BANC - Banc of California: I'm Cautious About The Upcoming Merger With PacWest

2023-07-26 20:57:06 ET

Summary

• Three areas related to the merger worry me: high deposit costs, brand loyalty, and high unrealized losses.
• Benefits of the merger for BANC include balance sheet growth, cost savings, and loan quality improvement.
• The December 2024 target price is below the current market price; therefore, I’m maintaining a hold rating.

Banc of California (BANC) and PacWest Bancorp (NASDAQ: PACW ) have recently announced to merge pending regulatory approvals. Warburg Pincus and Centerbridge Partners will also inject new equity into the merged entity. Obviously, the management of Banc of California is optimistic about the merger. As mentioned in the press release, it anticipates the merger to increase the proforma common equity tier I ratio (“CET1”) by 10%. (For more details on the management’s expectations related to the merger, see the management’s presentation ). However, there are certain areas where I disagree with the management, including the impact on the margin, which I’ve discussed below.

Margin will Likely Contract

PacWest Bancorp’s net interest margin (“NIM”) was just 1.82% during the second quarter of 2023 mostly because it had a very large balance of costly borrowings. As per the merger agreement, these borrowings will get paid down by the proceeds raised from newly issued equity as part of the merger. But even without these borrowings, PacWest’s NIM is below the NIM for Banc of California because PACW’s cost of interest-bearing deposits was 3.35% while BANC’s cost of such deposits was only 2.60% in 2Q 2023. As a result, I’m estimating BANC’s net interest margin to contract by 25-50 basis points as a result of the merger.

The management mentioned in the press release that it expects the margin to increase following the merger as it intends to undertake repositioning measures. However, the repositioning ignores the deposits of PacWest Bancorp. The following snapshot from the presentation summarizes the repositioning strategy.

Branding of the Smaller Bank will Survive

By asset size, PacWest is around four times larger than Banc of California. Usually when the size difference is that large, the larger bank acquires the smaller bank. Further, the surviving brand is usually of the larger bank. However, in this case, Banc of California’s brand will survive, according to the merger agreement. This unusual arrangement raises the question of brand loyalty. As an overwhelming majority of customers will see their bank’s name change, there is the risk that a significant portion of customers will switch to other banks after the merger. Therefore, customer retention may become a problem next year.

However, this branding decision is not completely wrong. PacWest’s reputation had taken a hit when it sold off some of its loans and cut its dividend in order to increase its capital to the required levels. Although there was no deposit run on the bank, the threat was very much there because of these negative signals.

Banc of California will Take on Considerable Unrealized Losses

Another area that concerns me is the large unrealized mark-to-market losses on PacWest’s Available-for-Sale securities portfolio. These losses totaled $584 million at the end of June 2023, as opposed to BANC’s unrealized losses of $38 million. If Banc of California sells all of the acquired AFS securities under the repositioning strategy, then the earnings could take a hit of $3.5 per share before tax in 2024. (Please note that the equity value already incorporates this unrealized loss; therefore, it will not change when the unrealized loss turns into realized loss).

The Merger Promises Benefits as Well

Apart from the three points discussed above, I’m positive about the merger from BANC’s perspective. Firstly, the merger will resolve Banc of California’s loan growth issue. The company’s loan portfolio had declined in size for four straight quarters before slightly recovering in the second quarter of 2023.

Further, the merger will save costs. The management has estimated pre-tax cost savings of ~$130mm or ~15% of core expenses, as mentioned in the presentation. This estimate seems reasonable to me (even bordering on a bit conservative) because there is considerable network overlap between the two banks. Therefore, there are plenty of opportunities to save costs.

Additionally, the credit quality of the proforma loan portfolio will be better than the legacy portfolio of Banc of California. The non-accrual-loans-to-total-loans ratio was just 0.47% for PACW, whereas the ratio was 0.94% for BANC. Therefore, the credit risk of the loan portfolio will decline.

Moreover, the injection of new equity will provide the merged entity the opportunity to improve the balance sheet. However, at the same time, it will result in earnings dilution.

Maintaining a Hold Rating

I’m using the peer average price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples to value Banc of California. Peers are trading at an average P/TB ratio of 1.1 and an average P/E ratio of 7.6, as shown below.

Equally weighting the target prices from the two valuation methods gives a combined target price of $13.2 , which implies a 10.6% downside from the current market price. Adding the forward dividend yield of 2.7% gives a total expected return of negative 7.9%. Hence, I’m maintaining a hold rating on Banc of California.

For further details see: