Asian Banks

Originally posted on the Street Insight section of thestreet.com 2/28/2006 4:35 PM EST

I am going to start my Long/Short picks by spotlighting Asian-owned/focused banks, a sector I have been following for fifteen years. My picks are: Cathay General Bancorp (CATY), Hanmi Financial (HAFC), Bank of Hawaii (BOH), Preferred Bank (PFBC), East West Bancorp (EWBC), and UCBH Holdings (UCBH). I think investors should own the group. Over the past 200 days, each of these banks, with the exception of CATY, have done better that the banking sector as a whole, as the following chart shows. The black line, Banks, refers to the Philadelphia Bank Sector Index (BKX). I note that Helene Meisler posted an article on RealMoney explaining why she expects the rally in bank stocks to continue. I agree, but expect these stocks to do better than the industry, for reasons explained below.

Demographic Rationale for the Sector

Between 2000 and 2004, minority group populations grew much faster than the 4.3% national rate. I think demographic trends favor the 74 Asian-owned banks in the U.S., owned by members of an ethnic community with the second fastest population growth from 2000 to 2004. The Asian population in the U.S. increased 16% between 2000 and 2004. The number of Asian firms grew by 24% from 1997 to 2002 (the latest year data is available). Overall, the number of firms in the U.S. grew by 10.3% during the same period. I like the sector's Asian exposure, also. A caveat: one must understand that there are many Asian communities in the U.S. Business practices and loyalties in Chinese, Korean, Vietnamese and other Asian communities differ widely.

Further, by June 2006, the Census Bureau will release updated survey numbers on Asian, black and Hispanic-owned businesses. We expect this data to show significant growth, as it has in the past. This will lead investors to look for ways to take advantage of this sector. Several pension funds, especially those in ethnically and culturally diverse states, have sought to harness this trend. I think this effort will lead them directly to these stocks, so we expect an increase in investor demand to buoy prices somewhat. Interest rates are, however, always a factor.

Understand the rationale. Just because you are a minority-owned financial institution does not mean you will benefit from these trends. Your ability to profit depends critically on the quality of management, product offerings, market share, costs (specifically, interest rates,) and which minority group we are talking about. My rationale is this: over the next 12 to 18 months, I believe these institutions will benefit because of their position as leaders in the Asian sub-sector of the banking industry.

Most of the banks are trading at levels that are below current price/book valuations.

Consolidation

There is significant consolidation occurring. I think some of the big VC and hedge funds are aware of these demographic trends and are financing a roll up strategy in this sub-sector. See the list below.

Asian Banks and Consolidation

• CATY 2006 - Acquired Great Eastern Bank (GEB).
• HAFC 2003 - Bought Pacific UnionBank. 1998 - Bought First Global Bank.
• EWBC 2005 - Bought United National Bank. 2003 - Acquired Pacific Business Bank. 2000 -purchased American International Bank.
• UCBH - 2006 - Bid for Great Eastern Bank (GEB). Lost to CATY.

This means these mergers will continue. Now, here's the problem. I don't know which of these banks will be acquired and which will be doing the acquiring. Rather than worry about that, I want to own them all. Strong fundamental factors mean, however, that I am not depending upon an acquisition to bail me out. Now, on to the specifics.

Cathay General Bancorp (CATY)

Cathay General Bancorp (CATY) just agreed to acquire Great Eastern Bank (GEB) for $58.44 per share. The deal will more than double Cathay's loans and deposits in New York, and provides a platform for expansion along the East Coast. CATY is a holding company for Cathay Bank, which offers financial services to individuals, professionals and small to medium-sized businesses primarily in the United States. This is a Chinese bank, with an office in Taiwan.

The bank has an expansive financial service product portfolio that should serve to provide a platform for future revenue growth. The bank also owns Cathay Trade Services, Asia Limited (CTS). CTS provides letters of credit for U.S.-based import customers. Cathay has representative offices in Taipei, Hong Kong and Shanghai. While these offices generate no income, I think they serve to tie the bank to it's US customer base.

If they can cement ties between Asian-owned business operating in the U.S. and Asian businesses, the bank may be able to profit from the significant trade growth. Founded in 1961, Cathay operates branches in Washington State, New York State, Massachusetts; Houston, Texas; and California.

Average return on assets (ROA) for all Asian banks was 1.11% as of June, 2005. Average return on equity (ROE) was 11.51% for Asian banks on 6/30/05. For Cathay, ROA and ROE were 1.70% and 13.77%, respectively, well above both ethnic group and minority bank sector percentages.

Cathay has a price/book of 2.34x. Regional banks in the Pacific U.S. sell for 3.2x book value. With the New York acquisition, the bank is not strictly a Pacific region player. I think this valuation metric is the appropriate in this case, given $15.41, I believe a target of $50 is possible. I believe the stock fell from $40.00 to $34.00 from mid-November to mid-February due to uncertainty over the planned, now successful, acquisition. Now that the deal's done, I expect the stock to rebound. I suggest using recent share price declines as a reason to buy.

To protect myself, I would use a downside stop-loss of $30: 20% below the stock's current price. The stock has not been below $30 since early 2004, so there is no reason to think it will go this low. This gives you 40% upside, 20% downside, and the trade is on automatic pilot. If it doesn't approach my target in 18 months, I will bail out.

Hanmi (HAFC)

Hanmi Financial is a Korean bank, the largest in the U.S. The bank operates 20 branches in Los Angeles, Orange, San Diego, San Francisco and Santa Clara counties. Starting in 1982, the bank has made a number of successful acquisitions, buying First Global Bank in 1998 and Pacific Union Bank in 2003. The bank has a strategic alliance with Woori Bank in Korea. Hanmi reported record net income in the first quarter of 2006 at $1.17/share. Much of this increase was driven by increases in net interest margin (4.77% in 2005 vs. 4.26% in 2004.) On January 24, the bank's stock was added to the Standard and Poor's Small Cap 600 index.

Hanmi has a price/book of 2.04x. Regional banks in the Pacific U.S. sell for 3.2x book value. With a most recent quarter book value of $8.77 and a most recent closing price of $17.88, my target is $28.00. I have a soft stop-loss at $16.5 with a hard stop at $14, so the risk/reward in Hanmi is very attractive. (I would reduce my position if it trades below the soft stop level of$16.5, and I would eliminate my position if it trades below my hard stop of $14.)

Bank of Hawaii (BOH)

Bank of Hawaii is the oldest bank in the sector, founded in 1897, and the only bank in the group that is not Asian-owned. The bank is based in Hawaii, Honolulu to be exact. I like the stock. As I mentioned in an earlier post on Fannie Mae (FNM), I like companies who have come through a scandal in the clear, and BOH falls into this category. The SEC announced on December 15, 2005 that it has ended a market timing investigation concerning Pacific Capital Funds, mutual funds managed by the bank. I feel this bodes well for the company and the stock.

Valuation for BOH is different, since the bank is trading above the 3.2x book for regional banks in the Pacific U.S. My target is $62.00, 16% above a recent closing price of $53. My stop loss is at $47.50, about 10% below the most recent close. While this may not seem like an attractive risk/reward ratio, I am conservative about my price target. The stock is close to its all-time high, and could easily run close to $70 as memories of the scandal fade.

Preferred Bank (PFBC)

Preferred Bank has been focusing on southern California's Chinese-American population since 1991. With nine branches in the Los Angeles area and a market capitalization of $322 million, the bank is one of the smaller banks in the group. The bank specifically targets ethnic Chinese migrants to southern California, a growing group. The bank reported record 2005 net income on January 25 of $16.8 million vs. $11.2 million in 2004, a 51% increase.

Preferred has a price/book of 2.59x. Once again, I am valuing the bank relative to regional banks in the Pacific U.S., at 3.2x book value. With a most recent quarter book value of $18.56, my target is $59.40. The stock closed on Friday at $48.18, so my target is 23% and eleven points and twenty one cents higher than current value. The stock reached a 52 week high at $48.50 on Feb. 17, 2006, so we know the stock is at the upper end of its trading range, just like BOH. My stop loss is $40, almost 20% below the recent quote. Just like BOH, I am using a conservative price target that could easily be revised upwards, especially if acquisition fever sweeps through the group.

East West Bancorp (EWBC)

East West Bancorp is the holding company for East West Bank, a bank providing retail and commercial banking services in California. The bank operates 45 branches in California, with a representative office in Beijing, China. The bank provides trade finance services to U.S. importers and manufacturers doing business in the Asia Pacific region. Jordan Khan wrote a Feb. 24 Long/Short Investor post recommending this bank.

We agree with his assessment, but for different reasons (see my comments on demographic factors above.) East West has a price/book of 2.81x. Relative to Pacific U.S. regional banks, at 3.2x book value, I believe the stock is undervalued. My target for the stock is $42.00, just below the stock's all-time high of $43.50. The bank has a most recent quarter book value of $12.99. EWBC closed on Friday at $37.02, so my target is only five points and higher than current value.

I am using a soft stop at $35 and a hard stop at $32. So I would trim positions at $35 and reduce positions at $32. The risk/reward ratio appears tight, but this stock could easily exceed my expectations as Asian bank stocks get attention.

UCBH Holdings (UCBH)

UCBH Holdings operates United Commercial Bank. The bank caters to an Asian-American target market via 50 branches in California, Massachusetts, New York and Washington State. Again, I like the bank's Asian exposure, with offices in China, Hong Kong and Taiwan. As with all of the banks recommended, UCB is an active international player, offering Pacific Rim trade financing services.

UCBH has a price/book of 2.74x. Relative to Pacific U.S. regional banks, at 3.2x book value, value the stock at $21.00. The bank has a most recent quarter book value of $6.42. UCBH closed on Friday at $17.79, so my target is 18% higher than current value.

I have a stop-loss at $16.25, which is 9% below the recent quote. So this stock has an attractive ratio of reward to risk, and may still benefit as investors become enthusiastic for Asian bank stocks.