I think it's fair to say that some banks just don't get a lot of love, at least not in the current investment environment. My clients and I own shares in three financial institutions that have struggled to recover their share price over the last few months, and even worse, they have significantly underperformed the Invesco KBW Regional Banking ETF (KBWR), which they are all a part of.
While the full-year change looks abysmal, the improvement since January 1st gives investors a reason to be optimistic.
Of the three stocks mentioned above, we view Bank OZK (OZK) as the exception because it was associated with concerns about bad loans and real losses that contributed to a major drop in Q3-2018. I wrote an article on it titled Bank OZK: A Sober Review Shows The Concerns Are Priced In that suggested the negative news was an overreaction and that the negative sentiment was already priced in. When OZK reported dismal Q3-2018 earnings it took a major hit when it comes to investor confidence, and I believe that it will take several more quarters before it can begin to restore its reputation.
This leaves PacWest Bancorp (PACW) and EastWest Bancorp (EWBC), which have both seen their share price suffer in an almost identical fashion and most important, without a true underlying reason (similar in size or impact of OZK's Q3-2018).
The remainder of this article will be used to analyze PACW's strengths and weaknesses and to provide an updated sentiment regarding its long-term prospects. I plan to perform the same analysis for EWBC in another article.
What Makes PacWest Bancorp Unique
PACW is a total of 74 full-service branches located in the state of California and one in Durham, North Carolina. PACW offers services to small, middle-market, and venture-backed businesses through the following three segments/groups, as paraphrased from Page 11 of the Q1-2019 Earnings Report:
- Community Banking: Provides real estate loans, commercial loans, and deposit/treasury management services to small and medium-sized businesses. These services are typically provided through PACW's 74 full-service California branches.
- National Lending: Provides asset-based, equipment, real estate, and security cash flow loans and treasury management services to established middle-market businesses on a national basis.
- Venture Banking: Provides financial services and tools that are focused on serving entrepreneurs and their venture capital/private equity investors.
PACW's national lending and venture banking groups are what truly make PACW stand-out from traditional community-based banks. PACW serves a very niche market that primarily consists of highly affluent investors that need specialty products that meet their needs.
It should also be noted that PACW has been making changes over the last three years focused on derisking the bank by reducing exposure to select loan portfolios and emphasizing an increase of higher-quality loans even though it came at the expense of reduced yield. In my opinion, the following two changes have had the greatest impact:
- Exiting the healthcare, technology and general cash flow lending origination businesses in 2017. The portfolio was reduced from $2.4 billion at the end of 2016 to $112 million at the end of March 31, 2019.
- Management decided that it would be more advantageous to emphasize the percentage of equity fund loans as a percentage of the $2 billion venture banking loan portfolio. At the end of 2016, the total percentage of equity fund loans student 16% but has since increased to 43% as of March 31, 2019.
One way these changes have shown up is that there continues to be a steady reduction in the number of loans that are labeled as special mention or classified. According to PACW's Q1-2019 10-Q, the definition of these terms are as follows:
- Special Mention: Loans and leases that have a potential weakness and require management's attention. If the weakness associated with these loans is not addressed by management it may result in further deterioration of the borrower's ability to repay the loan or lease.
- Classified: Encompasses loans with a credit risk rating of substandard or doubtful. Loans designated as substandard have a well-defined weakness that jeopardizes the collection of the debt and it is likely that PACW will sustain some degree of loss if left uncorrected. Loans designated as doubtful share all the same characteristics as substandard loans but have additional negative characteristics that make collection or repayment questionable and improbable.
The image above shows that PACW has seen a major improvement in the number of loans designated special mention or classified from Q1-2018 to Q1-2019. As of March 31, 2019, PACW had a total of $483 million of loans with either of these designations and was down from $623 million of loans in Q1-2018. One of the most compelling positives to consider is that PACW was able to lower the total dollar amount with these designations while increasing the total dollar amount of loans and leases held for investment by roughly 11% YoY or just under $1.85 billion.
I last reviewed PACW's Q3-2018 earnings report in my article that focused on their now-failed acquisition of El Dorado Savings Bank (here) and noted that some of the most disappointing (or concerning) metrics were:
- Net Interest Margin
- CET1 Ratio
Now, let's compare how these metrics have changed by examining what originally concerned me and how they compare with Q1-2019's current figures.
Net Interest Margin (NIM): Decreased from 5.18% in Q2-2018 to 4.99% in Q3-2018. The NIM has since deteriorated to 4.69% in Q1-2019.
The risk to NIM going forward has a lot to do with deposits (discussed in a separate section) and the potential impact of interest rate increases/decreases. Management summarizes all of these moving factors in their Q1-2019 10-Q interest rate scenario.
Of the $18.4 billion of total loans at March 31, 2019, $11.0 billion have variable interest rate terms (excluding hybrid loans discussed below), of which $10.6 billion have a loan rate higher than their floor rate, which allows them to reprice at their next reprice date upon a change in their index. Approximately 60% of the variable-rate loans (excluding hybrid loans) have a LIBOR index rate. Of the $418 million of loans with rates below their floor rates at March 31, 2019, $397 million (95.1%) will rise above their floor rates with a 100 basis point increase in market rates. LIBOR is expected to be phased out after 2021, as such the Company is assessing the impacts of this transition and exploring alternatives to use in place of LIBOR. The business processes impacted relate primarily to our variable-rate loans and our subordinated debentures, both of which are indexed to LIBOR.
Additionally, approximately $3.6 billion of variable-rate hybrid loans do not immediately reprice because the loans contain an initial fixed-rate period before they become variable. The cumulative amounts of hybrid loans that would switch from being fixed-rate to variable-rate because the initial fixed-rate term would expire were approximately $251 million, $593 million, and $1.2 billion in the next one, two, and three years.
The following image shows that PACW's current portfolio benefits when interest rates increase and lose value when interest rates decrease.
Interestingly enough, PACW's model suggests that the market value of its equity loans will see downside when interest rates increase. At first, it almost looks like its equity loans are a hedge against falling interest rates because the loans have a slight upside when rates are decreasing, but if interest rates decrease too much, PACW would expect to see a significant drop in value (with interest rates down 300 basis points).
Source: Q1-2019 10-Q
Equity-based loans account for just under 22% of total assets and have a projected market value of $5.74 billion based on current interest rates from March 31, 2019. The equity aspect of their assets appears to be rather stable when interest rates are increasing/decreasing until we began talking about a 300 basis point drop (which would be almost entirely unlikely).
Deposits: Deposits of $19.28 billion in Q1-2019 is well above deposits of $17.88 billion in Q3-2018. In order to make sure that this increase is not due to seasonality alone, we need to compare it to deposits at the end of Q1-2018 which were $18.07 billion. This represents an annualized deposit growth of 7% year-over-year (YoY). Most things would consider a 7% YoY deposit growth to be excellent.
One of the primary challenges encountered by practically all financial institutions is striking a balance between core deposits and time deposits (brokered funds). Core deposits are essential to an efficient operation because it generally represents the lowest cost of capital possible. In order to continue issuing new loans, it is necessary that banks like PACW continue to grow deposits so that they may fund these new loans. If there is a shortage or reduction in deposits then PACW is forced to reach out to other channels with the goal of shoring up deposits in doing so at the lowest cost possible.
Source: Q1-2019 10-Q
The image above demonstrates some of the important year-over-year changes in PACW's deposit mix, including:
- The cheapest cost of funds (non-interest-bearing demand deposits) now constitutes 40% of total deposits on March 31, 2019, compared with 46% on March 31, 2018.
- Interest checking accounts saw an increase of approximately $1.1 billion YoY and usually represents one of the lowest costs of capital
- Time deposits less than $250,000 in size increased from 8% of total deposits in Q1-2018 to 12% of total deposits in Q1-2019.
CET1 Ratio: The CET1 ratio dropped to 10.17% in Q3-2018 and has since dropped further to 9.48% in Q1-2019, which is well below the median CET1 ratio of comparable banks the average 10.75%.
I found the following breakdown of PACW's net interest income to be particularly helpful in understanding exactly how much the cost of deposits (interest-bearing deposits and interest-bearing liabilities) are putting downward pressure on earnings since it is causing a decrease in the net interest rate spread and the NIM.
There are a few extremely important items on the table above that we need to put the perspective:
- PACW's Q1-2019 total interest-earning assets yield of 5.6% is absolutely phenomenal, and it is important to understand that most banks would kill to have this type of return. Because this number is already high, it is difficult for PACW to see an increase in this rate because interest rates have stagnated.
- Interest-bearing deposits and liabilities have increased dramatically on YoY basis and have basically doubled in cost from Q1-2018 to Q1-2019. To put this change into perspective, total interest expense increased by $28.4 million over this time frame.
- I expect that the total interest-earnings assets yield to remain flat for a minimum of the next six months. I believe that interest-bearing deposits and liabilities will remain flat or increase by a negligible amount over the same time frame.
Strong Credit Metrics
While short-term negative sentiment surrounding PACW is apparent, there are still a number of positive developments and reasons to consider investing in PACW. Although the changes made over the last three years have put pressure on NIM, the improvement to various credit metrics looks promising.
- Reduced classified loans from 2.67% of loans on December 31, 2016, to 1.04% of loans on March 31, 2019.
- Nonaccrual loans were reduced from 1.11% on December 31, 2016, two .48% as of March 31, 2019.
- Provision for credit losses saw a decrease of 15 basis points from .42% in 2016 down to .27% in 2018.
These reductions are extremely important considering that we are approaching the point in the credit cycle where increased defaults have become inevitable.
Stock Repurchase Program
On February 24, 2019, PACW's Board of Directors authorized a new stock repurchase program that allows for an aggregate purchase price of up to $225 million of stock that expires on February 29, 2020. Given PACW's current share price of $39.32/share which represents approximately 5.72 million shares. Some shares were repurchased prior to February 24th under the previous agreement.
Source: Q1-2019 10-Q
The total amount of shares outstanding on March 31, 2019, were 120.2 million and $159.6 million remained available for share repurchases until February 29, 2020. Compared with Q1-2017, the number of total shares outstanding has been reduced by approximately 5.2% or roughly 6.3 million shares YoY. With $159.6 million remaining, the total number of shares that can be repurchased stands at 4.06 million.
Source: Q1-2019 10-Q
PACW appears to be doing an excellent job of managing noninterest expense even as building occupancy costs increased YoY. Compensation accounts for nearly 60% of the total noninterest expense and has remained flat when compared with Q1-2018. At the time when wages are rising, this is the most important noninterest expense to consider, especially because PACW has continued to increase in total size (assets), and we would normally expect this to be accompanied by increased wages (in the form of hiring new employees, bonuses, or pay raises).
FastGraphs - P/E Ratio
FastGraphs is an excellent tool for helping bring together the data presented in this article because everything that has been discussed so far is a component of the big picture but category on its own represents data that is actionable. As a long-term dividend investor, one of my primary goals (once I have reviewed the data above) is to determine whether or not shares are trading below, at, or above fair value based on historical valuations. Personally, I think it should be every investor's goal to invest when shares are selling below fair value because this represents the most optimistic scenario that an investor will see above-average returns. With that said, unless you are paying attention to the market on a daily basis (I am glued to three monitors and a Bloomberg terminal at work), then it can become quite difficult to identify investments with this kind of upside potential.
One of the reasons why I chose to use an 8-year FastGraphs chart is because I wanted to exclude the impact of the financial crisis on PACW's P/E Ratio between 2008 and 2011. On the 8-year I believe that the Normal P/E ratio average of 17.2x is far too high given the current interest rate and the cost of funds environment that banks are operating in. If we assume the P/E ratio of 17.2x is correct, we would be implying the current fair value of shares should be somewhere in the neighborhood of $63- $65/share. Because this premise seems so ridiculous I decided to test what PACW's P/E ratio would look like on the shortest term possible which is three years.
A P/E ratio of 13.2x is much closer to what I would consider PACW's fair value to be. Considering PACW is trading at a P/E of 10.3x or $38.59/share there appears to be significant upside to a P/E ratio of 13.2x which suggests a share value of $49.96/share. Overall, I believe that it is reasonable to see an upside of 29.5% in PACW's share price.
Declining NIM is something that all investors should consider when looking to add financial institutions to their investment portfolio, however, in PACW's case the negative trend associated with NIM needs to be put in the context of management's continued focus on credit quality and a major reduction in higher-risk lending activities.
PACW is currently priced as if interest rates will continue to increase at the same pace that they have over the last two years and this has created a roughly 30% difference in what shares should be trading for and what the market currently values the shares at.
I believe we will continue to see earnings remain in line with expectations for the remainder of 2019 and NIM should begin to stabilize during this time period. Better yet, income-focused investors can continue to collect a 6.2% dividend while they wait for the market to understand how they want to value PACW.
Disclosure: I am/we are long PACW, OZK. 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.
Additional disclosure: This article reflects my own personal views and is not meant to be taken as investment advice. It is recommended that you do your own research. This article was written on my own and does not reflect the views or opinions of my employer.