PACW - PacWest Bancorp: Proposed Merger Offers Adequate Upside And Limited Downside

2023-09-19 04:57:08 ET

Summary

• PacWest Bancorp's merger with Banc of California is expected to benefit shareholders and provide cost optimization and synergies. The merger will create a combined bank with $36.1 billion in assets.
• PACW's current market price offers a margin of safety with low downside risk, making it a speculative and potentially rewarding investment.
• The bank offers a healthy balance sheet full of cash, a relatively low level of HTM securities, and priced well below its tangible book value.
• I give PacWest a buy rating due to the nice asymmetry provided by the merger deal.

Thesis

Uncertainties and negative sentiment overhang the regional banks industry. PacWest (PACW) was among the most adversely affected banks. The expected merger with the Banc of California will benefit PacWest Bancorp shareholders. The deal is 100 % stock transaction.

Both banks have the chance to optimize their cost structures and provide synergies for the benefit of shareholders; the bank stated that the transaction will be accretive to tangible book value. The current tangible book value is $ 16.94, more than double the market price. I treat buying PACW shares as an event-driven position, providing a nice asymmetry of the bet.

The merger

On 25 July, PacWest Bancorp announced a merger with Banc of California. The image below from the last company presentation represents the deal terms.

According to the agreed conditions, PacWest stockholders will get 0.6569 shares of Banc of California for every PacWest share they possess in a 100% stock-for-stock transaction.

Since Banc of California's shares were trading at $14.50 (daily closing price) at the announcement date (July 25, 2023), the merger's implied value for PacWest Bancorp shareholders is $ 9.52. However, this value will fluctuate based on Banc of California's share price at closing. According to reports, the deal will be finalized in late 2023 or early 2024.

Warburg Pincus and Centerbridge, two private equity firms, plan to invest a combined $400 million (at a share price of $12.30), or 20% of the combined regional bank: Warburg Pincus 16% and Centerbridge 4%. Shareholders of PacWest Bancorp will hold 47% of the combined new regional institution, and investors in Banc of California will own 34%.

With $36.1 billion in assets and $30.5 billion in deposits, the combined bank will rank third in terms of size in California. According to the merger presentation, the deal should increase EPS by 20% and tangible book value by about 3% in FY 2024. The graph below illustrates new bank characteristics.

With $36.1 billion in assets, the combined bank will overtake the second-largest bank with its headquarters in California following the merger. The common equity tier 1 ratio will also be at least 10% pro forma.

The merger will solidify Banc of California as a primary player in the region. The table below shows the current state of the Californian bank industry.

Since 2019, six of the largest banks have left, thus leaving a substantial void. Banc of California will take the lead, fulfilling unserved demand.

Banc of California has managed to stay profitable despite the chaos and instability of US banking in 2023. The bank operates in Southern California from San Diego to Santa Barbara and has over 27 full-service community banking branches; it recently announced fiscal 2023 second-quarter revenue of $75.66 million, a decrease of 11.5% from the same period a year earlier and a miss on average projections of $1.88 million.

Regarding the bottom line, net income was $17.9 million, or roughly $0.31 per share, down from $0.34 per share at the same time last year but still a profit. In its most recent dividend announcement, the bank maintained its quarterly cash dividend payment of $0.10 per share, representing a 3.2% annualized forward dividend yield.

It is encouraging that Banc of California recorded noninterest-bearing deposit inflows of $74.8 million from new customers, up over 13% from the prior comparison period and fairly in line with first-quarter inflows. This is a relief from concerns that the failure of Silicon Valley Bank in March and other banking failures would dramatically erode depositor confidence in the local banking sector.

A significant portion of PacWest's $3.5 billion loan portfolio of high-quality senior secured asset-backed loans had to be sold to Ares Management (ARES). The Portfolio comprises senior secured, asset-backed loans of high quality with commitments totaling about $3.5 billion. The portfolio was backed by assets across sectors and asset classes, including consumer loans, small business loans, timeshare receivables, auto loans, asset manager and fund finance loans, residential real estate loans, and commercial real estate loans. Another deal was made by JPMorgan Chase , purchasing mortgages worth almost $ 1.8 billion to facilitate Banc of California's acquisition of PacWest Bancorp.

Company Financial

A quick overview of PACW reveals banks` improved standing. Its balance sheet is healthy, with more than adequate cash and fewer held-to-maturity securities [HTM]. The table below shows some metrics I use to measure banks` solvency and liquidity. The data is from the last financial report .

The loan-to-deposit ratio is 80 %, which is below my limit of 90 %. The cash-to-deposit ratio is well above small banks' average at 8.5 %. The images below illustrate the loans and deposit composition of the new banks. New banks will have a well-diversified portfolio of loans among various industries.

The cost of funding will improve, too. Non-interest-bearing deposits [NIB] will constitute 30 % of the total deposit base. However, the drawback is that those deposits are the most liquid and could be withdrawn without notice. The bank trades improved net interest margins [NIM] for higher liquidity risk. Looking at the big picture, the deposits are well diversified across maturities and interest rates.

Currently, PACW has adequate capitalization measured with Basel III metrics. The table below shows banks` current values. The data is from the last financial statement .

Even after the turbulent Q1 PACW exceeds the recommended minimums. The merger will significantly improve the numbers.

Company Valuation

To value PACW is not an easy task due to its precarious situation. Banks in distress are efficiently priced based on tangible book value and liquidation value per share. Given the proposed merger, I will use PACW`s table book value and stock for stock transaction ratio.

To calculate tangible equity from the company`s equity, subtract intangibles and goodwill.

• PACW total equity (including preferred shares) $ 2.03 billion
• PACW goodwill -
• PACW intangible assets $ 26.6 million
• PACW cash reserves $ 6.69 billion

TBV per share $ 16.94

Current market price $ 8.33 at Sept 19, 2023

The merger is a 100% stock-for-stock transaction, where west stockholders will get 0.6569 shares of Banc of California for every PacWest share. Considering the BANC market price of $ 12.75 on Sept 18, 2023, the PACW value is $ 8.37. However, using BANC's tangible book value per share at $ 14.56, PACW is valued at $ 9.56.

Risks

Liquidity, credit, market, and operational risks are shared between all banks. However, PacWest's case is different due to the proposed merger. Market risk carries significant weight due to 100% stock-for-stock transactions. If BANC stock drops significantly, PACW shares will get hurt, too.

The economic risk is well presented in the face of inflation and interest rates, thus moving broad equity markets. The economic downturn will not hit only BANC but the whole market, including the regional banks. Another risk worth mentioning is the operational risk for PACW and BANC. If one of the banks fails to deliver its promises, the merger will stall, impacting banks` share prices.

Regarding the usual risks, PACW has more than adequate liquidity, considering cash to deposit ratio and loans to deposit ratios. In conclusion, PACW's current market price offers a margin of safety with low downside risk. Basel III metrics are healthy, given the recent turmoil.

Conclusion

PacWest is a proper speculative position. It has to be played as such with appropriate risk management. The merger with Banc of California will potentially revalue PACW`s shares while limiting the downside risk. The most significant risks are operational and market. The former means a failed merger due to the company's wrong decisions, while the latter represents BANC`s share price decline.

Looking at PacWest alone, the bank offers a healthy balance sheet full of cash, a relatively low level of HTM securities, and priced well below its tangible book value. However, those facts alone are not enough to give a buy rating. The missing component is the proposed merger with BANC. That said, I give PacWest a buy rating due to the nice asymmetry provided by the merger deal.

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