Bank Of Hawaii: Interest Rates, Expenses To Pressurize Earnings

Summary

• Earnings are expected to decline partly because of the Fed rate cut in March that will squeeze margin.
• Branch network expansion is expected to add to expenses, thereby dragging earnings this year.
• Quarterly dividend is expected to be maintained at $0.67 per share, implying a dividend yield of 3.8%.

Bank of Hawaii’s (NYSE:BOH) earnings are expected to dip in 2020 partly because of the Fed rate cut in March that will compress margin. Further pressure is expected to come from the normalization of non-interest income. In addition, BOH plans on expanding its network which will increase operating expenses and hence drag earnings. The December 2020 target price implies a significant potential for capital appreciation, thereby, making BOH a good investment for a year’s time frame. Outlook for the near term is, however, not bright due to COVID-19 and the resultant deterioration of market sentiment. As the outbreak could take up to three months to settle down, I’m expecting jitters to remain in equities for the next quarter. Therefore, for the short term, I’m adopting a neutral rating.

Margin Compression To Undermine Loan Growth

BOH’s net interest margin, NIM, is expected to be one of the chief contributors to a decline in earnings this year. The 50bps Fed funds rate cut in March is expected to pressurize NIM as the effect of lower interest rates on yields will overcome the impact on deposit cost. However, as mentioned in the fourth quarter conference call, there was some lagged positive impact remaining to be taken from last year’s rate cuts, which will be realized this year. This positive impact is to come through a reduction in deposit costs. Consequently, I’m expecting the compression in NIM to be limited. As shown in the table below, I’m expecting BOH’s NIM to decline by 4bps in the first quarter and then by 2bps in the second quarter before stabilizing, on a linked-quarter basis.

The impact of lower NIM on net interest income is expected to be mostly offset by an expansion in the loan portfolio. BOH is planning to expand its branch network by four more branches this year, which will help build up loans and deposits. Moreover, the lowering of interest rates should encourage the origination of new loans. Furthermore, unemployment in Hawaii continues to be at record lows, with the unemployment rate recorded at only 2.6% for December 2019, as opposed to the national average of 3.5%. Low unemployment will push the demand for consumer loans. All of these factors are expected to drive loan growth in 2020. During the last conference call, which was held before the panic related to COVID-19 spilled over, the management mentioned that they expected loan growth rate in 2020 to be at a similar level as in 2019, i.e. 5.2%.

I’m expecting loan growth to miss management’s target due to the implications of COVID-19. Hawaii depends on tourism which will be particularly hit by the epidemic. The official statistics released so far do not show any negative effect from COVID-19, but I believe the situation should start reflecting in the numbers soon.

Considering the above factors, I’m expecting BOH’s loan growth to decelerate to 4.1% year over year in 2020. The following table presents my estimates for key balance sheet items.

Investments To Drive Expenses

As mentioned in the conference call, BOH plans on opening four new branches that will add to its occupancy cost and salary expense. Moreover, BOH is expected to continue to invest in technology and data services to facilitate customers that will also drive non-interest expense this year. Furthermore, the management expects a bump in depreciation this year. As a result of these factors, I’m expecting BOH’s non-interest expense to grow by 2.7% year over year in 2020, which is at the higher end of management’s guided range. The growth in non-interest expense is expected to be a major contributor to the decline in earnings this year.

Expecting Earnings To Decline By 7%

As discussed above, the compression in NIM and rise in non-interest expense is expected to constrain earnings this year. The bottom line is also expected to be pressurized by the normalization of non-interest income, which had surged in the last quarter of 2019 on the back of a one-off item. As mentioned in the conference call, this one-off item was a gain of $3.8 million related to an early buyout of a leverage lease. The absence of this gain in the future will return non-interest income to a more normal level in 2020; thereby leading to lower net income. I’m expecting BOH to book average non-interest income of around $44 million in each quarter of 2020, in line with management’s guidance.

The pressure on earnings from the above-mentioned items is expected to be partly offset by loan growth. Overall, I’m expecting BOH’s net income to decrease by 7% in 2020 to $5.16 per share. The following table presents my estimates for key income statement items.

Despite the prospects of earnings decline, I’m expecting BOH to maintain its quarterly dividends at the current rate of $0.67 per share. The dividend and earnings estimates suggest a payout ratio of 51.9% for 2020. As the management mentioned in the conference call that they will continue their strategy of paying out around 50% of earnings, I believe that dividend will be maintained at the current level instead of getting cut. The dividend estimate suggests a dividend yield of 3.8%.

Adopting Neutral Rating

I'm using the historical price-to-book (P/B) multiple to value BOH. The stock has traded at an average P/B multiple of 2.57 in the past, as shown below.

Multiplying this P/B ratio with the forecast book value per share of $32.6 gives a target price of $83.9 for December 2020. This target price implies an upside of 19.1% from BOH's March 6 closing price. The following table shows the sensitivity of the target price to the P/B multiple.

While the target price suggests a positive outlook for BOH over the next nine months, the outlook for the near term is less optimistic. Due to COVID-19, the overall market sentiment is expected to remain neutral to bearish in the next two to three months, which will also affect banking sector stocks including BOH. Moreover, COVID-19 has created the risk of further rate cuts (side note: I’m not expecting any additional rate cuts in the remainder of 2020). The anticipated decline in earnings is also expected to hurt investor confidence in the near future. As a result of these near-term headwinds, I’m adopting a neutral rating on BOH.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This article is not financial advice. Investors are expected to conduct their own due diligence, and consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.