PacWest Bankcorp Is An Acquisition Shark In The Pacific

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Business Description

Company: PacWest Bancorp is a regional bank that operates through two segments; Pacific Western Bank which include lending and deposit gathering activities and Capital Source which provides small and middle-market businesses loans and leases; it is focused on capital adventure. Pacific Western Bank has 80 offices mainly in southern California and San Francisco. Pacific Western also provides working capital financing to growing companies located throughout the Southwest, in states like Arizona or Texas. Capital Source and Square 1 Bank divisions have offices across United States in cities like Maryland, Denver, Chicago, New York and Midvale (Utah). With its strong presence in California, PacWest Bancorp has become 14th largest commercial bank in U.S.

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Investment Rationale

The Roland George Program invested in PacWest Bancorp (PACW) in May of 2016 and the stock has since risen 18.64% since the investment. This is above the S&P 500 return of 11.04% over the same period. The reasons for the original investment were:

Regional Banks in Takeovers: PacWest is a strong position for acquisitions due to their access to the California market. All of PacWest’s market capitalization is located within California, with 80 offices located throughout the state. This allows PacWest to take over many of the smaller regional banks relatively easily. With nearly 30 acquisitions since 2000, PacWest has been able to make acquisitions a core competency of their growth strategies. PacWest is projected to continue their acquisition strategy throughout the upcoming years.

Barriers of Entry: The banking industry has high barriers to entry due to laws, regulations, capital requirements, access to financing, and security concerns. There numerous regulations that banks have to comply with and the cost of compliance and threat of litigation are strong deterrents for new entries. The high capital requirements are another huge deterrent. High fixed costs and large sunk costs in the development of financial services keep many potential entries out of the industry. These factors make it difficult for new entries to get started, attract clients, and be profitable.

Innovative/Niche market: PacWest has consistently had a higher net interest rate spread over its competitors. The industry average ranges between 3 to 3.5% while PacWest has achieved a net interest spread of over 5% every year. This is mostly due to their focus on commercial leasing. PacWest’s large commercial lending platform is suited for lending money to new start-ups who need the capital and are willing to pay higher rates. PacWest also has strong entrepreneurial and venture capital products to offer clients. The industry standard is to focus on real-estate and on house mortgages, which is why they have lower margins. This niche market is also perfectly located, as California has a high number of yearly startups.

Competitors: PacWest is a regional bank based in California focusing on personal financing. They are comparable to Bank of the West and West America Bancorp regional banks based in California. PacWest is also a competitor to the large national banks, including JP Morgan, Bank of America, and Wells Fargo.

Recent Performance

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Since the purchase of PacWest Bancorp in May of 2016, the stock has made a return of 18.64%

Earnings Below Expectations (Move A): PacWest reported earnings 9.74% below expectations for Q3 of 2015. This drove the stock price down 14.65%. The earnings were $69.63 million, below the $85.1 million earnings of Q2 2015. This unexpected 18.18% below expectation earnings drove the price drop of the stock.

Merger With Square One Financial Completed (Move B): On 10/7/2015, PacWest completed its merger with Square One financial, making their combined assets worth $21.3 billion, over their $16.8 billion before the merger, a 26.79% increase in total assets. Square One Financial will continue to operate their venture backed company and venture capital firm focused business under PacWest.

Fintechs Startup Disrupted Banking Industry (Move C): At the beginning of the year 2016, Fintechs (companies using financial technologies) began to rise up. The Fintechs were in direct competition with the Banking industry and took away business from the banks, shifting the returns down by 22.37% over a week. PacWest was not hit as hard, only losing 16.53% due to their focus on personalized relationships.

Strong Earnings Led To Steady Increase (Move D): After the previous quarter had slightly underperformed expectations by 2.5%, Quarter 3’s strong performance of $92.85 million led to the price pop. The actual earnings were 6.7%above the estimates which helped drive the increase in the price. The stock price continued its steady growth based off of the strong performance.

Market Positivity in Response to Election (Move E): The surprise election of Donald Trump impacted the Banking Industry significantly, increasing the average stock price by 12.5%. PacWest Over performed the Industry and made a 15.49% return on the day of the election alone. This market positivity has continued to keep the banking industry percent returns on stocks above the S&P 500.

Financial Analysis

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Third Quarter 2016 Highlights: The net income for PacWest rose to $93.9 million for the quarter, % over Quarter 2’s $82.2 million. This was brought about by a small increase in net interest revenue, up $800,000 over the previous quarter. However, this net interest revenue was 2.6% below analyst expectations. This brought the EPS up from Quarter 2 of 2016 from $.68 to $.77, a 13.24% increase. This increase in revenue and earnings has been steady, with only a few quarter decreases over the last five years. During this quarter, Donald D. Destino was brought on as the executive vice president, investor relations, and corporate development.

Fourth Quarter 2016 Highlights: PacWest had a strong final quarter in 2016, with revenue totaling $277.2, 5.27% above the estimates for the quarter. They reported net earnings of $85.6 for the quarter, 1.51% above expectations. During this quarter, PacWest entered into a sale-leaseback agreement with the Quarter Group. This agreement was for the acquisition of four bank-owned properties for approximately $12 million. PacWest also sold two of its retail branches to First Foundation Bank, totaling $200 million. There were no loans associated with the purchase. During this quarter, PacWest was able to achieve loan growth of 4.8%, above the industry average of 1.9%.

2017 Expected Performance: PacWest has a strong outlook for the year of 2017, with expected revenues to increase 4.42% over 2016. The Financial and Banking sector has a strong outlook for 2017 with promised deregulations of banks and an increase to interest rates. Both of these factors will positively affect PacWest, allowing for easier acquisitions and mergers. With interest rates rising, PacWest is expected to make 5.31% more from net interest income over the year 2016. Earnings per share are set to rise up to $.80 by the end of the year 2017, a 12.68% over the $.71 at the end of quarter 4 of 2016.

Earnings Surprise History: PacWest Bancorp has been fairly predictable with their past earnings, with only minor variations from the estimates. Q4 2015 was exactly on the estimate with PacWest reporting a $.60 earnings a share. Q1 of 2016 PacWest outperformed the estimates by 4.23%, reporting $.74 earnings over the estimated $.71 for the quarter. In Q2 2016, PacWest slightly underperformed expectations, reporting $.68, 2.86% less than the $.70 expected earnings. In Q3 2016, PacWest outperformed expectations by 6.94%, reporting $.77 earnings and the estimate was $.72. Q4 of 2016 PacWest did exactly as estimated reporting a $.71 earnings for the quarter. For the last eight quarters, PacWest has had an average positive surprise of 3.60%. The price reaction has ranged from (2.80%) to 7.50%, with an average of 2.65% over the eight quarters. PacWest is estimated to report earnings of $.72 for Q1 of 2017.1.41% over the estimated earnings of Q1 2016.

Analyst Recommendations: Analysts have been favorably recommending PacWest for over a year, with 2 strong buys, 5 buys, and 4 holds according to Thompson Reuters. On Morningstar, PacWest earned 1 strong buy and 1 hold recommendation from the two analysts watching the stock. None of the analysts are giving the stock an underperform or sell rating. The price targets range from $55 to $62 according to Thompson Reuters. This is a range of -.2% to 12.5% price difference over the current price, with the mean percentage difference being 7.33% at $59.15.

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Growth Drivers

Net Interest Spread: Net interest spreads is the difference in borrowing and lending rates for banks and is comparable to the gross margin of non-financial companies. The net interest spread is how much a bank makes on the money that they borrow and lend, directly directing their revenue. The regional bank average spread is currently at 3.82%, 14 basis points above the spread during the financial crisis. PacWest has a current net interest spread of 5.26%, considerably higher than the industry average. The industry interest spreads have gone above 4% since 2008 while PacWest has had a spread around 5% during the same period. The net interest spread has been decreasing slowly for the industry over the last few years.

Mergers and Acquisitions: For regional banks, the main source of growth comes through mergers and acquisitions. PacWest themselves have merged or acquired 15 other financial service companies since 2008. East West Bancorp, a direct competitor, has had 7 mergers and acquisitions since 2008. For the industry, the average mergers and acquisitions is 9 since 2008, for regional banks under $10 billion market capitalization. Under the Riegle-Neal Act of 1994, which most importantly empowered nationally chartered lenders to operate across state lines, regulators can only approve mergers or acquisitions if the combined companies’ deposits don’t exceed 10% of total deposits nationwide. This is a problem for banks like JPMorgan Chase, Bank of America, and Wells Fargo, all of which have already passed the 10% threshold. These banks hold 11.1%, 11.3%, and 10.5%, respectively, of total domestic deposits.
This gives smaller banks, like regional, more power to merge with other smaller banks because they will never reach the 10% threshold.

Loans and Leases: The primary source of income for PacWest is from loans and leases, which accounted for 90.97% of their total revenue for the year 2016. That is 13.01% above the total loans and leases of 2015, but in 2015 loans and leases accounted for 92.57% of their total income. These loans and leases are comprised of consumer loans, real-estate loans, C&I loans and leases, including equipment-secured loans and leases and venture capital loans. Their loan breakdown is 55% commercial, 44% Real-estate, and 1% consumer. The largest growing sector of loans is the commercial loans, growing 35.78% over one year. While the growth rate is most likely not sustainable, it indicates the greatest potential for growth.

Economic and Industry Analysis

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Rising Interest Rates: The interest rates are anticipates to rise this year, driving demand for banking services. This also allows the banks some more discretionary funds to spend on asset allocation and other services. Interest rates are forecasted to reach around 1% by the end of 2017, the highest it’s been since the financial crisis of 2008. The interest rates have already risen to .75%, which has reinforced the predicted interest rates rise of the year. This rise will give the banks more tools to use in order to drive earnings for the industry. Banks can increase their margins and drive earnings at no extra cost with rising interest rates. Currently, the Fed Funds rate is set to increase to 2.90% by 2019, over 2.50% above its post-recession level. While the actual numbers will vary, the rates are set to rise steadily.

Political Positivity: The election of Donald Trump has driven the prices of the banking stocks up, in anticipation of lower regulations. On the day of the election, the entire industry experienced an average 12.5% increase in stock price. These promised deregulations aim to benefit both the large and the small to medium banks. For the smaller banks, these deregulations are expected to make acquisitions and mergers easier for the smaller banks to continue their expansion. The positivity has for the most part continued into Quarter One of 2017, keeping the industry stock prices higher than the pre-election stock prices. The financial sector trend is projected to continue throughout the upcoming quarter. Since Trump has taken office, the prices of banking stocks have fluctuated a little bit due to the market volatility following Trump’s every move. However, the banking industry as a whole has been less susceptible to these fluctuations, steadily rising YTD.

Online and Mobile Banking: The fastest growing sector of consumer banking is online and mobile banking. Many consumers don’t want to have to go to the branch to transfer money into their accounts. With online and mobile banking, consumers no longer have to physically go to a branch in order to transfer funds to and from accounts. There are now many fully online banks, with no physical branches. These banks have much lower costs than their brick and mortar counterparts and can pass on their savings to customers with better rates. Another disruptive trend for brick and mortar banks is the rise of mobile banking. The current generation, ages 18-29, are the leaders of mobile banking, with about 68% regularly using mobile banking services. 53% of smartphone users have adopted mobile banking as their primary banking method. PacWest offers electronic statements, transferring funds, and bill pay online. For corporate accounts PacWest also offers wire transfers, remote deposit and positive pay. Banking is moving towards online at a fast pace, with a lot of consumers already using online banking. Online and mobile banking may become a disruptive trend to traditional banking. If banks do not adapt to the growing demand and use of online and mobile banking then they may be left behind by the industry.

Pro Forma Income Statement

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Revenue: I assumed a 14.5% revenue growth over the next four periods. The average over the past eight was 14.11%, but with the promised deregulations and rising interest rates the growth rate should increase. The reason that it is only a slight increase is that interest rates grow are growing slowly and that the deregulation of the financial sector may be postponed until 2018. However, in any scenario revenue growth is growing. Over the same period, the industry revenue grew by 10.82%, with PacWest outperforming its peers by 3.68% revenue growth. The industry will start to grow revenue over the next year, but I estimate that it would reach 11.5% growth for the entire year.

Interest Income: I assumed a 13.25% growth of interest income over the next year. The average over the last eight quarters was 10.30% growth. The increase in interest income is directly tied to the rising interest rates and this will lead to an increase in interest income. This will be the lead driver of PacWest’s increased revenue growth for the coming four quarters.

Loan Loss Provision: The loan loss provision is the reserve of cash in the event that a loan is defaulted on. The average for most banks is about 2-3% of their interest income, but PacWest operates on an average 4.53% loan loss provision, which I used in my estimates. PacWest uses the higher loan loss provision to mitigate the risk of one of their larger loans being defaulted on.

Risks: The current economic climate of uncertainty is a major risk for PacWest Bancorp. Should the uncertain economy weaken, then PacWest would experience a decrease in loan demands, a decrease in deposit balances, decrease in loan, value, and decrease in net interest income. The risk of economic downturn is fairly low, with most economic indicators of recession still showing positivity. Unemployment is below 5% and inflation was 2.07% for the year 2016. Another risk that faces PacWest is default risk. Every loan that PacWest makes there is a risk that the borrower will be unwilling or unable to repay their debt. PacWest also incurs extra risk by having an overwhelming majority of their loans and leases concentrated in a single region. This makes PacWest more susceptible to regional economic downturns, on top of the risk of the overall economy entering into a downturn. Finally, the acquisitions that PacWest performs exposes them to uncertainty risk. This uncertainty risk will be unavoidable as long as PacWest acquires and merges with other entities.

Valuations

In this section, we estimate the fair values of PacWest Bancorp’s stock. It should be noted that all input data were derived from historical company data and pro forma estimates.

Free Cash Flow Valuation Model: The free cash flows valuation model assumes a constant growth rate of a company’s free cash flows forever. Using this model I derived a fair value of $59.10, undervalued by 7.24%.

Residual Income Model: This model values securities using the company’s current book value per share and the present value of expected future residual income. The calculations can be seen in the Appendix 5 and I derived a fair value of $56.87, undervalued by 3.2%

Average Fair Value: $58.43, undervalued by 6.03%
Reasons To Hold: After my analysis, I have found three main reasons to hold all 900 share of PacWest Bancorp.

Strong Fundamentals: PacWest has had strong revenue and earnings growth over the past five years. They have managed to continue their growth even through the financial crisis of 2008. This growth is also projected to continue for the next year. A 14.5% growth rate of revenue over 2017 will raise their total revenue to $1.2 billion for the entire year. That’s over the $1.07 billion over the year of 2016. PacWest has also been increasing their net income and their earnings per share as well. These factors indicate a strong performance for PacWest in the upcoming years.

Acquisitions: While I have not found any acquisitions for 2017 in the works, there is a strong possibility that PacWest will seek to acquire more, smaller regional banks and financial institutions. This would add extra value that is not accounted for in my growth rates or pro forma statement. Also, since PacWest hasn’t announced any news on acquisition, that means that the market has not yet priced in any acquisitions. That would further undervalue the stock at its current price. Also, there is a strong possibility that banking will be deregulated in the next year or so. This would make it easier for banks to acquire and merge with other banks and thus, continue their growth via acquisitions and mergers.

Rising Interest Rates: The rising interest rates will benefit the banking industry the most. With interest rates rising from all-time lows, banks will have more tools available to use for generating revenue. For PacWest, who has maintained high net interest margins throughout the recession, they will be able to increase their margins more. Plus, PacWest’s main source of income is their interest income, and with interest rates rising they will be able to generate more income from interest. While this will also increase their interest expense, they will more than be able to make up for that in increased revenue. PacWest is well positioned to maximize the results of the rising interest rates and turn it into profit.

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