Description

I think this is an interesting trade around 1Q next week as people are afraid of another shoe dropping which I DON'T think will happen.  I also think it could be very interesting investment as it could be $50-80+ by year end or sooner if conditions stabilize.  longer-term, this is a well run bank which could go much higher.  I am not sure I will see it past YE.  I wrote this up on vacation to help make sure I wasn't tricking myself.  also, note I am not a historical FIG analyst.  as such, feel free to blast the idea.  that said, I think its too cheap and for very understandable reasons (looks a lot like PACW/SIVB) and could start to differentiate.

Western Alliance Bank {“WAL”) is a high quality regional bank based in the Southwest U.S. with headquarters in Phoenix.  After the GFC, nearly every major regional bank in AZ and NV failed.  WAL was the last one standing.  As a result, WAL competes on advantaged basis in the region as its main form of competition is the local branches of SIB’s.  This is high functioning mgmt. team that continues to exploit its geographic advantages as well as compared to other banks to.  Management doesn’t “rent out its balance sheet cheap.”  Despite their push to grow the bank with high ROEs, the management has intentionally avoided the traps of other management teams.  They have moderate duration risk on their loans.  While time will tell on how their loan book matures from a credit perspective, they have seemingly underwritten with robust standards and derived superior terms due to their local presence or exploiting inefficient national niches.  An example would be lending to an owner-occupied commercial office building on a 60% LTV for $3-5mm versus lending $1bn into a vanilla CMBS structure.  As a result of these efforts, WAL was rapidly growing its deposit base and lending out on an attractive basis which drove strong NIM.  Prior to the crisis, it had hoped to grow deposits by 10-15% this year.

WAL’s real faults are the following:

• 85% of its deposits are from commercial entities which tend to have larger deposits
• 12% of its 12/31/22 deposits were from the technology sector. 
• Deposit to loan ratio is high

Prior to the crisis, WAL was forecasted to generate $10/share of E.P.S. which compares highly favorably with the ~$32/share stock price.  The recent volatility will compromise 2023 earnings forecast.  However, should they stabilize and return to growth that figure COULD be on the table for 2024.

Why did WAL trade off so much?

1. Anything that screened with large technology exposure got spanked.  WAL’s 12% technology exposure put it on the short screen fast as people rushed to attack anything that looked like SIVB and PACW.
2. In the rush to short/sell, WAL also suffered from a western geographic footprint that made it resemble SIVB and PACW even more.
3. Given the reflexivity of stock prices and deposit outflows, the larger commercial entities rushed to hedge their risk and took some deposits out.  Management highlight some of the losses the week of 3/16.

This caused the first swoon in the stock.  WAL was probably about to recover but then it completely botched its update on 4/4/23.  On 4/4/23, WAL announced they were reporting on 4/18 and provided a handful of encouraging data points on important issues.  HOWEVER, the report left out the most essential component of the results… the 3/31/23 deposits.  The stock began to really suffer as the market used various metrics to attempt to back into where deposits could have gone as the most obvious conclusion was that the management team was hiding something.  Some math pointed to a staggering outflow from $52bn on 12/31/22 to possibly $35bn+/-.  The risk then became that the stock drop would lead to another deposit flight.  As such, in mid-afternoon of the next day, the management team released the 3/31/23 deposits which were a bit lower than hoped but respectable at $47bn.  This is a 11% drop from 12/31/22.  It is important to disclose that WAL has seasonal deposit flows and received an additional $7.8bn of inflows by 3/8/23.  As such, the peak to trough is more pronounced.

I suspect management was reluctant to issue this data as it might have been a bit light to the message they had conveyed during the quarter.  However, there are some really reassuring aspects to this figure.

• Deposits increased from 3/20-3/31 by nearly $1bn
• Deposits also increased by $1bn+ in the first few days of April which includes 2 weekend days
• Management is aggressively deploying ICS to grow insurance which means that 70% of deposits are now insured, leaving a much smaller component of the deposits that are susceptible to outflow.  Previously that figure was 55%.
• Book value grew modestly during the quarter as lower rates helped.  One COULD conclude that they were EPS+ despite the turmoil and reported $25bn of new borrowings at one point in 1Q23.

The botched update was a clear mistake and the market does NOT appreciate attempts to inflate stability.  I suspect they were seeing deposits return quickly and hoped to report a more pronounced trend by 4/18.  That said, I suspect that it can further grow insured deposits to 75%+.  If truly pressed, it can shrink its book by 25% and move entirely to insured deposits if needed.  It is able to do this because it doesn’t have material mark to market losses.  The failure of SIVB means that its technology business could expand too.  As such, we have a highly profitable bank well below book value and tangible book that may have taken the last big gut shot.

To be clear,  WAL did not suffer because it took unusual investment risk or had a large duration hole – quite the opposite.  The book is 30% securities with a modest mark-to-market.  The loan book is mostly floating with loans to a variety of different industries.  It does have some office exposure but its mostly local, smaller properties with loans to renovate and a fair amount of owner-occupied facilities.  LTV’s are low.  Further, this isn’t down-town NYC, Chicago or SF.  It is in places with far better attendance.  If we are going into a nuclear winter, it could face impairments.  However, this loan book looks fairly well underwritten and with no epic fails like Manhattan rent-control properties.

How has the crisis impacted the earnings outlook?

As I mentioned, the sellside forecasts previously anticipated roughly $10/share of E.P.S.  The crisis has adjusted four items.  1)  they most likely will miss their deposit growth target of 10-15%.  In fact, they might be lucky to end the year flat.  2)  They are unlikely to lend out as much of newly accumulated deposits.  Amortization payments will likely exceed loan outflows for a bit as they stabilize liquidity.   3)  They are currently borrowing up to $10bn from the FHLB.  4)  Deposit costs and funding costs will increase.

To REALLY simplify the impact of the deposit decline/loan growth, I assume their topline is flat from 4Q22 and EPS from the period is the run-rate which might be a bit conservative as I suspect they grew loans in Jan/Feb.  from there, I adjust EPS for the FHLB loans.  They had started to borrow in March to obtain liquidity in the event of a run.  As deposit flight risk depletes and with more certainty around their ability to access the BTFP, I suspect that these borrowings drop and the incremental borrowings are only what they have lost in deposits which at this point is only roughly $4bn.  Should they claw back deposits this will drop to zero and run-rate 4q22 of $8.4/share is restored.  Below is a table to show the impact.

Based on these adjustments, I suspect WAL can generate at least $6-7/share of EPS despite the substantial outflow.  Part of this assumption is based on my assumption that the contagion is largely contained and deposit flows stabilize.  As they recover lost deposits, the next impact is funding costs.  They will likely need to remain competitive to source new funds.  They are already competitive at 1.5%.  Below is a sense for how NIM compression or higher funding costs impact them.

A couple of thoughts here

• their rates on their LIBOR based loans lag but will ramp in tandem with higher deposit rates, materially reducing compression when compared with a SCHW
• new loans issued will have a much higher rate but this is a slow path to NIM normalization
• Deposit costs have been rising far slower than LIBOR

Overall, I think it’s fair to model at least 50bps of compression though.  So perhaps they get back to $8.4/share of EPS as they recover the lost deposits… but then they lose $2/share to deposit costs which gets you back to $6/share. 

Valuation:

WAL trades at 0.7x book and 0.8x tangible book as people view it as a going concern risk.  I think that is unwarranted based on deposit balance recovery and the fact that 70% are now insured.  Further, I suspect that deposit flight is over for now – with some risk of another scare.  On normalized earnings, it looks cheap on 2023 at less than 5 p/e.  if you assume by 2024 they have recovered their deposits but suffer from 50bps of NIM compression, then again its $6/shr and a 5x p/e.  I suspect I am being extremely conservative on these estimates but especially for 2024.

Further, the stock is largely derisked on 1Q key metrics.  I suppose the one issue for 1Q is that 2023 estimates need to be brought way down.  Big picture:  this stock is too cheap unless it fails.

How could it fail? 

• a huge further shock to the banking system which can be hedged by shorting the KRE or SCHW
• a staggering hit to the stock which scares depositors.  Suspect the worst of the news is out – especially if the deposit recovery continues
• some viral online rumor about their solvency but keep in mind 85% commercial who will be more fact based
• Could QT and decline in M1 drive deposits in all banks down? 

Catalyst

1Q earnings

further stabilization of regional banks