By Ann Heffron, CFA, CPA

OTC:CPKF

READ THE FULL CPKF RESEARCH REPORT

CPKF's (OTC:CPKF) first quarter net earnings jumped $1.9 million, or 56%, year over year to a record $5.3 million, while 2021's first quarter diluted EPS soared by $0.40, or 60%, to $1.08 from $0.68 posted a year ago.

This was well above our estimate, which had called for a $0.4 million decline in net earnings to $3.0 million and a $0.07 decrease in diluted EPS to $0.61.

The main factors behind the difference between actual results and our estimate were: (1) noninterest income was $2.1 million higher than our estimate due to a larger-than expected contribution from PPP income recognized during 2021's first quarter of $1.87 million; (2) noninterest income was $0.3 million more than we had estimated due to higher-than-expected mortgage banking income; and (3) compensation expense came in $0.4 million lower than anticipated. These were offset by: income tax expense that was $0.5 million greater due to higher pretax earnings and an effective tax rate of 16.6% that was 1.6 points higher than our 15% estimate.

The major reasons for the first quarter's $1.9 million, or 56%, increase in net earnings versus the prior-year quarter were a $2.2 million, or 17%, gain in net revenues, as growth in net interest income (up $3.1 million) was partly offset by a $0.9 million, or 16%, drop in noninterest income, as well as a $0.4 million decline in the provision for loans losses. This reflected $0.5 million growth in mortgage banking income, a $0.2 million increase in merchant services income, and a $0.3 million gain in other miscellaneous income. These positives were more than offset by the absence of securities gains ($1.2 million in 2020's first quarter), a $0.2 million net loss on foreclosed assets, and a $0.5 million decline in cash flow income on lower receivables balances. Other contributing factors included a $0.2 million, or 3%, increase in total noninterest expense, largely stemming from a $0.1 million rise in compensation costs (up 2%) and a $0.1 million (up 4%) advance in other miscellaneous expense, as well as $0.5 million higher income tax payments due to greater pretax earnings and a slightly higher effective tax rate.

We are raising our 2021 diluted EPS estimate by $0.50 to $2.75 from $2.25, 15% above 2020's actual diluted EPS of $2.40. Our initial diluted EPS estimate for 2022 is $2.50, $0.25 or, 9%, below our 2021 estimate. The main reason for the EPS decline in 2022 reflects the winding down of the PPP, and related decrease in recognition of deferred processing fees. Details of our estimates are discussed more fully 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. 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, 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, 2020 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. (We note these amounts have been tweaked under new provisions when the Consolidated Appropriations Act (CAA) was signed into law on December 27, 2020. The CAA provides for two types of PPP loans, initial or first-draw loans up to $10 million, for entities that have never received a PPP loan, and second-draw loans up to $2 million for entities that have. The Paycheck Protection Program ended on May 31, 2021).

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. 

Through the end of September 2020, CPKF had generated about $77 million of PPP loans, of which $58 million remained outstanding at March 31, 2021. This included about $34 million of additional PPP loans that were generated in 2021's first quarter under the CAA.

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 3.30% for full-year 2021 and full-year 2022, exclusive of any impact from the recognition of deferred processing fees.

The NIM will be supplemented by the recognition of deferred processing fees. Of total deferred processing fees of about $2.97 million earned during 2020, only $770,000 was taken into income during 2020 while $1.89 million was recognized in 2021's first quarter. Moreover, we estimate that deferred processing fees earned from new PPP loans added under the CAA in 2021 generated an additional $1.52 million of deferred fees in the first quarter and $420,000 in the second quarter. These deferred processing fees will likely be booked into income during during the final three quarters of 2021, with most of this coming in the third and fourth quarters.

For 2021, we are cutting our estimate of the loan loss provision from $0.9 million to $0.7 million, about 64% below the level of 2020's $1.95 million, which reflected the bulking up of loan loss reserves in preparation for the possibility of asset quality deterioration due to economic distress caused by COVID-19 (which failed to materialize, as asset quality remains strong). For 2022, our initial estimate for the loan loss provision is also $0.7 million.

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. CPKF will be opening a new tech center, which will house IT operations, marketing, and merchant card processing, and will add to depreciation expense beginning in 2021's third quarter. Finally, the Company added a full-service branch to its network in the third quarter of 2020, which will also increase expenses.

Loan demand, other than for PPP loans, appears to be solid, with our estimate for loan growth in both 2021 and 2022 at 5%.

We are maintaining our estimate for merchant services income at $4.0 million, with $4.2 million our estimate for 2022. We are cutting our estimate of cash management fee income to $1.8 million from $2.0 million, as customers opted for PPP loans, rather than cash flow financing. With the winding down of the PPP, we expect cash management to bounce back in 2022, and are estimating cash flow fee income of $3.3 million.

For the first time in 2021, CPKF has shown a separate line item for its mortgage banking operations (previously included in other income), while at the same time folding the ATM income line item into other income. Our initial stand-alone estimates for mortgage banking income are $2.5 million in 2021 and $2.2 million in 2022.

On January 22, 2021 Chesapeake Financial Shares increased the quarterly dividend 4% to $0.130 per share from $0.125, effective March 1, 2021, payable on or before March 15, 2021. Notably, CPKF has increased the annual dividend payment every year for the past thirty years since 1991. This follows on the heels of a 6-for-5 stock dividend, paid October 15, 2019.

In 2021 for the fourteenth 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 #117 in the nation out of approximately 479 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 11.14%. Chesapeake Bank again garnered a top ranking in the American Banker's list of "Best Banks to Work for", and had a #24 spot in 2020, out of the 85 banks listed.

Chesapeake Financial Shares, Inc. (CPKF or the Company) is a financial holding company headquartered in Kilmarnock, Virginia, with $1,238 million in total assets at March 31, 2021. CPKF is predominantly a small business lender with 16 branch offices 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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