WABC - a short idea

Just did some work on WABC. Basic thesis very good bank but priced to perfection in an unfortunate location, and will not escape unscathed. Analyst estimated for losses are way too low:

WABC is a very well run institution with conservative lending standards, and a more than adequate capital cushion. The company trades at a significant premium to its peer group (Bloomberg) at 3.4X Price/Book, and 5.25X Price/Tangible Book vs. peers at 1.16X and 2.24X respectively. Other bank indices are trading at even lower multiples, with the Nasdaq Bank index at 1.03X Price/Book, and the KBW bank index at 0.74X Price/Book. The company’s sole area of operations is Northern and Central California, and as the research indicates, estimates for 2009 are significantly too high, as loan loss provision assumptions are much too low. Downwards estimates revisions will lead to significant multiples compression for this institution that is priced to perfection.
In addition, the significant valuation premium (41% deposit premium) makes it very unlikely that WABC is acquired and significantly reduces the likelihood that this stock will lead any bank sector snap-back.
Based on my earnings assumptions and using a modified dividend discount model, WABC should trade closer to 1.9X BVPS, still well above its peer group. This would result in a $27 share price. Given the volatility of bank sector earnings, Price/Book is a more appropriate metric at present.

It is clear that WABC’s credit metrics have been very solid. The company has also largely avoided the most problematic areas: C&D loans are a small part of the portfolio, the company maintained standards on home mortgages (no sub-prime, 80% LTV and full documentation), and has minimal 2nd lien exposure. That being said, CA is the epicenter of this economic downdraft, and conditions have worsened significantly since the end of Q3. Home prices have declined 48% since the peak, making even 80% LTV loans underwritten back in 2005 underwater. Office vacancies are increasing rapidly, unemployment in the State is now at 8.3%, retailers are under severe pressure, and the state is in fiscal crisis. CRE prices are also declining reducing collateral protection in that asset class. This points to increased pressure in CRE, both owner occupied and non-owner occupied, as well as growing pressure on C&I loans. At a recent conference in San Francisco, it was disclosed that pools of performing CRE loans were receiving bids of $0.80-$0.85. Commercial property prices are down 15-35% in the San Francisco/Northern California area.
The consumer portfolio is largely auto loans, and though WABC had solid underwriting, auto prices are down 12% according to the Manheim index. This will lead to a higher severity of loss in that portfolio.
High unemployment and talk of raising the sales tax in California to offset a massive fiscal deficit will put great strain on the C&I portfolio which consists largely of small businesses.
The current CEO has been running WABC since 1988 so a historical look back is worthwhile. NCOs peaked at 0.65% back in 1993. Assuming NCOs peak in 2009, provisions will be highest this year. My loss estimate for the portfolio has NCOs peaking at 1.5% in 2009, and staying high at 1.4% in 2010. The company has stated a desire to keep the allowance over 2% given its geographic concentration, and the allowance peaked at 2.45% during the early 90s. Macro conditions are significantly worse this time around and WABC will surely be impacted to a greater extent than in 1993. Assuming NCOs are closer to the 1993 peak vs. my estimate, will still lead to a greater than 10% shortfall in EPS.
With net interest margin peaking, and a shrinking balance sheet, pre-provision earnings are likely to be flat at best. WABC is no longer buying back shares, and it is hard to see how the company can keep EPS flat to slightly up y/y as according to consensus.
The company’s efficiency ratio is already at 40%, and it is unlikely that the firm can reduce operating expenses to offset the impact of increased provisions and a shrinking balance sheet.

Recent results:
WABC reported GAAP EPS of $0.00 but excluding the impairment on FNM/FRE preferreds, an operating EPS of $0.78 excluding the $0.81 impact of the FNM/FRE charge and $0.03 tax benefit. WABC was able to expand net interest margins by 85bps y/y offsetting the impact of a 12% reduction in earning assets. Total revenues fell 2% linked quarter however, as 3bps of net interest margin expansion was more than offset by a 3% decline in earning assets. Fee income was down 4% from the prior quarter offset by a similar reduction in operating expenses. The company’s efficiency ratio is an impressive 40%.

Valuation:
Street estimates for 2009 of $3.10/share are too high. I forecast $2.37/share Analysts reach that number tweaking several different factors:
1. Continued net interest margin expansion: Most foresee continued net interest margin expansion. Given the already low rates, and increased competition for deposits, it is unlikely that WABC will be able to expand margins further.
2. Street analysts forecast continued reduction in operating expenses. This is unlikely given the already efficient operation that WABC is running.
3. Balance sheet growth: WABC is forecasted to grow its balance sheet, even though the company has explicitly stated its cautious outlook, and has shrunk earning assets by 12% y/y.
4. Drawing down loss reserves: some analysts foresee a reserve drawdown where NCOs exceed provisions. This is highly unlikely when the company has explicitly targeted a 2%+ allowance ratio, competitors are scrambling to increase reserves, regulators are pushing for conservatism, and the economy is declining at a rapid rate.
5. Loss provisions: this last point is the most crucial. Apart from one outlier that is forecasting $20M in provision expense, the street is clustered around a provision expense in the low single digits. Not only does this indicate no deterioration of credit, but also the street, as mentioned above, is factoring a drawdown in the allowance. Both conclusions are very hard to see in this economic environment. My analysis of potential embedded losses in the portfolio point to significantly higher losses. I see charge offs peaking in 2009 at 1.5% of average loans, and provisions in 2009 of $38M or 1.6% of average loans. WABC will likely build the allowance, provisioning more than charge offs in this environment, and losses embedded in the portfolio are likely to be significantly higher than in the early nineties. As previously mentioned, charge offs peaked at 0.65% in 1993. The current environment points to significantly higher severity of losses across the board, and increased frequency.
· It is also unlikely that WABC grows its loan portfolio, as it is more likely to conserve capital against any unexpected losses, particularly from its investment portfolio. Based on my earnings expectations of $2.37/share, WABC should trade closer to 1.9X to 2.0X BVPS. This would still confer a significant premium to its peer group. On a tangible book basis, the $27 target would equate to 3.0X tangible book still at a large premium to its peer group. On a PE basis, 11.2X 2009E is appropriate, given the earnings shortfall and the limited visibility in this environment. Smaller regional banks with limited exposure to capital markets and sub-prime lending have significantly outperformed their larger peers. However as we have seen in the past, the credit crisis began in sub-prime mortgages but expanded to hit other sectors. At present, prime mortgages are under pressure, CMBS pricing points to significant deterioration in CRE loans, and C&I loans are bound to be impacted. Accounting and loan composition have shielded some of the regional banks to date. WABC valuation will appear even more stretched, if its peer group multiples compresses to closer to some of the larger regional banks. Eventually all institutions, even the most conservative will be affected. Though not factored into the analysis, WABC will also have to bear the cost of a proposed sharp increase in FDIC insurance premiums (expected to rise 5bps for WABC, $0.06 impact).
· WABC’s significant premium to the sector makes it an unlikely acquisition target, and its defensive characteristics make the stock unlikely to lead any market snap back. Both attributes provide investors with downside protection.