csfotoimages
This has been a bad year for growth banks in general, and particularly those banks with sizable venture capital and/or private equity lending businesses. The market has likewise been merciless with banks showing vulnerability to higher than expected deposit betas and weaker growth leverage in FY’23 and beyond. With PacWest (NASDAQ:PACW) ticking all of those boxes, it’s been a brutal run since my last update on the stock, with the shares down about 50% against a roughly 10% drop in the larger regional bank group – SVB Financial (SIVB) and Signature (SBNY) have done similarly poorly, but that’s cold comfort at best.
I’ve been very surprised by the performance challenges at PacWest this year, as I thought management would be better able to leverage low-cost deposits to fund loan growth and drive better operating results. At this point I’m tempted to think that the worst of the damage is done, but it’s going to take visibility on better spread performance and operating leverage, as well as more confidence in the outlook for private equity/VC lending demand, before the Street is likely to reconsider this name again.
Another Weak Quarter Saps Sentiment Even Further
When I last reported on PacWest, the company was coming off of a strong run of outperformance relative to sell-side expectations, but since then the company has logged three straight quarters of $0.04/share misses, with a sizable pre-provision miss in this third quarter report.
Revenue rose 13% year over year and 2% quarter over quarter, missing by about 4%. Net interest income rose 22% yoy and 3% qoq; not only did net interest income miss (by about 3%), but that sequential growth compares pretty poorly to a sector that has seen many regional banks report double-digit sequential spread income growth. Net interest margin rose just 24bp yoy and 1 bp qoq, one of the weaker performances I’ve seen so far. Fee-based income declined 35% yoy and 7% qoq, missing by close to 10%, but this does remain a relatively small part of PacWest’s business.
Operating expenses rose 18% yoy and 3% qoq, missing by about 5%. Given the shortfall in revenue, the results were even worse on an efficiency ratio basis, with the company missing by about 400bp at 51.2%. Pre-provision profits rose 7% yoy and 2% qoq, which again is weak relative to what many “Main Street” regional banks have been reporting, and this represented a $0.14/share miss. Lower than expected provisioning did help support reported EPS.
Like many banks, PacWest saw a big hit to tangible book value due to mark-to-market adjustments on its securities portfolio (included in AOCI). Tangible book value per share fell 29% yoy and 5% qoq, and the bank ended the quarter with a pretty weak 8.6% CET1 ratio (below management’s 10% target).
Slower Loan Growth And Worse Deposit Betas Undermine Growth
As-reported loan growth wasn’t bad this quarter, with PacWest seeing 35% year-over-year and 4% quarter-over-quarter growth. That was better than average for the sector, though as a “growth” bank, PacWest is expected to do more than just a little better. Construction lending was fairly strong in the quarter (up almost 8% qoq), but VC lending has noticeably weakened (down 8% qoq), pressuring C&I lending (down 2.5% overall).
Loan yield performance was mixed – while PacWest’s 5.12% loan yield in Q3’22 was quite a bit higher than the 4.3% to 4.6% I’m seeing at most regional banks, the improvement (up 11bp yoy and 47bp qoq) was less impressive.
Originations were weak in the quarter, down 75% yoy and 38% qoq, and management guided to slowing loan growth performance from here.
Deposits rose 12% yoy and about 1% qoq this quarter, which wasn’t too bad on a relative basis, while the 1% yoy and 4% qoq decline in non-interest-bearing deposits was more on par with many banks this quarter.
I’ve written many times this year that I expect deposit betas to head higher than many banks and sell-side analysts have been expecting (meaning that, as rates go up, banks will see deposit balances decline and/or deposit costs go up). Saying that, I didn’t expect to see the magnitude of increase that PacWest has shown; the quarterly interest-bearing deposit beta this quarter was a very high 59%, with a cumulative total beta of 30% (many banks had previously guided to full-cycle cumulative betas around 30%).
PacWest saw its total cost of deposits jump from about 8bp a year ago and 18bp a quarter ago to 70bp this quarter, which really undermines the bull thesis that PacWest could drive attractive profitable loan growth from a solid deposit base. Time deposits (CDs) doubled from the year-ago level (at a cost of 1.32% this quarter versus 0.36% a year ago), and borrowings likewise increased with a concurrent increase in borrowing costs.
The Outlook
Credit quality isn’t a concern yet, but the credit cycle has likely peaked and I would expect some increases in credit costs from here. At this point, though, I’m more concerned about what spread leverage PacWest still has in the tank and whether they can generate enough revenue growth to drive attractive pre-provision profit growth over the next two to three years. At this point, double-digit pre-provision profit growth could be off the table, which is definitely a major sentiment headwind for a growth bank.
Unlike many banks where I have been increasing earnings expectations for FY22 and FY23, I’ve had to go the other way with PacWest, and my long-term core earnings growth rate has fallen from around 8% to around 5% to 6%. This may well prove to be an overreaction, but I’m concerned about the sharp early increase in deposit beta and the weakening loan growth prospects, particularly as the bank needs to continue reinvesting in opex (IT, namely) to remain competitive.
The Bottom Line
Relative to lowered expectations, PacWest shares do look undervalued now, as that 5% to 6% core earnings growth can support a high-$30s fair value, as can a 20%-plus ROTCE in FY’23 and a 9x multiple to my FY’23 EPS estimate. Whether any or all of those assumptions are valid now is certainly in debate, as I didn’t expect the sharp decline in PacWest’s operating performance.
Even if those estimates and outputs are valid, the fact remains that banks are out of favor and likely to remain so for a few more quarters – at least until there’s more visibility/confidence on the end of the rate hike cycle and its impact on the economy – and particularly banks like PacWest, First Republic (FRC), Signature, and SVB. At some point the negative trends in VC funding, deposit mix, and loan demand will flip back, but until then it will likely be difficult to get a lot of positive excitement around these shares.
Be the first to comment