PacWest Bancorp’s (NASDAQ: PACW) 2Q 2020 was actually sort of ugly, and things are going to get much uglier. Here’s the stock’s inconclusive reaction to net earnings of $0.28 per share announced on July 16 compared to 2Q 2019’s $1.07 per share.
When you consider that 1Q 2020 EPS was negative $12.23, however, things might be looking up. Not so fast. In order of importance, I’ll be reviewing credit quality, net interest income and non-interest income and expense. Then I’ll take a look at yet another worst-case EPS and dividend forecast and discuss some intangibles.
Credit Quality: Throw the Forecasts Out
Deteriorating credit quality cascades like whitewater rapids, going from bad to worse over a series of quarters or even years before it finally eases. PACW – like many banks – is at the beginning of the cascade.
In case they missed the first quarter, Well Fargo (NYSE: WFC) told investors everything they needed to know about West Coast-headquartered bank credit quality for 2020 with its massive 2Q 2020 $8.4 billion loan loss provision – and that was after 1Q 2020’s $2.9 billion. Yes, it’s the impact of the unprecedented steps taken to ameliorate the COVID-19 health crisis.
PACW followed the trend with a $120.0 million loan loss provision following the $112.0 million for 1Q 2020. The first-quarter provision was somewhat expected as the switch to CECL methodology required most banks to provide additional reserves to “catch-up” with the new requirements. The size of PACW’s 2Q 2020 provision was a bit of a surprise. The total first half provision of $232.0 million is about 64% of the $364.9 million I had previously estimated for the entire year.
We are at the beginning of the cascade for PACW’s credit quality. According to PACW CEO Mark Wagner in the 2Q 2020 Press Release, the bank granted “loan payment modifications on approximately $1.8 billion, or 9% of loans and leases, most during May and June.” That’s a huge number of loan modifications, a large number of which may eventually migrate to nonperforming assets. Wagner continued with a general comment on credit quality:
“We continued enhanced monitoring of our loan portfolios and saw less loan migration to special mention during the second quarter after being proactive in downgrading loans in the first quarter. We recorded another significant provision for credit losses largely due to deterioration in the macro-economic variables used in our CECL forecast.”
The key phrase in the paragraph above is “deterioration in the macro-economic variables.” Here’s a quick look at credit quality trends for the past four quarters:
As I stated in my 1Q 2020 review, my concern is not the present, but the future, i.e., the cascade. Specifically, although there was less migration to special mention loans in 2Q 2020, there was obviously strong migration to classified and nonperforming loans. From 1Q 2020 to 2Q 2020, although special mention loans – marked here in red – declined, classified loans increased $145.5 million or 98.5% and nonperforming assets increased $70.3 million or 72.2%. These are strong signs that we’re at the start of the rapids; rough, but only foreshadowing the cascade to come.
Net Interest Income: Management Squeezes Back at the Margin Squeeze
The margin squeeze continued, but management squeezed back in 2Q 2020. Net interest income before the loan loss provision actually increased $4.5 million or 1.8% over 1Q 2020. The table below shows what happened.
On the negative side, the decline in interest income accelerated to $17.3 million or 5.9% compared to 1Q 2020, following on the smaller $2.3 million or 0.8% drop from 4Q 2019 to 1Q 2020. YTD 2020 interest income was $53.7 million or 8.7% lower than YTD 2Q 2019. Loans increased about $886.6 million or 4.6% between the sequential quarters, but average loan yield fell 53 bps from 5.54% to 5.01% due to continued variable rate loan repricing and the closing of $1.2 billion of low-rate government guaranteed Paycheck Protection Program (“PPP”) loans.
On the positive side, at least for PACW, management responded with an epic squeeze of its deposit customers; in one quarter, the average rate on interest bearing deposits dropped 55 bps from 0.95% to 0.40%. Even better, the total cost of deposits, including non-interest bearing demand deposits, plummeted 34 bps from a 1Q 2020 average of 0.59% to a 2Q 2020 average of 0.25% – that’s really cheap money!
Favorable volume gains played a big part. Total deposits increased $3.4 billion or 17.1% to $22.9 billion. Non-interest bearing demand deposits increased $1.1 billion or 14.9% in a single quarter from $7.5 billion at the end of 1Q 2020 to $8.6 billion at the end of 2Q 2020. Over the same period, there were also big gains in interest checking, up $1.5 billion or 45.8%, and money market accounts, up $786.0 million or 16.7%, while non-core CDs less than $250,000 declined $563.3 million or 27.0%. Combined, core deposits increased from 82% to 85% of total deposits. The increase in core deposits was driven by customers depositing PPP loan proceeds and venture banking, where deposits increased by $2.0 billion to a record $8.7 billion at 2Q 2020.
Warning! Some of the increase in core deposit balances will disappear quickly to pay employees of small- and mid-sized businesses and fund venture investments, on the margin reversing the reduction in deposit costs over the remainder of the year.
The increase in deposits allowed for a massive decrease in borrowings which declined $2.2 billion to $60.0 million at 2Q 2020. Expect generally more expensive borrowings – averaging 0.61% 2Q 2020 – to be used to replace any decline in core deposits.
Surprisingly, the interest spread, comprised of a 4.53% earning-asset yield and a 0.55% cost of interest-bearing liabilities, actually increased to 3.98% for 2Q 2020 from 3.86% for 1Q 2020, as the earning-asset yield declined 49 bps compared to the 61 bps decline in the cost of interest-bearing liabilities.
Management really did squeeze back. Big picture, however, the margin squeeze continued as the denominator impact of the $1.1 billion increase in average earning assets in 2Q 2020 swamped the increase in net interest income before the provision for loan losses. As a result, the net interest margin (taxable equivalent) fell another 11 bps from 4.31% in 2Q 2020 to 4.20% in 1Q 2020.
What Kills Earnings Faster? Loan Loss Provision or Margin Squeeze?
The loan loss provision – as a reflection of credit quality – has emerged as the No. 1 earnings killer for PACW. Referring back to the table in the previous section, a 2Q 2020 loan loss provision less than about $116.0 million would have produced a gain in net interest income after the provision over 1Q 2020. The temptation must have been enormous. To put things in perspective, the average annual provision from 2015 to 2019 was $47.2 million. PACW has already – for just the first half of 2020 – set aside about 5 times its annual provision for the last five years.
Unfortunately, net interest income will resume its decline, but at a slower, and for 2020, manageable pace. Management is now pushing on a string in terms of deposit costs – at an average 0.40% 2Q 2020 cost of deposits, there’s almost nowhere to go but zero. Some of those cost gains from core deposits will reverse, too. As we’ve seen, the yield on interest-earning assets will continue to fall – loan yield was down 53 bps from 1Q 2020 to 2Q 2020; exacerbated by PPP loan growth, but most of the decline is associated with variable loan repricing and new loan production at lower rates.
For 2020, the No. 1 earnings killer will be the loan loss provision.
Non-interest Income and Expense
The $9.8 million or 33.5% increase in non-interest income over 1Q 2020 won’t be repeated for 3Q 2020 unless management pulls the trigger on some more non-recurring income items.
The first non-recurring item was a $7.7 million gain on the sale of about $122.0 million in securities – a $7.5 million increase over 1Q 2020. The second was buried in the $2.4 million or 58.2% increase in other income from $4.2 million in 1Q 2020 to $6.6 million in 2Q 2020. There was a $2.9 million increase in dividends and gains on equity investments, the majority of which was a $1.5 million gain on the sale of an equity investment, partially offset by no repeat of the $1.1 million in bankruptcy proceeds received during 1Q 2020.
The more steady-state items, service charges, commissions and fees and lease income netted out to a small 1.9% decline from 1Q 2020, but lease income bears watching as it has been inflated by early lease termination fees as struggling businesses cut expenses. Without more one-time gains, expect non-interest income to be level to slightly declining for the second half of 2020.
PACW management has been diligent about cost control, so 2Q 2020’s $9.0 million or 7.6% sequential quarter increase in non-interest expense (excluding the 1Q 2020 $1.5 billion goodwill write-down for comparison purposes) was an unpleasant surprise. We needed to see some green here, but all the highlights are yellow.
In fairness to management, most of the increases in non-interest expense appear to be for virtually non-discretionary purposes. The $5.1 million or 120.6% increase in insurance and assessments was the major item, but it was essentially uncontrollable. The FDIC hit PACW with a higher insurance assessment rate due to the 1Q 2020 net loss driven largely by the $1.5 billion goodwill impairment charge. As a result, FDIC insurance expense will be much higher for at least one year.
The $1.6 million or 16.4% increase in other expense resulted from the decision to pay off $750.0 million in FHLB Advances – the borrowings we discussed earlier – which resulted in $6.6 million in prepayment penalties. The Advances had a weighted average interest rate of 0.96% and were essentially replaced by cheaper deposit funding. The prepayment penalties were partially offset by the reversal of a $1.5 million loss contingency and a decline in other activity-related expenses due to the impact of COVID-19 on customers.
The $729,000 or 27.5% sequential quarter increase in loan expense was logically but ominously linked to “higher loan-related legal and workout expenses” in the 2Q 2020 Press Release. We can expect this expense category to grow over the rest of the year. Finally, the $648,000 or 10.0% sequential quarter increase in data processing expense resulted from one-time expenses associated with creating loan origination and documentation systems to implement the PPP.
A potential wild card is another goodwill impairment write-down. With the stock trading consistently below 2Q 2020 book value of $29.17 per share, the argument could again be made that, paraphrasing the 1Q 2020 10-Q, the pandemic has continued to cause a significant decline in stock market valuations including PACW’s stock price and that the bank’s estimated fair value is again significantly less than its book value. As the market is apparently looking through any goodwill write-downs, perhaps the only “real” impact of another write-down causing a GAAP quarterly net loss would be the risk of a second FDIC insurance re-assessment resulting in higher FDIC insurance expense.
On a positive note, there were no employee layoffs. 1Q 2020, however, saw a huge $13.4 million or 17.89% reduction in compensation expense due to “lower bonus accruals” compared to 4Q 2019. PACW has always run lean and it could be with “only” 1,835 full-time employees as of January 31, 2020, there is little redundant staff to cut. For confirmation, according to the FDIC Statistics at a Glance for March 31, 2020, the average U.S bank had $9.8 million in assets per employee, but PACW has about $14.9 million in assets per employee. PACW’s efficiency ratio also supports this theory. Although the efficiency ratio drifted up to 42.9% 2Q 2020 from 40.6% 1Q 2020, the average efficiency ratio for banks in PACW’s size peer group for March 31, 2020 was 54.93% according to the FDIC’s Quarterly Banking Profile. Even subtracting 2Q 2020 one-time expenses, e.g., prepayment penalties, we can expect higher FDIC assessments plus the increasing costs of dealing with troubled assets to keep non-interest expense under pressure in 2020. Efficiency has always been ingrained in PACW’s corporate culture; that won’t change, but some expenses can’t be controlled.
2020 Estimated Earnings: An Exercise in Futility?
Forecasting earnings for PACW depends largely on the analyst’s projected loan loss provisions for 3Q and 4Q 2020. I have a method, outlined in the table below, that assumes that PACW will reserve an additional $191.0 million for loan losses during the second half of 2020, but my forecast is hampered by the bank’s new CECL methodology and the impact of COVID-19. I am assuming that the 1Q 2020 loan loss provision included a fair amount of CECL “catch-up” requirements and that 2Q 2020 was truly “forward-looking.” Obviously, I am very concerned about credit quality for the second half of 2020. My old revised worst case (!) estimate was EPS of $2.50 for 2020, right in line with the Street, but it’s much lower now:
My estimate is for worst-case adjusted earnings (excluding the goodwill impairment) of $1.44 per share, equivalent to a payout ratio of roughly 69% – again edging towards my personal danger zone of 70%. Could we see another dividend cut in 2020? Well, the CFO just left under odd circumstances…
Intangibles: Poor Communication
Intangibles covers a lot of ground. For example, there was no press release regarding the resignation of CFO Patrick J. Rusnak posted on the website as of July 17, 2020. His resignation was received June 22, announced June 24, and is effective January 1, 2021. No hurry, I suppose.
Rusnak is an industry veteran who joined the bank on April 27, 2015 from Sterling Financial which was acquired by Umpqua Bank (NASDAQ: UMPQ). Rusnak is only 56 years old with compensation well over $1.5 million a year and no payments upon a voluntary resignation. The only explanation in the June 22, 2020 8-K is that he’s leaving “to pursue other interests.”
Also, as of July 17, 2020, the PacWest Bank Investor Relations web page linking to its parent PACW still references 1Q 2020 earnings. Press releases are few. In addition, PACW does not regularly conduct quarterly earnings conference calls, so there’s no give-and-take to better understand management’s viewpoint.
Granted, PACW is a business bank, but at $27.4 billion in assets, it’s the 5th largest bank in California and should improve communication with the investment community.
Conclusion: Watch and Wait
PACW’s earnings have been under pressure from the margin squeeze for what seems like years. Now, the pressure on credit quality is intensifying as the bank’s prime small- and mid-sized business clients have been pounded by the impact of COVID-19.
PACW is at the beginning of the credit quality cascade and will be negotiating Class V rapids for the rest of 2020 and at least half of 2021.
The bank is cheap, but it’s still too early to buy the stock. As of July 17, at $18.56 per share, the stock trades at about a 12.85 PE on my estimated adjusted 2020 earnings, .97 x tangible book and a 5.31% yield, but… see the picture above. I don’t think the majority of investors are expecting the cascade of deteriorating credit quality and I expect to see downward 2020 earnings revisions from the Street over the next few weeks.
The $120.0 million in 2Q 2020 loan loss provision was a warning shock that provided needed clarity on asset quality. Now that we can see what’s coming, we can be a little less bearish. At some point over the next 2 or 3 quarters – maybe more, the rapids will subside to a gentle stream and PACW will be an excellent speculative play. Meanwhile, unless something crazy happens and we see the stock trade at $15.00 or $16.00 per share (20%-25% below current tangible book) – and that’s only for those who can afford to speculate, we can watch and wait.
Disclosure: I am/we are long PACW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.