CPKF: Some Surprises, But a Good Quarter Overall

By Ann Heffron, CFA, CPA



CPKF’s (OTC:CPKF) third quarter net earnings increased $0.4 million, or 11%, year over year to $3.8 million, while 2021’s third quarter diluted EPS soared by $0.09, or 13%, to $0.78 from $0.69 posted a year ago.

This was well above our estimate, which had called for a $0.6 million decrease in net earnings to $2.8 million and a $0.11 decline in diluted EPS to $0.58.

The main factors behind the difference between actual results and our estimate were: (1) net interest income was $1.2 million higher than our estimate due to a larger-than expected contribution from PPP income recognized during 2021’s third quarter of $1,178,000, as well as higher average interest-earning assets; (2) noninterest income was $0.8 million, or 14%, more than we had estimated due to better-than-expected contributions from all segments; (3) the provision for loan losses swung a positive $0.7 million to a credit of $525,000 (i.e., a reversal of the loss provision) from an estimated charge (provision) of $175,000; and (4) income tax expense was $0.2 million less than our estimate due to an effective tax rate of 2.7% that was 5.9 points lower than our 8.6% estimate. These were partly offset by: (1) the provision for cash management losses that came in at $1.0 million versus our $30,000 estimate offset and (1) other miscellaneous expense that was $0.9 million more than projected.

The major reasons for the third quarter’s $0.4 million, or 11%, increase in net earnings versus the prior-year quarter were a $1.6 million, or 12%, gain in net revenues, as growth in net interest income (up $2.4 million, or 29%) was partly offset by an $0.8 million, or 14%, decline in other noninterest income. The decrease in noninterest income reflected a $0.6 million drop in mortgage banking income on weaker activity as well as a $0.2 million fall in other miscellaneous income. In addition, earnings benefitted from a $1.15 million decline in the provision for loan losses to a credit (reversal) of $525,000 from a charge (provision) of $625,000 in the prior year. Moreover, income tax payments were $0.5 million lower due to a reduced effective tax rate that was 11.8 points less than a year ago. These positives were partly offset by a $2.9 million, or 32%, increase in total noninterest expense, largely stemming from a $0.5 million rise in compensation costs (up 8%), a $1.0 million advance in the provision for cash management losses, a $1.3 million jump in other miscellaneous expense (up 46%), and a $0.1 million (19%) rise in occupancy costs.

We are again raising our 2021 diluted EPS estimate by $0.20 to $3.15 from $2.95, 32% above 2020’s actual diluted EPS of $2.40. Our diluted EPS estimate for 2022 increases by the same amount—to $2.70 from $2.50, $0.45 or, 14%, below our 2021 estimate. The main reasons for the EPS decline in 2022 reflect the winding down of the PPP (and related decrease in recognition of deferred processing fees of an estimated $4.13 million in 2021), the absence of securities gains ($730,000 in 2021 to date), a loss provision of $0.7 million (compared to zero in 2021), and a $0.7 million drop in mortgage banking income, partly offset by a $1.3 million decrease in the cash flow loss provision.

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 $0.2 million remained outstanding at September 30, 2021.  PPP loans that were originated in 2021 under the CAA totaled $36 million, with a remaining $11.7 million outstanding as of September 30, 2021.

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, but reduced our estimate for full-year 2022 by 5 basis points to 3.25%, with both estimates excluding any impact from the recognition of deferred processing fees.

The NIM will be supplemented in 2021 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, of which $1,178,000 was recognized in the third quarter, significantly more than the $660,000 recognized in the second quarter. The remaining $0.4 million balance of deferred processing fees will likely be booked into income during during the final quarter of 2021.

For 2021, we are cutting our estimate of the loan loss provision from $0.7 million to $0.0 million, following the $525,000 reversal of the loss provision in the third quarter. This compares to 2020’s $1.95 million loss provision, 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 remains $0.7 million.

The provision for cash flow losses, a separate line item listed under other noninterest expense, is raised from $0.12 million to $1.44 million in 2021. This follows the $1.0 million rise in the loss provision during the third quarter and an estimated $350,000 bump in the fourth quarter to beef up loss reserves going forward. These adjustments stem from the bankruptcy of one $2.3 million credit, for which there is no expectation of any recovery, but which is now fully written off.

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 recently opened 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, and we are maintaining our recently increased estimate of loan growth in both 2021 and 2022 at 8%.

We are increasing our estimate for merchant services income by $0.2 million to $4.2 million, with $4.3 million our estimate for 2022. We are also raising our estimate of cash management fee income to $1.8 million from $1.5 million in 2021 and to $2.0 million from $1.7 million in 2022, as growth is coming in a bit higher than anticipated.

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 stand-alone estimates for mortgage banking income are $3.0 million in 2021 (up from $2.4 million previously) and $2.3 million in 2022 (up from $1.8 million before).

For the second time this year, Chesapeake Financial Shares increased the quarterly dividend. On October 14, 2021, the Board of Directors raised the dividend by 8% to $0.14 per share from $0.13 per share, payable on December 15, 2021, to shareholders of record at December 1, 2021. This follows a 4% dividend increase to $0.13 per share from $0.125 per share declared in January 2021 and paid on March 15, 2021. Notably, CPKF has increased the annual dividend payment every year for the past thirty years since 1991.

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.

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