With everything that’s happened in the wake of the COVID-19 pandemic, including the Fed’s commitment to keep rates very low through 2023, it’s not so surprising that banks are under pressure. -perform. So, in this context, Bancorp East-WestPerhaps not so surprising is (EWBC)’s 30% over 30% year-to-date drop in line with its peers. While this name has many advantages, including its cross-border lending capabilities and strong profitability, the reality is that East West cannot escape the pressures of lower spreads, limited loan growth and rising loan costs. credit.
There are plenty of banks that look undervalued today, so investors are spoiled for choice. East West isn’t among the cheapest, but I think there’s an argument for a more compelling idea based on its high quality. With that, I think it’s still a name worth considering.
A slightly riskier loan portfolio, but solid capital
East West’s credit performance could rightly be called “mixed” as write-offs were quite high during the last bad credit cycle (the global financial crisis), but have since improved to higher levels. to those of peers. While you could argue that East West learned some lessons and changed its policies in response, the reality is that you really never know about bank underwriting until you complete the cycle…and like write-offs typically don’t peak until minus four quarters into a recession, so that’s still just the beginning.
With higher-than-expected provisioning spending in the second quarter, East West increased its reserves to around 1.85% of ex-PPP loans. Honestly, with many similar sized peers closer to 2%, it’s not as high as I would like. East West is small enough not to go through the DFAST process, but using data from other banks I would estimate that East West would be around a third reserved against a Fed Severely Adverse scenario, versus closer to 45% for many peer banks. Coming out of the second quarter, East West was a little worse than average on the non-performing loan ratio (compared to its peers), but also a little above average when it comes to the NCO ratio.
I also see a somewhat high level of risk in the loan portfolio. About 3% of the loan portfolio is devoted to energy loans, which are already experiencing much higher levels of criticism and non-performance, and now have 9% loan loss coverage in reserves. East West also has significant exposure to Entertainment (around 2%, more focused on film production), Retail CRE (around 9%) and Hospitality CRE (around 5%). Loan-to-value ratios are around 50%, providing some cushion, but CRE’s almost 10% rollover rate out of Q2 is worth watching.
The good news is that the new CECL rules force banks to take bigger reserves earlier in the process, so I don’t think there will be big reserves from here. Of course, a lot depends on how the economy goes from here. Significant stimulus efforts have so far cushioned the blow, and perhaps they will succeed in helping businesses and consumers get closer to recovery, so we will never see the big rise in bad debts. I also want to point out that East West is in a strong capital position, with a CET 1 ratio of 12.7%. It would take a disastrous credit loss experience to really put the dividend at risk, and I think East West remains well positioned to be opportunistic on the M&A front if the right deal comes along.
Navigating in a difficult environment
The next two years are going to be difficult for banks. It’s hard to make money as a spread lender in a near-zero rate environment, and East West doesn’t have a particularly large set of fee-generating businesses to offset lower spread income. .
What East West does have, however, is a good deposit base. In addition to a strong base deposit franchise (and increased deposits, including non-interest bearing deposits), East West was able to withdraw and reprice some higher priced CDs earlier this year. With that, deposit costs have fallen to less than 50 basis points, and I think they can fall to around 25 to 30 basis points over the next year. This will help offset some of the pressures on loan yields, which I expect will be much larger – from around 4% in the second quarter to probably something closer to 3.75%.
Loan growth remains a big unknown, but generally speaking, loan growth isn’t particularly good during recessions. Although East West is one of those “bigger than you think” banks, with about $37 billion in loans, it’s still quite heavily funded by Southern California, so the trajectory of SoCal’s health and recovery is a key factor.
The health and content of trade with China is also important. East West is one of only three US banks licensed to operate banks in China. So far, lending to Chinese companies has not been a particularly large part of the business (about 3% to 4% of lending), and East West is primarily focused on working with Chinese companies that have operations in the United States (helping to finance trade, film production, etc.). This leaves the company exposed to further deterioration in US-China trade relations, although you could also argue that should relations improve after the next election, East West could be a significant beneficiary.
Between low spreads, low loan growth, higher credit losses and limited incremental expense leverage, I expect East West to deliver low single-digit pre-provision earnings growth in over the next two years before a stronger rebound from 2023. That’s not bad, as I see a lot of banks likely to show a contraction in PPOP, but I see modest risk that East West policy with respect to PPP loans leads to relative underperformance as the bank recognizes more up-front fees – arguably the correct accounting treatment, given the shorter tenor of these loans, but still an area of potential differentiation that investors may initially misunderstand.
I have some concerns about East West’s exposure to oil/gas production, retail and hotel credits, and an arguably modestly underfunded position, but East West has the capital to weather a fairly unfavorable credit cycle. On the other hand, I think East West’s cross-border lending capabilities and its specialized lending capabilities in areas such as private equity, entertainment and life sciences are all strengths that can generate above-average loan growth. I also like the company’s leverage on small business loans, which generally generate higher returns and offer a moderately defensible moat, because the big banks generally don’t want to bother with it and the smaller banks don’t cannot compete on the level/range of services.
Compared to my early 2020 expectations, I have reduced my earnings expectations for East West as I have for almost all US banks. After a significant drop in earnings in 2020, I expect a modest rebound in 2021 and acceleration after 2023. I’m looking for just over 2% core earnings growth over the next five years, accelerating to 4 % over the next 10 years (with growth from year 5 to year 10 of around 6%). Discounted, these base earnings estimates support a fair value of around $40.
The exceptional profitability of East West also pleads for a higher share price. I expect the annual return on tangible equity to remain comfortably in the double digits (near mid-teens), arguing for a multiple of 1.65x on the tangible pound (a fair value above $50 ).
East West is barely trading above the tangible pound today, and I really don’t think that’s a reasonable price. Yes, there are risks to the business from persistently low rates, higher-than-expected credit losses, and deteriorating US-China trade relations, but I think a decade from ROTCE in middle to high teens should get a bit more respect. Banks is still out of favor, and likely will be for a while longer, but it’s a name to consider for investors who can patiently wait out the cycle.