 million higher than our $0.17 million estimate due to the potential effects of COVID-19 on the loan portfolio; (2) noninterest expense that was $0.4 million more than estimated due primarily to higher other miscellaneous expense; and (3) income tax expense that was $0.1 million larger due to higher-than-estimated pretax earnings and a tax rate of 15.0% versus our 14.0% estimate.

The major reasons for the first quarter's 13% increase in net earnings versus the prior-year quarter were a $2.0 million, or 17%, advance in net revenues, largely due to growth in net interest income (up $0.8 million) and net securities gains (up by $1.1 million), partly offset by a $1.1 million, or 14%, rise in total noninterest expense, primarily from greater compensation costs (up $0.7 million) and increased other miscellaneous expense (up by $0.4 million), as well as $0.4 million more in the loan loss provision and $0.1 more income taxes due to greater pretax earnings and a higher effective tax rate of 15.0% versus 12.6% a year ago.

We are increasing our 2020 diluted EPS estimate by a $0.15 to $2.45, a $0.16, or 7%, increase over 2019's $2.29. Our initial 2021 diluted EPS estimate is $2.50, a nickel higher than our 2020 estimate. There are many uncertainties in our estimates, stemming from the effects of COVID-19. We discuss these below.

First, CPKF has participated in the Paycheck Protection Program (PPP), designed to provide a direct incentive for small businesses to keep their workers on the payroll. Through the beginning of June, CPKF had generated about $75 million of PPP loans. The Small Business Administration (SBA) will forgive loans if all employees are kept on the payroll for eight weeks and the money is used for payroll (60% of the forgiven amount must have been used for payroll), rent, mortgage interest, or utilities. PPP loans are guaranteed by the SBA for 100% of amount of the PPP loan not forgiven. Loans issued prior to June 5 have a maturity of 2 years and 5 years after that. All loans have an interest rate of 1%. In addition, lenders receive fees for processing the PPP loans: 5% for loans of $350,000 or less, 3% for loans between $350,000 and $2 million, and 1% for loans of $2 million or more. PPP loans provide for the deferral of payments for a period of 6 months, including payment of principal, interest and fees. Interest will accrue, but payments will not be required during the first 6 months. Processing fees will be amortized over the contract life and adjusted based on actual prepayments. Upon notification from the SBA of the amount of the PPP loan to be forgiven, acceleration of recognition of deferred processing fees will occur for the percentage of the loan forgiven. 

The PPP will have countervailing impacts on the CPKF's net interest margin. First, the 1% annual interest rate is lower than is typical for CPKF loans, which will tend to reduce the NIM. However, PPP processing fees, amortized over the life of the loan, will add to the NIM. Moreover, when a PPP loan is forgiven, any deferred processing fee will also be added to the NIM. We have estimated a net interest margin of 3.75% for the second and third quarters of 2020, and a 5% net interest margin for the fourth quarter, assuming the majority of the deferred processing fee (estimated at $2.8 million) is recognized at this time. For full-year 2020, our NIM estimate is now 4.08% (up from 3.70% previously), which compares to an actual NIM of 3.98% in 2019. Our initial NIM estimate for 2021 is 3.70%.

Secondly, we have significantly increased our estimate of the provision for loan losses in 2020 to $2.3 million from $0.7 million, to allow for any asset quality deterioration that may occur as a result of the pandemic. At present, a portion of the loan portfolio is on deferral, with three months' of payments added onto the back end of the loan. Though these loans are in deferral, they are still accruing interest for the time being. After three months, the loans will be evaluated to determine their status. CPKF has wisely chosen to beef up its loan loss reserves in preparation for the possibility of asset quality deterioration due to economic distress caused by COVID-19, though asset quality remained strong in the first quarter.

For 2021, our initial estimate for the loan loss provision is $1.2 million, about half the level of 2020. We assume some economic improvement from 2020, though note the $1.2 million level is still much higher than the loss provision had been in each of the past six years prior to the pandemic.

There are other factors adding to CPKF's expense burden going forward. CPKF expects several new hires to increase compensation costs. CPKF's digital strategy for its new on-line banking platform requires investing in new technology, leading to higher IT expense. Finally, the Company expects to add a full-service branch to its network in the third quarter, which will also increase expenses.

Loan demand, other than for PPP loans, has softened, and we have reduced our loan growth estimate for 2020 by one-half, to 4% from 8%. Our initial estimate for loan growth in 2021 is 5%.

Finally, we have cut back our estimate of net merchant card income, reflecting the termination of one independent sales organization (ISO) in the first quarter, as well as lower card volumes due to reduced consumer spending during the pandemic. Thus, we have cut our estimate for merchant card revenues to $3.4 million from $4.9 million in 2020, and are using an initial estimate of $3.6 million for 2021.

On October 18, 2019, Chesapeake Financial Shares, Inc. approved a 3% quarterly dividend increase to $0.125 per share from $0.121 per share, payable on or about December 15, 2019 to shareholders of record on December 1, 2019. Notably, CPKF has increased the annual dividend payment every year for the past twenty-nine years since 1991. This follows on the heels of a 6-for-5 stock dividend, paid October 15, 2019.

In 2020 for the thirteenth consecutive year, Chesapeake Financial Shares, Inc. has been included in the American Banker magazine listing of the "Top 200 Community Banks" in the United States. The bank ranked at #75 in the nation out of approximately 511 publicly traded banks and thrifts with less than $2 billion in assets in the study, up from #148, when CPKF first broke into the rankings in 2008. The ranking is based on a three-year average of return on average equity (ROAE), which for CPKF was 11.48%. Chesapeake Bank again garnered a top ranking in the American Banker's list of "Best Banks to Work for", moving up to a #19 spot in 2019, out of the 85 banks listed, from a #25 place in 2018.

In other news, Chesapeake Financial Shares, Inc. graduated in 2019 from the OTCQB Venture Market to the OTCQX Best Market, trading on OTCQX under the symbol CPKF.

Chesapeake Financial Shares, Inc. (CPKF or the Company) is a financial holding company headquartered in Kilmarnock, Virginia, with $958 million in total assets at December 31, 2019. CPKF is predominantly a small business lender with 15 branch offices and one loan production office that serve customers in the eastern region of Virginia between the Potomac and James Rivers. CPKF, which began as Lancaster National Bank on April 13, 1900, has a long history and strong ties with the communities it serves.

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