PacWest Battered As Deposit Betas Shoot Higher

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.

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PacWest Battered As Deposit Betas Shoot Higher

PacWest Still Undervalued As Opportunities To Deploy Excess Capital And Generate Profit Growth Continue To Improve

 

Banks have done well in general since the middle of 2021, but banks with strong leverage to loan growth in 2022 and the opportunity to drive double-digit pre-provision profit growth are doing even better. PacWest (PACW) was one of the banks I was bullish on back in the summer based on that undervalued profit growth leverage for ’22-’23, and the shares have since climbed another 20% or so, beating its peer group by around 500bp over that period.

PacWest doesn’t offer above-average asset sensitivity (and the bank’s internal deposit beta projections may be too optimistic), and I do think a capital raise (likely subordinated debt and/or preferred equity) is possible, but I still like the growth leverage story, and I believe high-single-digit long-term core earnings growth can support double-digit share price appreciation from here.

 

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PacWest Still Undervalued As Opportunities To Deploy Excess Capital And Generate Profit Growth Continue To Improve

PacWest's Strong Core Profitability Overshadowed By Credit Concerns

It’s early in the third quarter reporting cycle, but LA’s PacWest Bancorp (PACW) is not standing out in a good way. Weaker revenue on greater spread pressure is not a surprise, but credit quality remains a real concern, as PacWest has above-average exposure to sectors under greater strain from COVID-19.

When I last wrote about PacWest, in the days before COVID-19, I was concerned about the bank’s ability to profitably grow loans, and the risk that this would be/become a “value trap”. Since then, the dividend has been cut, credit quality looms as a larger threat, and the shares have declined about 50% - far worse than regional bank peers.

PacWest is a more challenging stock call now. On one hand, this is a very profitable bank with a fairly healthy capital situation. On the other hand, while I do think reserves are adequate, I am nevertheless concerned about the risk of increasing credit strain in the CRE portfolio, as well as a more prolonged hit to loan demand. With a fair value in the mid-$20’s, this name looks a lot more interesting now, but investors should be aware of the above-average risk that goes with that appreciation potential.

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PacWest's Strong Core Profitability Overshadowed By Credit Concerns

Weak Loan Growth Makes PacWest's Spread Compression Even More Painful

All things considered, I’d say that PacWest Bancorp (PACW) held up well in trading after earnings, given that there were few real positives in the quarter and core pre-provision profits missed by a pretty wide margin. Spread compression was already built into expectations, but instead of the second half loan acceleration bulls were hoping for, deceleration is what they got.

I was cautious on PacWest when I last wrote about the stock because I was worried about the choppy near-term outlook (increasing loan competition, increasing spread pressures, and pressures on credit), and the shares have underperformed the broader banking group by about 10% since then. While I do see value in the shares, and the dividend helps lessen the sting, the last few quarters have me on edge regarding the bank’s real competitive advantages and the underlying end-market conditions.

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Weak Loan Growth Makes PacWest's Spread Compression Even More Painful

PacWest Running Hard To Stay In Place

PacWest (PACW) is in a strange place right now, as management actively tries to upgrade and de-risk the loan book, offset major pressure from paydowns and payoffs, and figure out how to profitably grow deposits in an environment of increasing deposit cost pressure. While core earnings per share were basically in line with expectations, spread compression still remains a risk.

I still like the basic business that PacWest is in – niche commercial lending for smaller businesses and financial products for tech and VC firms like the capital call lending that has also been a growth driver for First Republic (FRC). It’s going to be hard for PacWest to make much core earnings headway with high repayment levels and rising deposit costs, but the longer-term potential is still attractive and the bank’s large dividend yield will pay investors to wait, though investors should realize that this isn’t “money for nothing” and the business strategy pursued by PacWest is riskier compared to typical community banks.

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PacWest Running Hard To Stay In Place

Strong Growth In Niche Commercial Lending Taking PacWest Into 2019

Loan growth has been relatively disappointing across the banking sector during this rate cycle, but several banks have reported improving momentum in the fourth quarter, and with better than 20% growth in originations in the fourth quarter, I’d say PacWest (PACW) certainly qualifies. Rising deposit costs are going to be an issue in 2019, but PacWest’s low expense ratio and niche commercial lending franchises should offer some cover.

The attempted acquisition of El Dorado Savings didn’t work out, but I fully expect this highly acquisitive bank to remain on the hunt for opportunities to grow its core deposit base and/or expand its footprint beyond its Southern California base. PacWest isn’t wildly undervalued, but I like the risk/reward/quality combination and the company’s position in niche commercial lending.

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Strong Growth In Niche Commercial Lending Taking PacWest Into 2019