In a market where bank stocks are out of favor, maybe it makes sense to consider less typical banks, and Westamerica Bancorporation (NASDAQ:WABC) is nothing if not atypical of your normal bank. With loans making up less than 15% of earning assets, Westamerica is basically a deposit-gathering institution that effectively outsources and diversifies credit risk by taking those deposits and preferentially investing them in a portfolio of mortgage-backed, government-backed, municipal, corporate, and collateralized debt securities.
Westamerica shares have fallen about 17% since my last update, initially tracking the wider declines in regional bank stocks, but outperforming more of late, I think, as investor concerns have shifted away from duration and liquidity risks and toward credit risks. I’d also note that the bank has trailed the performance of intermediate bonds, and that’s not historically all that common for the shares.
Westamerica is so atypical of banks that it’s tough to recommend this as a bank stock. Instead, I do think it’s a quality allocator capital whose growth is going undervalued today. By no means is this a suitable investment for all investors, but it may fit a niche for some and low-single digit core earnings growth can support a fair value in the mid-$50’s.
Strong Spread Growth, With Good Expense Leverage
With that intro in mind, I don’t think it will come as a great surprise that Westamerica’s third quarter financials were quite a bit different than those of the typical bank. With rock-bottom funding costs and improved yields on securities and loans, Westamerica saw NIM expansion and good pre-provision profit performance, beating expectations by a high single-digit percentage at the PPOP line.
Revenue rose 15% year over year and about 3% quarter over quarter, beating expectations. Net interest income rose almost 19% yoy and 3% qoq, with net interest margin up almost a point yoy and 9bp qoq to 4.43%. Earning assets declined very slightly. Non-interest income increased 4% sequentially and contributed about 14% to revenue.
Operating efficiency was impressive this quarter, with opex down 5% yoy and 4% qoq, pushing the efficiency ratio below 31% – one of the best in the business. Pre-provision profits rose more than 26% yoy and about 6% qoq, driving a roughly $0.12/share beat.
Tangible book value per share was up significantly from the prior year (up 28%) and down about 1% sequentially.
As Always, A Curious, But Profitable, Balance Sheet Mix
Westamerica reported a nearly 10% year-over-year decline in loans, as well as a nearly 4% sequential decline. These declines were well in excess of the overall banking system performance this quarter, but consistent with a long pattern of reduced lending (loans have declined at an annualized rate of more than 7% since 2012).
Commercial lending was particularly weak, down 20% yoy and 4% qoq, while commercial real estate lending was up slightly on a sequential basis (about 56% of all loans). Westamerica overwhelmingly focuses on owner-occupied CRE lending with relatively low loan-to-value ratios (75% or less); this is not a high-rise office lender.
Loan yields improved 34bp yoy and 10bp qoq to 5.27%, a relatively low yield on a comparative basis. Loan yields at WABC have hardly budged since the start of the Fed tightening cycle (5.27% vs. 5.14%), and this is part of the reason that the bank directs so much of its capital toward securities – it has a stringent underwriting philosophy and yields for the loans that can pass muster just aren’t that high.
Securities balances fell about 3% qoq on an end-of-period basis, with an effective average yield of 4.32%, up 10bp from the prior quarter (and up from 2.5% at the start of this phase of the credit cycle). With that, the bank’s loan beta is incredibly low (2.5%), while the earning asset beta is a more respectable 38%.
Westamerica continues to leverage an incredibly low-cost funding base to support its securities and loan portfolios. Deposits were down about 12% year over year (worse than average), but barely down on a sequential basis, while non-interest-bearing deposits were down only about 11% yoy and actually improved slightly on a sequential basis – much better than average. Total deposit costs are an almost-unbelievable 0.08%, up from 0.04% in the prior quarter. Cumulative interest-bearing beta is a bit under 2%.
Credit is not much of a concern. While non-performing loan balances did increase 45% qoq, they increased off a low level and the NPL ratio of 0.14% is still very low on a relative basis. Likewise, charge-offs were pretty consistent with year-ago and quarter-ago levels (up 6bp).
The Outlook
With securities making up so much of the balance sheet, unrealized losses are an understandable concern, but management has been fairly proactive on managing these risks – gross unrealized losses were steady through the June quarter relative to the start of the year (September’s 10-Q was not available as of this writing). I’d also note that collateralized loan obligations are around 30% of the securities book and do adjust on a quarterly basis. This is not a situation like SVB or First Republic where large holdings of low-yield, high-duration securities undermined capital and led depositors to flee the bank over solvency worries.
The size of securities in the asset mix creates some modeling eccentricities for Westamerica, and this is the only bank where I’ve actually increased my core earnings estimate from the start of the year – not by a lot, but still up. Likewise, my FY’24 estimate isn’t that much lower either (down 4% versus my model at the time of that last article).
I’m looking for core earnings growth from Westamerica on the order of 3.5% over the long term, fairly consistent with the 4%-plus historical growth rate (and tangible book value per share has grown over 6% over the past decade). It’s possible that the changes in the banking sector, including higher loan yields, could lead to some loan growth here, but I wouldn’t count on it, and certainly not as a long-term trend.
Instead, I expect 3% to 4% long-term deposit growth to continue to flow preferentially toward securities, though with a meaningful allocation to corporate securities and collateralized loan obligations (about 84% in total as of Q2’23), the bank kinda-sorta does make loans, just not in the conventional way.
On a discounted core earnings basis, I think Westamerica is undervalued below the mid-$50s. I get similar results with a P/E approach using a 10x multiple on ’24 earnings ($5.25); that’s lower than I’d normally use but reflects how bank valuations are now. Likewise, an adjusted ROTCE-P/TBV approach gets me to around $54.
The Bottom Line
I do think that Westamerica shares are likely to regain ground relative to intermediate bonds over time – that’s how it’s been historically and I don’t see why this time will be substantially different. Beyond that, I do think the shares are undervalued based on management’s demonstrated capabilities and the growth I think this business can generate. It’s not a straightforward bank stock, and certainly not suitable for everyone, but given low credit risk, incredible funding costs, and the likelihood that rates start heading lower in ’24 (boosting security values), I think these shares are worth a look.
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