PACW - PacWest Bancorp: 4 Pros And 2 Cons Make The Stock Worth Buying

2023-05-07 04:51:28 ET

Summary

• The regional banking sector has taken a big hit following the failure of 4 major regional banks. However, uncertainty remains high after First Republic was recently acquired by JPMorgan.
• The yield curve is currently inverted, and this indicates an imminent stock market crash. This happens about once every decade and I see this as a great buying opportunity.
• PacWest’s benefits outweigh the risks, but the risks remain very high. That is why I have allocated part of my portfolio to a handful of regional bank stocks, including PacWest.
• These risks are significant but given the stable (and recently growing) deposit base, the risk is a lot more manageable. This gives me confidence to keep the stock in my portfolio for the long term.

Introduction

In my article on First Republic, I gave 4 reasons why the stock was buy-worthy. After the quarterly earnings announcement, it turned out that there were more deposit outflows than expected. As a result, JPMorgan bought First Republic through a government auction, and this caused great panic in the regional banking sector.

The Fed announced May 4 that interest rates will rise 25 basis points as expected. This will bring the benchmark rate to 5% and 5.25%. The Fed hinted that this could be the last increase for now. Meanwhile, inflation has fallen sharply from 9.1% at its peak in June 2022 to just 5% now. PacWest fell sharply by as much as 60%, but now seems to be rebounding. PacWest' shares are at 80% plus as of May 5, and Western Alliance ( WAL ) is also 40% plus. Equity markets are clearly panicking and volatility in regional bank stocks is significant.

My portfolio includes several regional bank stocks that I bought cheaply during the failure of SVB Financial. I have invested part of my portfolio in several regional bank stocks to spread the risk. One of the investments is PacWest ( PACW ). This stock also fell significantly, while fundamentals are strong, and now that quarterly earnings are better than expected, the low price provides a buying opportunity.

A Unique Opportunity Every decade

The bank lending margin is the difference between the interest rate on new loans and the weighted average interest rate on new deposits of households and businesses. The inverted yield curve suggests that banks are not making money on new loans because short-term rates are higher than long-term rates. The yield on 10-year minus 3-month Treasury bonds is extremely negative at -1.89%. In an earlier article , I mentioned the strong correlation between a bear market and the inverted yield curve. Investors may fear the bear market but I see it as a strong buying opportunity that occurs about every decade.

Investors could sell their stocks before the yield curve inverses and buy after the reversal when the yield spread exceeds 2%. Currently, the yield spread is deeply negative, indicating that a stock market crash is imminent. Currently, some regional banks have already crashed significantly which is why I have invested some money in a handful of regional bank stocks, including PacWest.

Earnings Analysis

PacWest' 1Q23 results were above expectations as deposits stabilized in March and then grew by $700 million in April. At the end of December 2022, deposits are about $33.9 billion and first quarter results show deposits at $28.2 billion. Plus, April's deposit growth we arrive at $28.9 billion with which deposits have fallen only 15%.

Another plus is that total insured deposits increased from 48% to 71%; about $8.3 billion is uninsured. And with readily available liquidity of $12.4 billion, the coverage ratio is more than adequate. PacWest will reduce its assets to $35 billion, which is expected to bring its CET1 capital ratio above 10%. The CET1 ratio currently stands at 9.22%. The tangible CET ratio is 5.07% and the tangible CET ratio excluding AOCI losses is 6.73%.

The result was a net loss of $1.21 billion, partly due to a goodwill impairment of $1.38 billion from the decline in the share price due to recent market volatility. Further declines in the share price are likely to have a stronger negative impact on earnings for the second quarter. But this relates to unrealized losses that are not necessarily an issue at this time.

AOCI Losses Are Significant Compared To Total Equity Capital

Regional bank stocks such as PacWest and Western Alliance show a lot of volatility and all have a number of red flags that Silicon Valley Bank also had. One red flag is the large exposure to unrealized securities losses as a percentage of total equity. Also, the large amount of accumulated unrealized income (AOCI) as a percentage of total equity poses a significant risk to the bank's survival when it has to sell assets.

At the time of SVB Financial's failure, FactSet had prepared a table showing a number of regional banks and their AOCI / (total equity - AOCI). Accumulated other comprehensive income (OCI) includes unrealized gains and losses included in the equity section of the balance sheet. A high percentage of AOCI relative to adjusted book value indicates high risk.

However, PacWest is not included in FactSet's table below, but we infer from the quarterly figures that AOCI was $736 million. With total equity of $2,771 million, the AOCI / TEC-AOCI is 36%. This is a significant risk for PacWest compared to other banks.

Looking only at unrealized securities losses and the effect on the CET 1 ratio adjusted for unrealized securities losses, we arrive at a chart showing the strongest and weakest banks. This chart comes from JP Morgan and clearly visualizes the potential risks. These risks are in hold-to-maturity ((HTM)) portfolios. Silicon Valley Bank relied heavily on HTM treatment for its growing securities portfolio. The sale of HTM securities can lead to sudden losses at market value. With deposit outflows, these assets will have to be sold - at a significant loss - which will drastically reduce the CET1 ratio.

PacWest's projected CET 1, adjusted for unrealized losses on securities, is quite low at 6%, which in turn poses a significant risk when depositors move their deposits to other banks. Again, PacWest has sufficient cash to cover their unsecured deposits, which greatly reduces the risk of deposit outflows.

Another stock that has fallen strongly is Western Alliance. However, Western Alliance is quite strong on the chart with an expected adjusted CET1 of 8%. Western Alliance is also in my equity portfolio of regional banks as a risk diversification.

Investors in PacWest hope that deposit outflows remain steady. And recent quarterly figures show that deposits actually increased in April, this may be due to PacWest's attractive savings rate. Investors will have to monitor deposit outflows closely to make a prediction about potential risk. Of course, this remains a gamble, but given the enormously favorable valuation numbers (price-to-book value = 0.3), the growth potential is enormous.

Key Takeaway

The regional banking sector has taken a big hit following the failure of 4 major regional banks. However, uncertainty remains high after First Republic was recently acquired by JP Morgan. The yield curve is currently inverted, and this indicates an imminent stock market crash. This happens about once every decade and I see this as a great buying opportunity. Shares of some regional banks have fallen significantly, so I have allocated part of my portfolio to a handful of regional bank stocks, including PacWest. PacWest has advantages and disadvantages. The advantages are primarily the deposit growth and greatly improved uninsured deposit rate in April, the large coverage of uninsured deposits, the attractive stock valuation and the once-in-a-decade opportunity to buy bank shares cheaply. The risks are the large AOCI losses as a % of total equity and unrealized losses. The expected CET1 capital ratio also does not look attractive. These risks are significant but given the stable (and recently growing) deposit base, the risk is a lot more manageable. This gives me confidence to keep the stock in my portfolio for the long term.

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