CPKF: Strong Third Quarter Was Better than Expected

Author: Zacks Small Cap Research | December 22, 2020 12:20pm

OTC:CPKF

Chesapeake Financial's (OTC:CPKF) third quarter net earnings rose $0.2 million, or 5%, year over year to $3.4 million, while 2020's third quarter diluted EPS decreased by $0.04, or 6%, to $0.69 from $0.65 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 significantly better than our estimate, which had called for a $0.9 million decline in net earnings to $2.3 million and $0.19 drop in diluted EPS to $0.46 (off by $0.23).

The main factors behind the difference between actual results and our estimate were: (1) a $0.9 million jump in other miscellaneous income due to large gains in refinancing fees stemming from strong mortgage loan origination; (2) merchant card income growth that was $0.3 million more than expected; and (3) compensation costs that were $0.2 million below our estimate. These were offset by: (1) net interest income that was $0.1 million less than we had estimated as the net interest margin was a bit lower than expected and (2) income tax expense that was $0.2 million higher due to greater-than-estimated pretax earnings.

The major reasons for the third quarter's 5% increase in net earnings versus the prior-year quarter were a $0.7 million, or 5%, gain in net revenues, as growth in net interest income (up $0.8 million) was partly offset by a $0.1 million, or 2%, drop in non-interest income, which reflected $1.1 million growth in miscellaneous income from higher mortgage refinancing fees that was more than offset by the absence of securities gains ($0.7 million in 2019's third quarter), a $0.1 million fall in merchant card income, and $0.4 million decline in cash flow income. Other contributing factors included a $0.1 million, or 2%, rise in total non-interest expense, primarily from greater compensation costs (up $0.2 million) offset by reduced other miscellaneous expense (down by $0.1 million), as well as $0.4 million more in the loan loss provision.

We are reducing our 2020 diluted EPS estimate by a nickel from $2.45 to $2.40, an $0.11, or 5%, increase over 2019's $2.29. However, we are maintaining our 2021 diluted EPS at $2.25, 6% below 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 end of September, CPKF had generated about $77 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 loans 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 3.55% for the fourth quarter of 2020, exclusive of any impact from the recognition of deferred processing fees.

The NIM will be supplemented by the recognition of deferred processing fees. Originally, we had estimated that the majority of the deferred processing fees (estimated at $2.96 million) would be recognized during 2020's fourth quarter. We are now estimating that approximately $1 million of deferred processing fees will be booked in 2020's fourth quarter, while the balance will be recognized in 2021's first quarter. At the same time, we are cutting our 2021 NIM estimate, exclusive of any impact from the recognition of deferred processing fees, to 3.45% from 3.70%, stemming from the effect of continuing low interest rates.

Secondly, our estimate of the provision for loan losses in 2020 is $2.4 million, about 4.5 times higher than in 2019, to allow for any asset quality deterioration that may occur as a result of the pandemic. Though asset quality remained strong in the third quarter, 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. Positively, certain loans, which had previously been on deferral though still accruing interest (with deferred payments added onto the back end of the loan), are no longer in deferral. This means these loans are paying full principal and interest unless granted an interest only period.

For 2021, we are reducing our estimate of the loan loss provision to $0.9 million from our initial estimate of $1.2 million, about 40% of the level of 2020. We assume some economic improvement from 2020, though note the $0.9 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 added 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 somewhat, and we have again reduced our loan growth estimate for 2020 by one-half, to 2% from 4%. Our estimate for loan growth in 2021 remains 5%.

Our estimate of net merchant card income has been increased due to recent improvement in card volumes. For 2020, our new estimate for net merchant card income is $3.8 million, up from $3.2 million before, while our 2021 estimate is now $4.2 million versus $3.4 million before.

Finally, we had previously slashed our estimates of cash flow income, as customers opted for PPP loans, rather than cash flow financing. We are maintaining these reduced estimates of $2.5 million in 2020 and $2.0 million in 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 $1,172 million in total assets at September 30, 2020. CPKF is predominantly a small business lender with 16 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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