East West Bancorp Likely To Outperform, But Not Priced Accordingly (NASDAQ:EWBC)

Today’s environment doesn’t really play to East West Bancorp‘s (NASDAQ:EWBC) strengths. Above-average loan growth has become considerably more expensive, growth is not so much in vogue, and ongoing tensions with China reduce the value of the company’s operations in that country. Even so, the shares have outperformed since my last update on the company, not only outperforming the regional banking group and the S&P 500, but also other “growth banks” like First Republic (FRC), Pinnacle (PNFP), SVB Financial (SIVB), and Signature (SBNY).

I continue to believe that East West is undervalued, but I do freely acknowledge that some of the bigger catalysts are out of management’s control – namely a less hawkish Fed and better relations between the U.S. and Chinese governments. I expect above average growth here over the next three years and the longer term, with core growth of around 7% supporting a fair value close to $90.

Mixed Results To End The Year

Like many banks, East West had a mixed quarter, though it was more unusual in that spread revenue growth was strong, but the miss was driven entirely by operating expenses. By the same token, this is one of the few banks where net interest income expectations went up meaningfully for FY’23 after the quarter was reported.

Revenue rose almost 32% year over year and more than 8% quarter over quarter, beating by about 3% or $0.11/share. Net interest income rose 49% yoy and almost 10% qoq, beating by $0.15/share and comfortably beating the 6% or so average net interest income growth from its comp group. Net interest margin rose 125bp yoy and 30bp qoq to 3.98%, while earning assets grew 1.5% from the prior quarter.

Despite efforts to grow fee-generating businesses like wealth management and treasury payments, non-interest income is still a relatively small part of revenue (10% or so), and line-items like foreign exchange are still significant. This isn’t meant as some blistering critique, but just pointing out that there’s still work (and likely opex investment) to do here. Non-interest income declined 2% qoq, missing by about $0.04/share.

Operating expenses rose 22% yoy and 19% qoq, missing by about $0.18/share and by about 330bp on the efficiency ratio. Pre-provision profits rose 57% yoy and 3% qoq, missing by about $0.07. While East West did beat at the bottom line, that was driven by lower provision expense and lower tax expense.

A Stronger Growth Outlook On Lending Strength

Operating costs are going to be higher in 2023, but so too is spread income, and East West was one of the relatively few banks to offer meaningful upside on spread income growth in 2023. It’s not clear whether or not net interest margin has peaked, but I do think it can stay near 4% for a couple more quarters before a relatively gradual decent through 2025.

Spreads are getting a boost from the bank’s above-average earning asset sensitivity, with a healthy loan beta of 54% cycle-to-date. Given that C&I lending is predominantly variable-rate and that East West is enjoying good spreads on new production, coupled with the fact that I think C&I lending will be one of the stronger areas in 2023, I think East West is well-situated for above-average double-digit loan growth in 2023 to go along with those healthy spreads. I’m also bullish on multifamily lending, as I believe the market can absorb a lot more capacity in the coming years.

Deposits were up 4% qoq this quarter, and the less than 3% contraction in non-interest-bearing deposits was a fair bit better than the 6%-10% contraction many comparable banks have seen, and East West still has close to 38% of its deposits in this category.

With a loan/deposit ratio in the mid-80%’s (“good” would be below 80%), though, management is having to spend up to keep up the loan growth. Time deposits grew 28% qoq, with the average cost increasing from 1.05% in the third quarter to 2.16% this quarter. East West’s cumulative deposit beta is already on the high side of its comp group (27% versus 19.5%), but largely in-line with First Republic, Pinnacle, and SVB, and better than Signature, and it’s going to head higher, which is why I don’t expect all that much expansion in net interest margin anymore.

I’m not really concerned about credit, though provisioning and charge-offs will be heading higher. Criticized loans actually declined modestly from the third quarter (1.9% of loans versus 1.93%) and charge-offs remain comfortably low (at 0.08%). I’d also note that reserves are currently about 600% of non-performing loans, giving the bank plenty of cushion at this point.

The Outlook

With about 14% of the loan book in China (mostly C&I lending), improved trade relations with China would be a big help. East West is one of the very few American banks with a license to operate in China, and the company has done well within a range of verticals, including movie production, private equity, and lending to U.S. affiliates/subsidiaries of Chinese companies. The removal of COVID-19 restrictions should help reenergize business activity in China, but better East-West relations would be a help.

As mentioned above, I also want to see more progress in building up fee-generating businesses like treasury payments and wealth management. I believe M&A could be a means of achieving this, and with a CET1 ratio of 12.7%, East West has more than enough capital to make some selective acquisitions. I’d also say that the bank has ample capital with which to buy back shares, but the standard practice of the company has typically been to hold back on buybacks during periods of uncertainty (like now).

I expect East West to generate double-digit pre-provision growth from ’22-’25 without a dip along the way, and there aren’t many banks I can say that about. I also expect above-average core operating income growth over that time, and I likewise expect above-average long-term core earnings growth of 7%.

Between discounted core earnings, ROTCE-driven P/TBV, and P/E (using a 10.5x multiple on my ’23 EPS estimate of $9.13), I believe East West should trade somewhere around $88.50 to $98.

The Bottom Line

There are some interesting high-quality opportunities out there now, including Cullen/Frost (CFR), Pinnacle (PNFP), and Synovus (SNV) (you can read about those here, here, and here), but I think East West definitely earns a spot on that list as well. My expectations may prove too optimistic, but East West has a strong track record behind it and I think today’s valuation doesn’t give enough credit to the long-term growth potential here.