Description

I am recommending a long position in Banc of California.  The idea was submitted in 2017 by ATM and I believe enough has changed since then for a re-visit.  ATM highlighted the transition to BANC 2.0, and we are now on to BANC 3.0; the second management team removed from the problems created under the leadership of Steven Sugarman.

One area of opportunity within bank investing is owning banks that operate in attractive markets with improving fundamentals and are potential acquisition targets.  The first two characteristics are relatively objective while the third is more art than science.  The art; given BANC’s ownership/board composition and management team, I would be very surprised if BANC were an independent company three years from today.  In the event BANC doesn’t sell, the investment should still do well assuming continued operational improvements in a reasonable economic environment.

A few points up-front:

• The macro environment is always an important consideration in any single stock investment.  Given the unprecedented intervention by central banks and government fiscal policies and the corresponding impact on the price of money, the macro environment is particularly relevant today for the entire market but especially banks.  In some sense, it’s all macro for banks.  Although there is always differentiation.

• Two major themes driving my thought process with bank investing: 1) non-interest income and 2) consolidation:

• The level and opportunity with non-interest income is key because, for the most part, non-interest income isn’t constrained by capital and therefore can be extremely helpful in generating “excess” return on equity (ROE).  Durable and growing fee income should command a higher multiple, all else being equal.

• Banks who largely depend on spread lending are commodity-like and in any commodity business, the focus is on cost.  The two cost levers for banks are interest expense and non-interest expense.  Interest expense is a function of deposit franchise - the ability to attract and maintain low cost deposits.  Non-interest expense is a function of management’s ability to run an efficient operation - efficiency ratio.  Scale is important in commodity businesses; as such bank consolidation will likely continue to accelerate in the coming years.  I want to own spread lenders with attractive deposit franchises who are more likely to be sellers in this environment.

OK, back to BANC.

Brief History

In the interest of full disclosure, BANC is not free from controversy.

Steven Sugarman joined the Board of First PacTrust Bancorp, Inc. as part of a recapitalization led by COR Capital in 2010; Sugarman took over as CEO in 2012.  Sugarman was COR’s managing member.  In 2013, the company’s two banking subsidiaries, Pacific Trust Bank and The Private Bank of California, merged to become Banc of California.  In 2014 the company purchased 20 branches from Popular; the acquisition doubled the number of branches and increased total assets to $5 bn.  Then the fun began as Sugarman led a growth strategy that took the stock from ~$10 in early 2015 to almost $25 by the middle of 2016.  In August 2016, BANC announced a $100 mm/15-year commitment for the naming rights of the new LA Football Club stadium.  A $1 bn bank committing to $100 mm for naming rights, yep.

In October 2016 an analysis of BANC was posted to Seeking Alpha.  Feel free to search and read if you have some free time.  Long story short, the analysis alleged an extensive web of relationships between BANC executives/board members with Jason Galanis and other significant related party transactions.  Galanis had a questionable past, to say the least.  In January 2017 the SEC announced an investigation and Sugarman resigned.  Same day.  In February 2017 BANC announced that an independent investigation by its Board found no Finding of Violation of Law.

As you can imagine the clean-up process was not easy.  The issues were reputational and operational.  New management was installed but allegations and lawsuits persisted.  A new CFO faced a lawsuit straight out of Page Six; prostitutes, drugs, etc.  He resigned.  Credit issues, seemingly unrelated to the previously mentioned accusations, plagued the bank for several quarters.

Ultimately the management team turned over again.  The current CEO (2019), CFO (2019) and Chief Credit Officer (2019/2020) having all previously worked at PacWest (PACW).  BANC is almost a subsidiary of PACW at this point.

Board & Ownership

As you can imagine, the Board has also turned over; only one of the ten directors remains from the Sugarman era.  The Chairman is independent.  Richard Lashley (Managing Member of PL Capital; #4 shareholder with ~6.8% ownership) and W. Kirk Wykoff (Managing Partner of Patriot Financial; #9 shareholder with ~2.9% ownership) joined the Board in February 2017.  According to Bloomberg, BANC represents ~15% of PL Capital’s holdings.

The largest non-ETF/fund investor is Wellington owning ~11%.  Nick Adams is likely involved with the analysis/decision to own BANC at Wellington and their sub-advised funds.  If you care, feel free to read my write-up of First Opportunity Fund (FOFI) from 2011 for a brief background on Nick and his investing record, dated at this point.  In any event, Nick is a highly respected investor in the financial sector.  While Wellington does not have a Board seat, their voice is likely heard through Lashley, Wykoff and management discussions.  Shareholders have a meaningful voice at the table.

Basics

Banc of California is headquartered in Santa Ana, CA; $8 bn in assets with tangible book value per share of $13.39 and current dividend yield of 1.25%.  BANC has 31 branches from San Diego to Santa Barbara with the majority clustered in Los Angeles to Orange County.

Banks are simple; interest earning assets, net interest margin (NIM), provisions (credit), and non-interest expense (efficiency ratio).  I will provide a brief summary of trends in key statistics and then spend time on an acquisition analysis.

The strategy in the post-Sugarman era has been to reposition the balance sheet to be a more traditional “relationship-focused business bank”.  What does this mean?  Develop and strengthen deposit relationships with small and medium sized businesses and shift interest earning assets more towards loans and, within loans, more towards C&I and other commercial.  I’ll let the numbers tell the story:

Interest Earning Assets (avg balances, $000)

OK, a lot of numbers,  My key takeaways:

1. Interest earning assets declined from $10 bn to $7 bn and loan share increased from 65% to 79%.  The decline in securities was: 1) ~$1 bn in CLOs, 2) ~$400 mm in US Gov’t and 3) ~$400 mm in other.

2. Loan composition: 1) commercial increased from 63% to 79% of total loans, 2) within commercial, C&I,CRE and SBA increased and 3) consumer declined due to less focus on single family.

3. Total deposits decreased from $8.0 bn in 2017 to $5.8 bn in 2020.  The $2.2 bn decline was: 1) ~$1.4 bn in money market, 2) ~$570 mm in CDs, 3) ~$320 in interest bearing checking and savings and 4) an increase of $140 mm in non interest-bearing checking.

4. Non interest-bearing checking represented 15% of deposits in 2017 and 23% of deposits in 2020.

What does all of this mean?  The shift from securities to loans increases yield, all else being equal.  Shift within loan book to commercial is more consistent with a business focused bank.  Deposit mix shift will lower interest costs, all else being equal.  The shift away from money market and CDs and towards non-interest bearing checking is consistent with the strategy of growing core deposits.  Management has stated they expect interest earning assets will likely grow from here.  The repositioning will continue but the bulk has been completed.

Let’s look at the last few years of financial performance and my 2021 estimate:

Highlights

A few points:

1. Non-interest expense has been very messy over the last few years.  The above was as reported.  My full year 2021 estimate annualizes 4Q20’s level of ~$40 mm.

2. BANC exited the stadium naming rights commitment in 2Q20.  There was a $26.8 mm charge. Total future savings of $89 mm over the next 12 ½ years.

3. Management has stated they plan to repurchase Preferred Stock this year; on February 9, management announced the redemption of the Series D Preferred.  Not sure when they redeem the Series E.

4. Extending one year; assuming mid-single digit asset growth, improving NIM and expense discipline, ~$1.50 in EPS is more than within reach.  Still using an arguably elevated provision expense.  ROE in 2022 likely ~10%.

BANC is trading ~12x my 2022 estimate when it will be generating a 10% ROE.  Hardly cheap.  Let’s look at an acquisition analysis using PACW as my acquirer for illustrative purposes:

I am going to use $25.50 as my acquisition price.  This is equal to a 10% deposit premium.  Further I will assume a 100% stock transaction under two scenarios: 1) PACW share price of $35 and 2) PACW share price of $40.  Lastly I am using 2022 EPS estimates:

The required synergies assuming 100% stock transaction for neutral EPS of 36% is likely a bit on the high side of what can be expected, but not completely unreasonable.  Unscientific but ~30% is typically more reasonable.

A few points:

1. Why not just own PACW:

1. Decent option but the analysis isn’t meant to be a guarantee that PACW will be the buyer.  Just laying out one idea.

2. In the world where PACW is at $40, BANC will likely be higher as well.

2. PACW and BANC should be highly asset sensitive if the curve continues to steepen.  There are reasonable scenarios where BANC’s earnings are in the $2.00+ range.

3. There could also be synergies outside of non-interest expense.  PACW has a larger NIM due to higher asset yields AND lower deposit costs.  Again, could be true for other potential acquirers.

Valuation as Stand-Alone

I will state the obvious; in a steepening yield curve environment banks in general could experience significant earnings growth.  Challenging interest rates have forced management teams to become more efficient.  Assuming the Fed keeps short-term rates low, deposit costs should stay low and short duration securities portfolios should do OK.  Banks, and BANC specifically, should experience meaningful operating leverage.  Low-mid single digit interest-earning asset growth, improving NIM and continued cost controls generates ~$2.40 - $2.50 in EPS in 2-3 years with a mid-teens ROE.  A 10x - 12x multiple is reasonable, so $25 - $30.  Maybe I am too optimistic, maybe I am too anchored.

A potential return of 30% - 50% in the next 12-24 months seems paltry in this market. Although I will take it. Happy to get more into the credit and/or capital sides of the story if anyone is interested. The short answer is there isn't much to say. BANC might have some bank specific issues in the future but next to impossible to handicap. Currently capital is more than adequate and credit is under control.

Catalyst

Interest rates/yield curve

Potential acquisition