1) Pacific Premier was risk averse during the credit boom due to enhanced regulatory oversight. Following the OTS order in 2000, a new management team that specializes in bank turnarounds was hired. Pacific Premier raised new equity capital and redirected the business model toward making loans with better risk adjusted yields. For the next several years, the bank operated under elevated regulatory scrutiny as new management untangled the bank from the unsafe banking practices employed by prior management.
The result is that Pacific Premier has low exposure to high risk loan categories: construction loans (0%) and non-conforming residential mortgages (2%). The $645m loan portfolio is mostly commercial real estate (CRE), 47% is multifamily, 26% is general CRE (offices, retail, warehouse, etc), and 17% is owner occupied CRE. Business loans account for 7%.
So far, Pacific Premier’s loans are performing far better than the industry. In aggregate, the ratio of non-performing assets to total assets for FDIC insured institutions is 1.54%. The ratio for 160 public banks in California is 1.21%, and for 860 public banks outside California it is 1.00%. Only 0.60% of Pacific Premier’s assets are non-performing.
Careful underwriting is another reason to expect solid loan performance, in addition to the reasons discussed – a risk-averse management team, limited exposure to the highest risk loan categories, and enhanced regulatory scrutiny following the order to cease and desist in 2000. Nearly every loan has a personal guarantee (3% exceptions). The largest loan is $12m.
The typical loan-to-value at inception for multifamily was 64% and for other commercial real estate was 62%. Given that the interest coverage is not typically less than 1.2x, if net operating income can decline by 25% (seems draconian, but say 7.5% decline in occupancy and 7.5% decline in rates, plus margin deterioration for fixed costs) and the bank forecloses, then cap rates can still increase by 100bps from 5.5% to 6.5% before the bank begins to really take losses on foreclosures. The average loan is over 24 months old, and the bank sold off nearly its entire 2007 production.
2) The bank has sufficient capital to hold the RMBS to maturity. Tier 1 capital amounted to $65m, or 8.96% of tangible assets. Technically, well-capitalized is over 5.0%; really, it is whatever the regulators say. And they are telling Pacific Premier they would like it to be 10.0%, including TARP. Pacific Premier received verbal feedback that if it applied for TARP proceeds its application would be approved. The bank is eligible for up to $22m. So with $87m of Tier 1 capital, its pro-forma capital ratio would 11.9%.
Scenario #1: If the RMBS were immediately valued at $0, the Tier 1 ratio would fall to 10.3%. So even if the RMBS is worthless immediately, the bank is still “well-capitalized” and is trading at 55% of diluted tangible book. But provisions to the loan loss reserve have been and will continue to increase.
Scenario #2: If the RMBS recovers just 50% of par over the next three years, this would equal roughly $9m of incremental losses spread across 12 quarters, or $0.75m per quarter, pre-tax. The bank’s pre-tax pre-provision income last quarter was $2.25m. If this run-rate continued, the sum for the next 12 quarters would be $18m (2.8% of loans). Given pro forma Tier 1 capital of $87m and tangible assets of $735m, the bank is able to provision $2.5m per quarter for the next 12 quarters and maintain a capital ratio greater than 10.0%. The cumulative provision would be $30m, or 4.7% of net loans. The provision during the past two quarters has been $0.7m (3Q) and $0.8m (2Q). In this scenario, at the end of 12 quarters, the diluted book value per share would be $6.50, and today the stock trades at 60% of this projected book value.
3) Insiders have been purchasing stock recently. I weight this factor lightly, and only because the management of Pacific Premier is not in denial about the credit outlook. They are preparing for a flat bottom in 2011 that will last two years. There are $60m of loans on the watch list and the bank has obtained updated financials and visited the properties to make updated appraisals. This sort of vigilance adds influence to the recent insider purchases. Moreover, there were six buyers of the 26% position that Security Pacific sold, and the buyers include a current and a former director of Pacific Premier.
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Comparison
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Tang. Equity/
Tang. Assets
|
NPA/
Assets
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REO/
Assets
|
Construction/
Total Loans
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Home equity/
Total Loans
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5yr Avg. ROE
|
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All Cali banks trading
between 30-50% of book (22)
|
9.50%
|
2.76%
|
0.28%
|
17%
|
4%
|
8%
|
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All US banks trading between
30-50% of tangible book (113)
|
8.95%
|
3.30%
|
0.62%
|
20%
|
4%
|
7%
|
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Pacific Premier Bancorp
(PPBI, 40% of tangible book)
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7.65%
|
0.70%
|
0.00%
|
1%
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0%
|
13%
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Catalyst
1) Acquiring deposits of a failed bank from FDIC. Pacific Premier has a high loan-to-deposit ratio and relies on FHLB borrowings. This makes the bank liability sensitive, which is positive for profit margins in the near term, but deposits would improve earnings reliability.
2) Seasoning of RMBS that potentially resulted in an earnings gain and increase in book value (this is a low probability event).
3) Time. Given reasonable expectations for 100% upside, a 2-3 year time horizon is budgeted.