PACWP - PacWest Bancorp: A Hidden Opportunity But Expect More Volatility

2023-03-22 11:25:03 ET

Summary

• PacWest Bancorp's non-cumulative preferred shares currently offer a double-digit yield on cost of 12%.
• They're trading for 64 cents on the dollar with a move back to par likely towards the end of the first half of next year.
• PacWest's banking operations are highly cash generative and supported by a large liquidity backstop.

PacWest Bancorp ( PACW ), a Los Angeles-based regional bank holding company, has become a casualty of the mini-banking crisis sparked by the collapse of Silicon Valley Bank. The commons are now down 46% year-to-date with a tepid recovery launched in recent days on the back of reports that the FDIC will expand its deposit insurance cap. The core risk here, and the driver of the fear, is that banks which take on short-term deposits and invest in long-term assets will be faced with a sustained flood of withdrawal requests which will force them to realize large losses inherent within their positive duration fixed income portfolios.

Critically, the impact of this duration mismatch has been heightened by the rapid rise in the Fed funds rate which has reduced the value of the held-to-maturity securities that form the base of PacWest's balance sheet.

PacWest has since updated the market to state that it has $10.8 billion in available cash and that insured deposits form 62% of total deposits. This reduces the likelihood of capital flight to the systemically important banks and means a blowup on the scale of Silicon Valley Bank is materially reduced. Critically, whilst PacWest has likely realized large cash outflows, the company is likely to remain a going concern. This is important for the Series A preferred shares which are backed by a highly profitable and generative bank. PacWest saw cash from operations of $202 million for its fiscal 2022 fourth quarter, up from $110.6 million in the year-ago comp.

The Hidden Opportunity

PacWest's 7.75% Series A Fixed-Rate Reset Non-Cumulative Perpetual Preferred Stock ( PACWP ) offers a unique opportunity against the broader shroud of fear and angst that has swept across the stock market in recent weeks. They currently pay out a fixed $1.9375 coupon annually for a 12% yield on cost against a preferred price of $16. These were trading above par at $25.30 per share in the months leading up to the mini-banking crisis and since they started trading in the summer of 2022.

To be clear here, the market was comfortable paying above par to gain exposure to PacWest whose operations now face an event which likely poses little risk to its underlying ability to meet its preferreds obligations. There is a lot to like here but it's important to flag that these are non-cumulative preferreds. This clause would heighten the propensity for the company to suspend dividend payments in the event they experience a marked deterioration of their financials. When compared to cumulative preferreds, any unpaid dividends stay unpaid rather than accumulating on the balance sheet as a liability.

However, preferreds occupy a position in the capital structure that's higher than common equity but lower than bonds. They're essentially a form of fixed income and any suspension of dividends would increase the cost of funding by highlighting PacWest as an unreliable borrower facing material stress. Indeed, most banks maintained their preferreds payments following the 2008 financial crisis. Hence, prospective investors in the Series A should be aware that they occupy a hybrid position in PacWest's funding structure where a suspension is unlikely but where the income is still not as sticky as they'd prefer. Non-cumulative clauses are the dominant way banking preferreds are structured so PacWest is fully in line with its peer group.

A Move Back To Par And The Yield To Call

Critically, it's the visceral fear of a dividend suspension that drove down its price by more than 60% to $10 as of the end of last week. The rebound to $16 is still a 36% discount to par, around 64 cents on the dollar. This discount will likely remain volatile in the short-to-medium term and a move back to $25 per share will likely only happen once the current crisis fully abates. The second half of next year seems like a prudent timeline. This would also require inflation to have fallen back to the Fed's 2% target to bring a conclusive end to the current rate hiking cycle.

What's the yield to call? A healthy 19.4% with preferred holders set to see positive returns driven by capital gains aggregated with $1.9375 yearly coupon payments. The redemption date is 4 years and 5 months away on September 1, 2027. This date will see the current fixed rate float at a rate equal to the five-year treasury rate plus 4.82%. This will then reset every five years. I think the next few months will likely remain volatile from a pricing perspective as the market tries to properly reflect the underlying risk from the most significant banking crisis since 2008. The core risk around income will likely centre on the common dividends which currently stand at $0.25 per share . This forms an 8.2% yield against PacWest's current stock price. We might see this reduced, a move which would fundamentally increase the safety of the preferred payments but might spark a sell-off regardless. The long-term opportunity here is strong with a 12% yield paid quarterly set against the backdrop of an inflation-beating near-20% yield to call. I'm looking to start a position soon.

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