Excess liquidity continues to weigh on PacWest Bancorp’s (NASDAQ:PACW) profitability, but management has made some strong moves to build the business toward even more long-term loan growth. Add more loan growth to an already-strong profitability story (one of the most profitable banks in its peer group), and you have a dramatically stronger long-term earnings story.
This significantly improved earnings outlook, not to mention a much better-than-feared credit migration through the COVID-19 pandemic, has driven very strong share price performance over the past year even with a recent pullback. Even with the strong move off of the pandemic bottoms, PacWest shares could still generate a double-digit annualized return from here on improving loan growth and the profit leverage that should produce.
PacWest continues to be held back in part by excess liquidity on the balance sheet – deposits that it can’t deploy into assets with attractive yields (like loans). That, and higher costs associated with growth projects at the bank, kept a lid on core earnings (pre-provision operating profits) relative to expectations, with higher than expected reserve releases driving the beat.
Revenue rose around 8% year over year and came in flat with the prior quarter, a total result that was a bit better than the sell-side expected. Net interest income rose 5% yoy and 2% qoq, again beating by a small margin. Net interest margin was a weaker-than-expected 3.4%, declining 29bp qoq and missing the Street by 29bp; management estimated that excess liquidity had a 73bp negative impact on the quarter (versus 61bp in Q1’21). Greater balance sheet growth helped offset that spread pressure, hence net interest income coming in about 1% better than expected.
Non-interest income rose 30% yoy (closer to 4% on a core basis) and declined 10% qoq, also beating expectations by a small margin. At less than 15% of revenue, PacWest still doesn’t generate all that much non-spread income. This isn’t unusual for a bank like this, but I do wonder if growing fee-based revenues could become a bigger priority for management in the coming years.
Higher compensation costs, some related to the Civic acquisition and some related to incentive compensation, drove expenses up 19% yoy and 3% qoq and above sell-side expectations. Even allowing for the higher than expected revenue this quarter, the efficiency ratio was a point worse than expected.
Pre-provision profits declined 1% yoy and 2% qoq, coming in basically flat with Street expectations. With pre-provision profits equal to about 2% of average earning assets, PacWest remains a very profitable bank, though that profitability is being compromised by excess liquidity (down 63bp from 2.62% last year).
Lower provision expenses drove the vast majority of the $0.54/share beat versus the Street, and tangible book value per share rose 8% sequentially – a good performance even when compared to “growth banks”.
Two of the biggest changes in the PacWest story relative to my last update on the bank are in credit quality and loan growth. Management built reserves to one of the highest levels among the peer group during the height of the pandemic, but credit quality has come through much stronger than expected, even with PacWest having higher exposure to more challenged areas like hotels, retail, aerospace, and energy services.
Loans increased modestly on an as-reported sequential average basis (about 1%), but increased a much more robust 5% on an organic end-of-period basis, as lending activity picked up throughout the quarter and ended strong. Commercial real estate lending grew more than 5% on an adjusted basis, while C&I loans rose around 10% on an adjusted basis, with strong growth in areas like equity fund lending, and consumer lending was likewise strong (up more than 7%).
Loan yields declined 2bp on a sequential basis (to 5.18%), while yields on new production jumped 19bp to 4.55%. PacWest continues to see good deposit growth, helping drive total deposit costs down another 1bp to 10bp.
Management has also taken some significant steps to drive further loan growth. The biggest was the February acquisition of Civic Financial Services, a national lender focused on specialty residential business loans like bridge loans, loans for property flippers, and rental property financing.
As is often the case with lenders like this, the business has been limited in part by access to low-cost capital, and PacWest has a significant opportunity to deploy low-cost deposits into the business and grow it at a double-digit rate in the coming years; management believes that this can become a multibillion-dollar business with all-in yields (including fees) of around 9%.
PacWest is also building its funding, despite the negative headwinds from excess liquidity this quarter. Back in April, management announced the acquisition of $4 billion in HOA deposits from Mitsubishi UFJ’s (MUFG) Union Bank. While the price paid looks a little high at first (a 5.9% premium), these are sticky, low-cost deposits (8bp currently; 21bp at the peak in the last cycle) that can help fund profitable future loan growth.
Between specialty asset-based/equipment lending, bridge lending to equity and VC funds, specialty residential lending (Civic), and more traditional “core” lending like multifamily CRE, I see some significant loan growth opportunities for PacWest, backed by a strong low-cost core deposit base. Given the leverage in the operating model, a materially improved outlook for profitable loan growth drives a material improvement in the long-term growth outlook, and the better-than-expected credit migration through the pandemic only helps that.
With that, my long-term growth expectations for PacWest have risen from the mid-single-digits to the high single-digits, with a long-term ROE around 12.5% instead of 10% before. As I’ve mentioned before, PacWest is an uncommonly profitable bank and running more growth through that business should drive some impressive profitability and return metrics over the next five years.
I absolutely underestimated how much the growth and margin outlook for PacWest would improve as the business returned to growth. Not needing those reserves it built during the pandemic was a significant help, but so too has been management’s willingness to reinvest in growth (Civic, the HOA deposit deal). With those moves, even after the major move in the shares, there’s still above-average return potential here.
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