Growth Is Good
A look at Western Alliance after an eventful year
I’ll keep this direct; I like Western Alliance Bank (WAL) here. As always, do your own due diligence and this isn’t financial advice.
Why is WAL cheap? Probably because they’re a historically growth highflier and 2023 saw 3 growers fail (FRC, SIVB, SBNY). And being honest, 2023 was an emotional year for bank investors, and as we know emotions can cause you do stupid things
Why shouldn’t WAL be cheap? They’re going to grow Revenue, EPS, TBV/S in excess of the industry again going forward. Their credit risk is less than headline metrics suggest. And their balance sheet has some rates down optionality in it. Oh, and they survived a near death experience and came out of it stronger. Bigger, faster, & stronger.
Gordon Gekko said famously, “Greed Is Good” and for WAL investors I think the mantra going forward is, “Growth is Good” from here on out.
Current Set Up & Forward Estimates:
Current Approx. Market Cap: $6.3b & Current Price: $57.44
Current Approx P/TBV: 121%
Current P/E (Forward): 7.5x
Q4 2023 Earnings: $144mm & $1.28 per share
Q1 2024 Earnings: $174mm & $1.60 per share
Q1 2024 Earnings (Ex. notables): $187mm & $1.72 per share
2024 consensus earnings around $7.85 per share. I feel like they may even come in light, but this is still growth from the past year. Crazy when you remember people thought they may go away completely during the crisis.
2025 consensus earnings around $9.44 per share is fairly robust growth. I would be ecstatic if they came even close. I think in the Soros style reflexive case, multiple expands far before they get to $8 a share in earnings, let alone $9 a share plus.
To note, there is considerable back half pick up baked into these numbers (more on that later). The bank said it needed to clean a few things up before growing in the 2H. And recently they did those things, and now are back to growth mode. In fact, much of my thesis is that people are asleep on this. When they wake up price will begin to match fundamentals.
Survived A Scare & Now Undervalued:
On the valuation side this is where I think most fly by investors are wrong on WAL. Historically a growth stock, they got absolutely obliterated during the March Madness that took down SIVB, SBNY, and FRC. At one point, they traded into the high-teens and people were pretty freaked out about their viability, which Ken Vecchione took issue with. I think most of this was their reputation as a growth bank & their general geographic footprint (being West Coast) and well losing $6b in deposits didn’t help either. But they survived & I do like the fight the CEO gives off in the NYT article below.
Because this is fresh in peoples minds, we have a historically cheap bank from a P/E standpoint. Even a slight lift from today’s multiple to an 8x one spits out a $62.8 dollar price. Multiple expansion to the 9x range gets us to the $70.65 range and getting back to historically more expensive times and … well you can do math. While EPS moves are what a bank controls (to some extent), the P/E multiple investors are willing to pay for a bank are driven by forces out of the banks control, like investor perception and broader interest rates. Over the course of this note I think you’ll see it’s only a matter of time before investors wake up and see that WAL is too cheap. And also, that for WAL growth is good.
While WAL is cheap relative to its own history, it’s also fairly cheap to other regional banks. On a trailing 5-year basis WAL is cheap to current earnings, probably because coming off the bank turmoil people don’t believe their future earnings. Whether that’s because of credit fears or liquidity fears, the end result is that they do appear cheaper relative to other regionals.
Growing Fundamental Earnings:
This is where I think the fundamentals for WAL break from the narrative and low multiple it’s commanding. Exhibit one is here, over the past 12-months EPS for WAL have grown 38bps. This compares favorably to KRX EPS which have fallen about 15%, KEY EPS which have fallen about 26%, and CMA EPS which have fallen about 35%. These are your stereotypical “hung bank” with stressed capital and less of an ability to grow due to past capital allocation decisions.
Looking back 5 years, WAL EPS have grown about 11% to 12% a year while the KRX has struggled to stay flat and banks like KEY & CMA have well, not grown. Now haters will say this is a result of the recent COVID era stimulus but looking back further at a 10-year track record only proves the point more. WAL has historically proven an ability to grow EPS above its peers and above the index. You can’t fault WAL for deciding to buy Amerihome (more on that later) and its subsequent bottom-line impact.
What else do you care about as a bank investor? A track record of printing mid-teen level Returns on Tangible Common Equity are a good thing. 15% in today’s market should command 150% of book or more depending on the balance sheet and outlook. The other thing you care about is are you able to produce growing TBV/S over time. And again for WAL the answer is a resounding yes, one does not accidentally produce TBV/S growth like they do. I can assure you it is intentional.
Criticism #1 - Credit Risk:
The main source of doubt around Western Alliance’s earnings & subsequently valuation rest in the credit world. Starting with the most noted problem, “WAL is provisioned too low relative to others”. And this is again where the fly by investors are either completely right or missing something. For me, it feels like they’re missing something even though factually the doubters are 100% correct, WAL does have a lower ALLL. Here they are next to a sample of regional peers.
Seems low at 67bps overall, especially next to medians of 1.14% and us having just lived through the NYCB Category IV crossing which led to their large bump in reserves. Now I can assure you WAL is aware of the $100b crossing and will be fully prepared to do so, but how do you get comfortable with the low reserve? Start by looking at the support they give on why the allowance is low. You’ll notice a few things you may not know. First, they reference CLNs or Credit Linked Notes. CLNs are effectively pools of loans where WAL has sold a first loss piece to a credit investor which in effect works like insurance. This is pricey, but net net lowers the regulatory risk weighting and inherent risk in the loans (and drops the amount you should reserve).
Another thing to remember is WAL plays in spaces with low historical levels of losses. A deeper dive shows 21% of the credit portfolio has protection, a government guarantee (EBO), or are cash-secured. Additionally, 22% of their loans are in Warehouse Lending or Low LTV Resi, which have very low historical losses. So 44% of their loans are in extremely low risk credit. And none of this can be captured in an ALLL/Loans headline percentage.
They also do have a decent portion of the loan book in CRE at around 30% of loans but have mitigants in place and are thoughtful on risk. Relative to other banks, this isn’t massive outlier per the below. And on the risk mitigants for example, in their $10b investor portfolio, they have 75% below a 60% LTV and 46% below a 50% LTV. They don’t do junior liens or mezz debt and have a limited exposure to multi-family at around $652mm. To me this feels like someone that is respectful of credit risk.
Lastly, they do pride themselves on running a higher-than-average criticized loan number and “Early Monitoring”, which in fact could just be PR on an investor slide. But so far has resulted in less than peer historical losses. Understood and appreciated that since 2014 we’ve been in an easy money world, but we have no other data to go off of and the data is what the data is.
Deposit Base & Non-Interest Expense Noise:
To understand WAL, you do need to understand what an ECR is. Bank nerds rejoice, an Earnings Credit Rate deposit is an interest-bearing deposit masquerading as a non-interest-bearing deposit, and Western Alliance has a lot of them (note this below is stale). Without them being classified as non-interest bearing, an investor would see a lot more interest-bearing deposits on balance sheet and would think WAL is much more liability sensitive. 12% NIB after all is a very low number relative to other banks.
ECR deposits are basically a Great Depression era Regulation Q byproduct (I promised you a history lesson).
Mechanically, instead of paying depositors interest the bank (and yes other regionals do this too) nets out service charges against a dollar amount that corresponds to a rate. Anything above and beyond that then comes in as non-interest expense and in this high-rate environment can lead to distortions in the expense base.
The good news is to complete bank nerds, this is not novel. But to the rest of the world, they’d just see an abnormally low interest expense/high portion of non-interest bearing deposits and an inflated efficiency ratio & cost base. The good news for investors is Western Alliance does break this out. Below you can see that about $137mm of non-interest expense is related to ECR deposits on a balance of $22b which correlates to about a 2.5% cost on these deposits on an annual basis. You can also see now how these deposits mess with the efficiency ratio, which they addressed on the call.
Which brings me to the last point on this. While WAL may “model” asset sensitive, they are in fact more neutral if not liability sensitive. Rates down comes with it the obvious decrease in loan yields, but more importantly for WAL unlocks pent up mortgage fee income and an improving non-interest expense due to the lowering of ECR expense. Positive operating leverage help that management will tell you if you listen,
To note, this business line is a result of the 2021 AmeriHome acquisition. At the time Amerihome was the 4th largest Mortgage Lender nationally, the largest bank correspondent producer, and carried a $99b servicing portfolio. While everyone knows volumes are down and owning a Mortgage Company in rates up is painful, when you zoom out you can see how this was a great strategic move. It diversified the bank away from CRE, added substantial non-interest income, and gave them upside optionality in rates down.
Where Could This Go Wrong?
Well credit, it’s always credit with banks. If you’re not comfortable with that then you should be buying bond funds. Maybe TLT interests you?
But seriously, if you wanted to hedge or fund the long you could just sell KRX/KRE. That has definitely worked over the past 6 months. This would limit some of the broader regional banking stock concerns and allow you to just play the potential WAL outperformance.
You could always build a basket of “bad banks” or ones that should struggle because they have thin capital & can’t grow, have worse credit profiles, or are distressed to begin with. I suppose there is also some risk WAL could underperform a really liability sensitive bank like FMBL or FFWM should rates fall, but I’m okay with that. Just know that you could lose to a more interest rate levered play.
Strategic Flexibility:
I still remember looking back during March Madness and seeing SIVB fail, and FRC fail, and SBNY fail and thinking to myself on Western Alliance, how in the world can I buy this right now? I saw it trade into the high-teens and candidly didn’t know the Company very well at all. And I think other investors have probably been shaken by the Regional Banking turmoil we’ve all gone through of late. But here’s the thing that gives me confidence.
This year Ken Vecchione said, we’re going to clean up our liquidity position and raise a bunch of deposits & we’re going to raise our CET1 & then we’re going to grow. And then you know what happened? He did it. Well at least the first two.
And so now you have someone that heard investors and regulators say he needed to de-risk the balance sheet and just raised $6.9b in deposits, got his CET1 to 11%, and got his L/D in check. And still pumped out $1.72 in earnings per share while doing it. Much of the reason for the WAL outperformance was because candidly people didn’t believe their forward guide. And on the recent call they started to wake up and say, maybe these guys are going to deliver.
In closing, I have to admit I didn’t know much about Ken Vecchione before this year, and I wish I had. He speaks about transformation, and it reminds me that the only constant in life is change, and the only thing that matters to Companies is how you respond to it.
Mike Tyson once said, everyone’s got a plan until they get punched in the face. And well as we all know, Western Alliance & Ken Vecchione got punched in the face last year and what I’m seeing now is a bigger, faster, stronger bank ready to get back to growth. I think at some point soon people will realize that Western Alliance is not last March’s balance sheet teetering on the brink losing 12% of their deposits with potential CRE losses about to take them out. I think sometime soon people will realize that Ken Vecchione is building WAL to stick around. A bank who acts like a winner, doesn’t take a victim mentality, and handles anything the world throws at them. And I respect that. My hope is they get back up to $70 a share, maybe even $75 in short order which is possible with just a few people realizing what I did. Feels like most of the street is picking up on this right now …
Until next time,
Victaurs