PacWest Shrinking To Improve Profitability Over Time (NASDAQ:PACW)

Many management teams, whether within banking or not, operate on the assumption that bigger is always better, but the reality is that the market has consistently rewarded profitable growth far more than just growth. In other words, margins matter. With that in mind, PacWest (NASDAQ:PACW) management is taking the difficult, and perhaps controversial, step to actively shrink the businesses by exiting certain lines of lending in favor of more relationship-driven business over the long term.

On balance I favor this new strategy, though there will be costs and pain in the short term. PacWest has outperformed some since my last update, but I think what was already a “wait and see” story due to perceptions around credit risk in the company’s unproven (since the global financial crisis) national lending lines is now even more so. I do see some upside from here, but I would expect that substantial rerating could rest on the bank proving (and/or the Street being willing to project) that this new strategy will generate better margins and returns, and that could take some time.

Lackluster Results Driven By A Top-Line Miss

PacWest’s fourth quarter results were not particularly strong, though I should also note that there were a lot of items subject to adjustment (to drive “core” results), so different analysts and investors may arrive at different conclusions as to the “real” numbers.

Revenue rose 5% year over year and fell 5% quarter over quarter by my calculations, coming in more than $0.12/share short of sell-side expectations (a little more than 5% off in absolute terms). Spread income was the main driver, with net interest income up 7% yoy and down 4% qoq (on an FTE basis), missing by around $0.10/share, as net interest margin declined 16bp sequentially (and rose 17bp yoy) to 3.41%. Earning assets rose a little less than 1% sequentially.

Non-interest income has a lot of moving parts, and I exclude gains/losses on securities, dividends and gains on equity investments, and warrant income/loss to drive a “core” number. Core non-interest income fell more than 12% yoy and about 15% qoq, driving the rest of the top-line miss.

Operating expenses rose 13% yoy and 2% qoq, which approximated sell-side expectations, but given the lower revenue base it was a more sizeable miss in terms of efficiency ratio (54.1% reported versus around 51% expected).

Pre-provision profits fell 3% yoy and 12% qoq, missing by more than $0.12/share. PacWest did recoup some of the miss with lower provisioning and a slightly lower share count, as well as other below-the-line items. Management made a little progress on capital, with the CET1 ratio improved by 14bp to 8.7%, but it is still well off the 10% target.

A Significant Shift In Strategy

With a new CEO leading the business and ongoing concerns about credit and capital, I suppose it shouldn’t come as a big surprise that there’s going to be a shift in the bank’s strategy. Still, the magnitude of the moves does surprise me a bit.

Management announced that it will be exiting the Premium Finance and small-balance Multifamily lending businesses. Both are relatively transactional businesses that aren’t driven by core banking relationships. I’d note along those lines that Texas Capital (TCBI) made a similar decision with its premium finance operation, choosing to sell it to Truist (TFC) because the business wasn’t self-funding and the bank couldn’t broaden its relationship with those customers. Management said it was considering all options for both businesses, so it is at least possible that they could seek sales.

The Premium Finance business makes up a little more than $850M of a $28.07B loan book and this should run off relatively quickly if PacWest doesn’t choose to sell it. The Multifamily business is quite a bit larger (around $3B), but has generated relatively low yields/returns for PacWest. While I’m bullish on multifamily lending as a category (given the housing shortage in the U.S.), not all multifamily lending operations are the same, and I do prefer relationship-driven businesses as opposed to something arguably more akin to small-scale “mortgage warehouse” finance.

In lieu of continuing these businesses, management will refocus on growing its core Community Banking lending operations, including relationship-driven CRE and C&I lending. While national lending in areas like asset-backed will continue, as well as the equity fund/venture lending operations, more traditional relationship-driven commercial lending will become a bigger priority. Given increasing competition in national lending and equity/venture lending, it does seem reasonable to refocus on operations where PacWest could really differentiate itself in attractive markets.

Funding Costs Are Pressuring Results

Although PacWest has a pretty decent cumulative loan beta through this cycle (almost 30%) and yields on new production are healthy (7.55% this quarter versus overall average loan yield of 5.73%), deposit costs are rising even faster and pressuring margins.

Total deposit costs rose 130bp yoy and 68bp qoq to 1.38%, and PacWest’s cumulative deposit beta of 36% ranks quite high among similarly-sized banks. With non-interest-bearing deposits running off at an above-average rate (12% in the quarter) and a somewhat high loan/deposit ratio (83%), funding costs loom as a significant headwind in 2023 and I expect pressure on spread margins in the first half of 2023 until the Fed eases off on rate hikes, deposit costs start plateauing, and higher-yield loan production catches up.

The restructuring efforts should also help ease some of the pressure. While it will take years to run off the Multifamily loans (unless PacWest sells the business and/or loans), they won’t be originating new Premium Finance or small-balance Multifamily loans, so that should ease some of the funding pressure.

The Outlook

Management hasn’t disclosed the profitability of its individual businesses (few banks ever do), so it’s tough to estimate the margin/return uplift that the business can or will see by refocusing around Community Banking operations. Likewise, this assumes that the refocus will be successful and that businesses like asset-backed lending and equity/venture lending remain competitive.

I’m expecting core profits to decline about 6% next year and again (by a low single-digit amount) in 2024, and my 2023/2024 EPS estimates are a bit below the sell-side average now (only about 1%-2%). Longer term, my estimates work out to core earnings growth around 4.5%, and that is less than I previously expected. Over the long term I think mid-teens ROTCEs are possible, and maybe into the high-teens, but I’m taking a more conservative approach for now.

Discounting those core earnings back, I get a fair value around $30. I get broadly similar results ($28-$32) with my ROTCE-based P/TBV approach and a forward P/E approach using a 9x multiple – while a bank like PacWest could typically sport a 10x or higher multiple, I think a little extra caution is appropriate given the change in business model, unproven credit in new businesses, and higher deposit betas.

The Bottom Line

I fully acknowledge the risk that I may be underestimating the profitability of PacWest’s refocused efforts and its ongoing focus on leveraging a high-touch service model across national businesses with significant scale. By the same token, this change in strategy may not be as successful as management hopes and PacWest may remain a more cyclical, lower-margin bank.

In any case, while I do think this shift in strategy is well worth monitoring, I don’t see quite enough upside from here to prefer PacWest over names with more undervaluation and clearer/cleaner near-term stories. That said, I do think my numbers skew conservatively, so if PacWest’s increased focus on returns, capital, and overall business quality do pay off, this may well end up looking like a good time to buy.