Hope Bancorp's (NASDAQ:HOPE) earnings per share declined by 39% quarter-over-quarter to $0.21 due to a surge in provision expense. Earnings will likely recover in the remainder of the year compared to the first quarter, but remain below last year's level. I'm expecting provision expense to remain elevated in the second quarter due to the worsening of the economy beyond the expectations in the first quarter. Moreover, the net interest margin will likely contract in the second quarter due to the full-quarter impact of the federal funds rate cuts in March. Consequently, I'm expecting HOPE's earnings per share to decline by 23% year-over-year to $1.04 in 2020. The December 2020 target price suggests a significant upside from the current market price. The uncertainties surrounding the severity and duration of the economic downturn could lead to a surprise jump in provision expense beyond expectations. The chance of an earnings surprise poses risks to earnings and valuation; therefore, I'm adopting a neutral rating on HOPE.
Worsening Unemployment to Boost Provision Expense
HOPE's provision expense surged to $28 million in the first quarter from $1 million in the last quarter of 2019. The management used Moody's Baseline V2 scenario assumptions to determine the provisioning requirement, as disclosed in the first-quarter's investor presentation and conference call. Most of the assumptions used are in line with my current macroeconomic outlook, except for unemployment. The scenario assumes an average unemployment rate of 8.7% for the second quarter. However, initial jobless claims totaled 30 million in the past six weeks, which can mean an unemployment rate of over 18% using a civilian labor force number of 162,913,000. There was already an unemployment rate of around 3.5% before the start of the COVID-19 pandemic, which means that currently, the total unemployment rate must be higher than 18%. I do not expect the unemployment rate to improve much in the second quarter as I'm expecting the economy to reopen by the third quarter. Therefore, I'm expecting actual unemployment during the second quarter to be worse than the unemployment rate incorporated in the provisioning for the first quarter. Consequently, I'm expecting that HOPE will need to book further provisions for loan losses in the second quarter.
HOPE's exposure to the hospitality industry will likely drive the provision expense. As mentioned in the investor presentation, hotels and motels made up 19.7% of total commercial real estate loans, or 13.6% of total loans, as of the end of March 2020. Moreover, other sectors too will drive provisions due to the widespread impact of the COVID-19 pandemic. As mentioned in the conference call, requests for loan modifications made up around 2% of total loans, which indicates the portion of the loan portfolio that is in trouble.
Based on the factors mentioned above, I'm expecting HOPE to book a high provision expense of $20 million in the second quarter. Further, I'm expecting provision expense to return to a more normal level in the second half of the year. For full-year 2020, I'm expecting HOPE to post a provision expense of $54 million, or 42bps of total loans, as opposed to 6bps of total loans in 2019.
Fall in Yields to Undermine Effect of Loan Growth, CD Repricing, and Favorable Changes in Deposit Mix
I'm expecting HOPE's net interest margin, NIM, to decline in the second quarter due to the full-quarter impact of the 150bps federal funds rate cuts in March. Most of the variable-rate loans have repriced down by the end of April, which will pressurize average yield this quarter, as mentioned in the conference call. Moreover, HOPE's participation in the Paycheck Protection Program, PPP, will decrease the average yield. As mentioned in the conference call, the management expects to earn over $14 million as lender's fees at an average rate of 3.6%. The fee under PPP is below HOPE's average yield of 4.7% in the first quarter. The fall in average yield and stickiness of core deposits will likely squeeze NIM this quarter.
On the other hand, the maturity of certificates of deposits, CDs, will ease the pressure on NIM in the remainder of this year. As mentioned in the investor presentation, CDs representing around 11% of total deposits will mature in the second quarter, 10% will mature in the third quarter, and 7% will mature in the fourth quarter of 2020. Furthermore, the management plans to shift the deposit mix towards lower-costing core deposits, which will support NIM this year. Due to the repricing and changes in deposit mix, the management expects to reduce the average deposit cost to below 1% in the second quarter, from 1.18% in March and 1.34% in the first quarter. (Note: The table below shows total funding cost, which includes deposit cost).
Considering the factors mentioned above, I'm expecting HOPE's NIM to decline by 23bps in the second quarter on a linked quarter basis. The following table shows my estimates for yield, cost, and NIM.
Continued loan growth will likely offset part of the adverse effect of NIM compression on net interest income. The high demand for relief loans will likely keep loan growth elevated in the second quarter before the growth returns to a more normal level in the second half of the year. Demand for PPP loans will also drive loan growth. Consequently, I'm expecting HOPE's net loans to increase by 5.2% year-over-year in 2020, as shown below.
I'm expecting NIM compression to outweigh the impact of loan growth; therefore, I'm expecting HOPE's net interest income to decrease by 2.3% year-over-year in 2020.
Expecting Earnings to Decline by 23%
The surge in provision expense and contraction in NIM will likely pressurize earnings this year. As a result, I'm expecting HOPE's earnings per share to decline by 23% year-over-year to $1.04. The following table shows my estimates for income statement items.
The uncertainties surrounding the severity and duration of the economic downturn can lead to surprises in future provision expense. Due to the uncertainties, the management has limited its guidance for 2020 and given only directional guidance in its latest conference call. These uncertainties make HOPE a risky investment for the near-term of around three to four months.
I'm expecting HOPE to maintain its quarterly dividend at the current level of $0.14 per share in the remainder of 2020. There is little chance of a dividend cut because the earnings and dividend estimates suggest a payout ratio of 54%, which is sustainable. Moreover, the year's total dividend amount of $70 million is only a small claim on capital. As of December 31, 2019, HOPE had $860 million of tier I capital in excess of the minimum regulatory requirement, according to the 10-K filing. The dividend estimate for 2020 suggests a dividend yield of 5.6%.
Adopting a Neutral Rating
HOPE's average price-to-book multiple, P/B, in 2019 was 0.86. Multiplying this average P/B ratio with the forecast book value per share of $16.4 gives a target price of $14.1 for December 2020. This price target implies an upside of 41.4% from HOPE's April 30 closing price. The following table shows the sensitivity of the target price to the P/B ratio.
The high upside suggests that HOPE is a feasible investment for a holding period of nine months. Nevertheless, I'm adopting a neutral rating on HOPE due to the stock's high level of risk. The severity and duration of the economic downturn are uncertain, which poses risks to the earnings estimate and valuation.
