OZK - Western Alliance: Wall Street Takes A Cautious Stance As Credit And Rates Evolve

Summary

• WAL had a pretty lackluster fourth quarter, with misses at the spread income and fee income lines and a 4% pre-provision miss, but expectations were low and guidance was encouraging.
• Cost-effectively funding 10%-plus loan growth in 2023 will test management's skills, particularly given guidance for further net interest margin improvement.
• Credit quality is a major issue with more bearish analysts and investors; while management's diverse business and dynamic allocation strategy should limit losses, it has to be proven.
• Long-term core growth around 7% can support a fair value close to $90, but rerating is likely dependent upon management hitting near-term profit growth targets and longer-term credit quality metrics.

The market typically takes a "wait and see" attitude with new risk/underwriting models, often preferring to see a business go through a full credit cycle before granting it a more typical valuation. Such would seem to be the case with Western Alliance Bancorp ( WAL ), as the Street still seems skeptical about how the bank's national lending programs will fare through a full credit cycle, not to mention the added pressures of higher funding costs.

I can understand the skepticism to a point; this certainly isn't a point in the credit cycle where you'd expect bold risk-taking to be rewarded. That said, "wait and see" can last longer than investors might expect; it certainly weighed on Bank OZK ( OZK ) longer than the numbers would have said was fair. In any case, while I do think Western Alliance has an interesting model that should generate above-average returns and that the shares are undervalued, it will likely take a year or so (if not more) for real re-rating to occur.

Fourth Quarter Results Weren't Great, But Seemed Good Enough To Reassure Investors

Taken in isolation, Western Alliance's fourth quarter results weren't all that strong. Investors were braced for worse performance, though, and management's guidance for 2023 was pretty encouraging, and I think management's efforts to explain various line-items and clarify risk exposures may have helped sentiment.

Revenue rose almost 27% year over year and 5.5% quarter over quarter, missing by about 3% or $0.17/share. Net interest income (full-taxed equivalent) rose more than 4133% yoy and 6% qoq, missing by $0.07/share as net interest margin missed by around 7bp (up 65bp yoy and 20bp to 3.98%) and earning asset growth disappointed (up about 1%).

Non-interest income fell 40% yoy and about 1% qoq, as mortgage banking is a major part of this business and declined 38% yoy (while improving 25% qoq). This was quite a bit lower than expected, making up the bulk ($0.10/share) of the revenue miss.

Operating expenses were mixed. Western Alliance saw negative leverage, with expenses up 42% yoy and 9% qoq (with efficiency ratio worsening 150bp qoq to 47%), but this was still about $0.055/share better than expected. Adjusted pre-provision profits rose almost 16% yoy and 3% qoq, missing by close to $0.115/share.

Lower provisioning added back more than $0.12/share, but I think some investors will question the low level of provisions given where we are in the credit cycle (more on this in a moment). Taxes were also a bit lower than expected, and bottom-line core earnings were about $0.02/share better than expected.

A Lot of Moving Parts To The Balance Sheet, Funding, And Credit

Loans

Taken at face value, Western Alliance's loan performance in the fourth quarter wasn't very good, with loans held for investment up 33% yoy but down almost 1% qoq. C&I lending was down more than 7% qoq, and while it would have been easy to assume that lower mortgage warehouse lending drove this, it was actually lower equity fund lending and lower corporate finance lending that drove it, with management reducing risk in these areas. First Republic ( FRC ) likewise saw reduced capital call lending this quarter, so this isn't an unparalleled decision.

I was surprised, though, to see the nearly 6% growth in CRE lending, with over 7% growth in investor (non-owner-occupied) CRE, as many banks are pulling back and taking a more cautious stance on CRE lending.

Loan yields were strong, improving 167bp yoy and 86bp qoq to 5.7%, with healthy (6%-plus) yields in both C&I and investor CRE.

Deposits

Deposits declined more than 3% qoq, with a 21% qoq decline in non-interest-bearing deposits. While that looks like a shocking decline, a lot of that (about two-thirds) was driven by seasonal flows in the mortgage warehouse business that will return. Still, CDs rose 50% qoq and overall interest-bearing deposit costs rose 95bp qoq to 1.99% (with a spot rate of 2.21% at quarter-end), while total deposit costs rose 58bp qoq to 1.14%.

Management doesn't seem all that worried about funding, guiding to mid-teens growth in FY23, and I'd note that Western Alliance was faster to move on lifting rates on deposit products than many other banks. The cumulative beta is rising (in the mid-20%'s for the fourth quarter) and will likely skew higher than average, and cost-effectively funding aggressive loan growth will be a challenge for the company in 2023.

Credit

Charge-offs remain quite low (0.01%), as do non-performing assets (0.13%), but some analysts and investors continue to worry that there's another shoe to drop here. Western Alliance had outsized losses during the global financial crisis and the business plan changed afterwards, with management pursuing a strategy of lending to diverse national lending markets like mortgage warehousing, hotel franchise, equity funds, municipals/non-profits, resorts, gaming, HOAs and so on.

Management's approach now is to dynamically allocate capital across these markets as opportunities develop. When risk-adjusted returns are no longer attractive, the bank pulls back (as with equity fund lending this quarter). They're very different businesses, but this does remind of Arch Capital 's ( ACGL ) approach to insurance - Arch has footholds in numerous insurance markets and allocates/reallocates capital based upon risks and returns, and has done an excellent job with this approach.

Time will tell if Western Alliance management is similarly adept at assessing and pricing risk. While the loan reserve level looks low at 0.60%, about a quarter of the loan book is covered by credit-linked notes that shelter the bank from default risk. While the adjusted reserve level of 0.78% is still low, Wells Fargo analyst Timur Braziler pointed out that it's about 8x the cumulative total of charge-offs over the past decade.

The Outlook

There's not much else I can say about the credit situation than "we'll know when we know". For years Bank OZK was discounted, particularly heading into downturns, on assumptions that the bank's seemingly-risky commercial loan portfolio would experience large losses, but that didn't happen. It took a while, but eventually the Street gained more confidence in the idea that they really do have a better mousetrap where underwriting is concerned. Investors can hope that the same will prove true for Western Alliance, but the Street isn't convinced yet.

Management's guidance for low-to-mid-teens pre-provision profit growth in 2023 went over well with investors, though I do think management's targets are ambitious if not aggressive. Given ongoing pressures on funding costs, I don't think funding 10%-plus loan growth and driving further NIM expansion (to around 4.0% to 4.1% by year-end) is going to be an easy task. If they do it, though, it will be another impressive check mark in building up analyst/investor confidence.

I'm a little below the Street for both FY'23 and FY'24 ($9.97 and $11.24 EPS respectively, versus Street estimates of $10.42 and $11.46). Still, I do expect over 7% long-term core earnings growth from Western Alliance, and the shares look undervalued across discounted core earnings, ROTCE-driven P/TBV, and P/E (using a 9x multiple on my '23 EPS to account for potentially higher operating/credit risk).

The Bottom Line

Banks in general have continued to see lackluster investor demand in the face of worries of rising credit losses, as well as the impact of higher funding costs and more limited operating leverage in 2023. I believe funding and credit are top-of-mind concerns for many investors with Western Alliance, and it will take at least a few more quarters to start answering those questions. I think Western Alliance will in fact answer its critics/doubters, but investors need to appreciate the above-average risk and the likelihood that a substantial rerating could take a year or more.

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