Earnings of PacWest Bancorp (NASDAQ:PACW) declined to $0.28 per share in the second quarter from adjusted earnings of $0.34 per share in the first quarter of 2020. The decline was mostly attributable to higher provision expense and an increase in FDIC assessment expense. Earnings will likely improve in the second half of the year due to lower provision expense. Overall, I’m expecting earnings in the second half of the year to be 89% higher than the earnings in the first half. For the full year, I’m expecting PACW to report earnings of $1.80 per share on an adjusted basis. The June 2021 target price suggests a high upside from the current market price; hence, I’m bullish on the stock for a holding period equal to or more than nine months. In the near term, however, the risks related to the pandemic are too high to allow much price appreciation. Consequently, I’m adopting a neutral rating for the remainder of this year.
Eye on Hotel Exposure
PACW is facing a high level of credit risks because the COVID-19 pandemic has driven up the number of loans requiring payment accommodations. As mentioned in the second quarter’s earnings release, PACW granted payment modifications on $1.8 billion worth of loans by the end of the June-ending quarter, representing 9% of total loans and leases. The payment deferrals are partly attributable to PACW’s exposure to COVID-19-sensitive industries. According to details given in the second quarter’s 10-Q filing, vulnerable industries made up around 12% of total loans, as shown below.
While most industries are likely to return to payment in the second half of the year, the hotel industry, which made up around 6% of total loans, will likely continue to defer payments until at least the mid of next year. I’m expecting the hotel industry to recover long after a COVID-19 vaccine first becomes available because the widespread production and immunization will take time. Most people are likely to avoid non-essential traveling until life returns to normal.
PACW reported a provision expense of $120 million in the second quarter, up from $112 million in the first quarter of 2020. As of the end of June, the allowances for loan losses stood at 1.53% of total loans as opposed to 0.74% of total loans at the end of December. The provision expense will likely trend downwards in the second half of the year because the economic outlook has not worsened much since the end of the last quarter. Further, I’m expecting new loan origination to be lackluster in the second half of 2020, which will limit the need for further provisioning. Consequently, I’m expecting PACW to report a provision expense of $160 million in the second half of 2020 compared to $232 million in the first half.
Paycheck Protection Program to Chiefly Drive Net Interest Income
The Paycheck Protection Program (“PPP”) will likely boost earnings in the second half of the year. As mentioned in the earnings release, PACW funded loans worth $1.2 billion under PPP. Assuming a margin of 2.75%, PPP will add an estimated $33 million to the net interest income over the life of the loans. As most of the loans are likely to get forgiven before the year-end, PACW will accelerate the fee amortization of the fees in the second half of the year.
Excluding the impact of the accelerated amortization of PPP fees, the net interest margin (“NIM”) will likely decline only very slightly in the second half of 2020. Although variable-rate loans make up a majority of total loans, around $8.8 billion, or 80% of the variable-rate loans, were at their floors at the end of June and thus were acting like fixed-rate loans, according to details given in the 10-Q filing. The interest rate sensitivity analysis conducted by the management also shows that NIM is not very sensitive to a decline in interest rates. The following table from the 10-Q filing shows the results of the management’s sensitivity analysis.
Considering the factors mentioned above, I’m expecting NIM to decline by just 2bps in each of the last two quarters of 2020. For 2021, I’m expecting the average NIM to be 10bps below the average for 2020 because some fixed-rate loans will mature and get replaced with loans originating at lower rates.
The expected forgiveness of PPP loans before the year-end will likely reduce the loan balance in the year ahead. Further, PACW’s participation in the PPP resulted in a corresponding increase in core deposits in the second quarter of 2020 due to PPP loan proceeds being deposited into customers’ accounts, as mentioned in the 10-Q filing. Consequently, PPP forgiveness will likely reduce deposits too in the second half of the year. Overall, I’m expecting the year-end loans to be 6% and the year-end deposits to be 3% below the June-end level. The following table shows my estimates for loans, deposits, and other balance sheet items.
Expecting Adjusted Earnings of $1.80 per Share for 2020
The expected decline in provision expense and the accelerated amortization of PPP fees will likely drive earnings in the second half of the year. On the other hand, normalization of non-interest income in the second half of the year will likely pressurize earnings. PACW’s non-interest income surged in the second quarter due to large one-time gains of $7.7 million on sales of securities. Further, the non-interest expense will likely remain high because the management mentioned in the earnings release that the hike in FDIC assessment expense in the second quarter will continue for a year. Overall, I’m expecting earnings to increase by 89% in the second half of the year compared to the first half. For the full year, I’m expecting PACW to report earnings of $1.80 per share on an adjusted basis. Including the impact of the goodwill impairment booked in the first quarter, PACW will report an estimated loss of $10.77 per share in 2020. The following table shows my estimates for PACW’s income statement estimates.
Actual earnings may differ materially from estimates because the uncertainties surrounding the COVID-19 pandemic can lead to earnings surprises.
Near-Term Risks Likely to Restrain the Stock Price this Year
I’m using the historical average price-to-tangible book multiple (P/TB) to value PACW. The stock has traded at an average P/TB multiple of 1.24 in the first half of 2020. Multiplying this P/TB multiple with the June 2021 forecast tangible book value of $21.9 per share gives a target price of $27.1 for the mid of next year. This target implies a 56% upside from PACW’s current market price; hence, I’m bullish on the stock for a holding period of more than or equal to nine months. The following table shows the sensitivity of the target price to the P/TB multiple.
PACW is also offering a decent dividend yield of 5.75%, assuming the company does not cut dividends any further and maintains its quarterly dividend at the new level of $0.25 per share. There is little threat of a dividend cut through 2021 because the earnings and dividend estimates suggest a payout ratio of 31%, which is easily sustainable.
Despite the attractive valuation, I’m not expecting the stock price to appreciate much in the year ahead. The elevated credit risks due to the COVID-19 pandemic and PACW’s exposure to pandemic-sensitive industries, especially hotels, will likely keep investor confidence low. As a result, I’m expecting the risks to constrain the stock price in the remainder of 2020; therefore, I’m adopting a neutral rating on PACW for this year.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: Disclaimer: This article is not financial advice. Investors are expected to consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.