EAST WEST BANCORP INC EWBC
November 27, 2012 - 4:44pm EST by
Wains21
2012 2013
Price: 21.32 EPS $1.89 $1.95
Shares Out. (in M): 140 P/E 11.3x 11.0x
Market Cap (in $M): 2,990 P/FCF 8.9x 8.7x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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  • Community Bank
  • California
  • Acquisition
  • secular tailwinds
  • Buybacks

Description

 

I.       Business Description:

 

EWBC began as a traditional savings and loan institution in 1972 before converting to a state-chartered commercial bank in 1995.  EWBC collects deposits primarily in the Chinese American (and to a lesser extent, Vietnamese American) depositor demographic through its 137 branches, located primarily in California, with a few branches in New York, Washington, Texas, Massachusetts and Georgia as well as 4 representative offices in mainland China and 1 in Taiwan.  EWBC’s primary interest earning assets include short term investment securities as well as commercial real estate, residential real estate, commercial business and trade finance loans. 

 

II.    Investment Thesis:

 

East West presents an opportunity to invest in a stable, profitable business, which in its own right, would merit a safe place to invest capital.  Complex accounting due to a successful FDIC assisted transaction to acquire their largest competitor in 2009, United Commercial Bank, (UCBH, written up as a short on the VIC in 2007), muddies the annual financial results, but contributes hugely to cash flows in the near term, providing an arsenal of cash to increase cash dividends and repurchase shares.  In addition, EWBC’s, near dominant market share in an industry that services an extremely fast growing segment of the US population provides enormous tailwinds for a company trading at a fairly pedestrian, 11.3x earnings. 

 

III. FDIC Assisted Acquisition of UCBH Explained:

 

On November 6, 2009, EWBC “purchased” most of the assets and assumed most of the liabilities of the former United Commercial Bank, its largest competitor at the time.  The acquisition included 63 U.S. branches, as well as a Shanghai branch and a Hong Kong branch.  I put the word purchased in quotes, because in actuality, the FDIC paid EWBC to take on UCBH’s assets and liabilities.  

 

FDIC assisted transactions can be complicated, but in simplified form, the FDIC runs an auction for the failed bank.  Buyers submit bids, and the bids in the case of UCBH, were based on what is the lowest price at which the FDIC can pay a buyer to take on the assets and liabilities of the failed bank.  In this transaction, the FDIC made a $172 million cash payment to EWBC at closing and EWBC assumed the vast majority of UCBH’s deposits, doubling its deposit base.  In addition, EWBC took on the vast majority of UCBH’s assets at a significant discount.  Given the short amount of time and limited information EWBC had to conduct due diligence, the FDIC guaranteed 80% of the losses up to $2.05B and 95% of any losses in excess of the $2.05B on the loan portfolio, the so called “shared-loss agreement.”  The shared-loss agreement for the commercial and single family residential mortgage loans is in effect for 5 years and 10 years, respectively.

 

Accounting for books of credit impaired loans falls under ASC 310-30.  In practice you separate out all the loans into pools of similar loans and account for each pool separately.  EWBC counts 52 separate pools for UCBH’s portfolio.  In describing and trying to understand how the accounting works, it’s useful to think of them as one pool of loans.  Here are the steps to understanding the accounting:

 

1.      Calculate the total undiscounted contractual principal and interest payments over the life of the loans.  Calculate the now total expected undiscounted principal and interest payments over the life of the loans.  Determine what the fair value of the loan portfolio is today.

 

2.      Subtract the total expected from the total contractual.  This is called the “nonaccretable difference”. Subtract the fair value from the total expected, this is called the “accretable yield.”  Every year, the accretable yield is assessed.  If the total expected is greater due to better performance on the loan portfolio, the accretable yield will be adjusted upwards and the nonaccretable difference downwards, and vice versa.

 

3.      The accretable yield accretes into income over the life of the loans. The accretable yield in this case is made up of interest payments and the principal that was re-designated as “additional yield”, if you will, that the purchaser receives for their discounted loans.  Because the “additional yield” is really return of principal, it gets reversed out of cash flows from operating activities and counted as cash flows from investing activities, creating some confusion on the cash flow statement.

 

4.      The nonaccretable difference does not get accounted for anywhere directly, however the way to account for the FDIC shared-loss agreement is to determine the estimated losses on the original contractual principal payments (which is going to be close to the nonaccretable difference), figure out what percentage of that the FDIC owes and book this as a receivable on the balance sheet. The loans on day 1 after the transaction are booked at their current fair value amount.  No provision-for-loan-losses is assumed as that was already taken into account. Any loans which subsequent to day1 after the transaction become nonperforming will be accounted for in a new provision-for-loan-losses account.  As the FDIC’s payments come due over the next three years, they are paid in cash and the receivable is reduced.  

 

 (For those interested in quickly seeing the transaction in summary form, see Note 2 on pg. 117 of the 2009 10K.)

 

IV. Chinese American Demographic:

 

East West is the dominant bank serving the Chinese American community, the fastest growing demographic in the US (more detail below).  East West gained this dominance by recognizing the need to speak the language, understand the various cultural nuances and be in close proximity to its target demographic.  In this endeavor, East West and its former rival, UCBH, opened branches in predominantly Chinese American neighborhoods in urban centers with large Chinese American populations.  They made sure that the bank tellers and loan officers, often Chinese Americans themselves, spoke English and at least one fluent Chinese language, Cantonese or Mandarin, as well as other dialects.  In addition, the banks employ several employees that speak Vietnamese as the Vietnamese-American neighborhoods tend to be concentrated in close proximity to the Chinese-American neighborhoods.  

 

According to the 1970 US Census, shortly before EWBC started, there were 435k Chinese Americans.  According to the 2010 US Census, there are now 4 million Chinese Americans, a growth rate of approximately 75% per decade, or 5.7% per year.  In 1970, there was a negligible amount of Vietnamese Americans living in the US, now there are 1.7 million.  A lot of press has been written about the increase in the Hispanic demographic due to immigration, especially in light of the recent Presidential election, however, not much air time is devoted to the rise in the Asian Americans, of which Chinese Americans, make up the largest contingent.  I’ll give a few perhaps surprising stats from a recent Pew Research Center Study, “Rise of the Asian Americans,” that came out in July 2012:

 

  1. In 2009, Asians overtook Hispanics as the largest source of immigrants, with roughly 430k Asian Americans immigrating compared to 370k Hispanic Americans immigrating, a trend that has continued through 2012. 

 

  1. The total population of Asian Americans is 17.3 million in 2010, approximately 5.8% of the total US population.  Chinese and Vietnamese make up roughly 33% of the total.  (Hispanics currently number 52 million.)

 

  1. The Asian American population grew faster than any other race group from 2000 to 2010 (46%). The Pew Research Center projects that the total Asian population will more than double to 41 million by 2050, roughly a 24% growth rate per decade, growing far more rapidly than the US population as a whole.

 

  1. Slightly more than 6 in 10 Chinese and Vietnamese Americans, own a home, about the same as the US population as a whole.  (Home ownership obviously increases the need for banking services.)  

 

  1. Asian Americans with a college degree number 49% compared to national average of 28% and median annual household income numbers $66,000 versus national average of $49,800.

 

  1. Nearly 75% of Asian-American adults were born abroad; of these, half say they speak English very well and half say they don’t.  (EWBC’s competitive advantage in speaking the language and understanding cultural nuance is the foundation of trust which is the most important aspect in any banking relationship.)

 

  1. According to the Hurun Research Institute, there are now approximately 960,000 Chinese millionaires living in China and an estimated half are considering emigration including 14% who have or are in the process of applying.  Of the half considering emigration, 40% prefer the US. 

 

V.    Basel 3, Tier 1 Capital Analysis, Regulatory Capital Impact:

 

Regulatory capital analysis is complex at the moment because: Basel 2 is getting phased out and replaced with Basel 3 starting in 2013, Dodd-Frank is beginning to weigh in and get implemented, and not least, it’s incredibly dull stuff.  My point in including it is to show that EWBC is very strong from regulatory capital perspective and can therefore use excess cash for more shareholder friendly activities like growing the asset base and returning capital, a point I will come back to in Section VII.  I’m also including a few summary bullet points below on Basel 3 as a reference guide.  

 

In summary, as of 9/30/12, EWBC had a Tier 1 Capital ratio equal to 14.7% and a Total Capital ratio equal to 16.0%, and therefore significantly exceed the requirements to be considered well capitalized under Basel 3 (which are stricter than the requirements under Basel 2).  Common Equity Tier 1 is newly emphasized under Basel 3, and therefore, EWBC does not yet report it in their filings.  A quick and dirty calculation to determine Common Equity Tier 1 is to take the Tier 1 Capital and subtract preferred equity.  As EWBC has only a very small amount of preferred equity outstanding (~$83MM), it is safe to assume they significantly exceed the 7% threshold to be considered well capitalized.

 

EWBC did issue several small trust preferreds in the 00’s which now comprise $133MM of Tier1 capital.  Trust preferreds will no longer be counted toward Tier 1 Capital under Dodd Frank for EWBC after 2015.  They will be phased out 1/3 each year starting in 2013.  Due to the trusts’ small size, they will have very little impact on EWBC’s capital ratios, but do generate a lot of noise in the filings.   

 

Limits and minima under Basel 3:

  • Common Equity Tier 1 must be at least 4.5% of risk-weighted assets
  • Tier 1 Capital must be at least 6.0% of risk-weighted assets
  • Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 8.0% of risk weighted assets

 

Total to be well capitalized under Basel 3:

  • Common Equity Tier 1 must be at least 7% of weighted assets
  • Tier 1 Capital must be at least 8.5% of risk-weighted assets
  • Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 10.5% of risk weighted assets

 

VI. Cash Flow Analysis:

 

EWBC currently has approximately $20B in interest producing assets.  EWBC’s net interest margin (“NIM”) as of 9/30/12 was 4.46%.  According to management guidance, they believe this will drop to 3.85% in 2013, mostly as the higher yielding loans acquired from UCBH roll off.  When I completely exclude these higher yielding loans, I get a NIM closer to 3.66%, which I think is a safe NIM to work with to get to core earnings.  As a sanity check, the median NIM of the top 40 U.S. Banks was close to 3.51% in a recent comp sheet I looked at. 

 

EWBC’s higher NIM than the median makes sense to me anecdotally, which bears a brief digression.  Personal visits to some of EWBC’s local branches yielded some interesting conversations with various loan officers.  On the commercial real estate and C&I side, EWBC competes with other banks on rates and terms and serves a broad demographic.  However, when it comes to residential mortgages, EWBC only lends what they call “no income” loans, which sounded scary at first.  Basically, because the vast majority of their clients are Chinese Americans, including recent immigrants, many of them do not yet have 2 years of US tax returns which are required by most banks to verify recent income and obtain a mortgage. EWBC waives this requirement in lieu of very high down payments, higher interest rates and a one-year $50,000 savings deposit requirement.  The loan officers I spoke with said that EWBC requires a minimum of 25% down, but average 40% (which jives with their reported 50% LTV ratio in their residential mortgage portfolio.)  Basically EWBC identified a large, growing, wealthy, underbanked, demographic and figured out a way to safely lend to them.

 

EWBC’s efficiency ratio has fluctuated between 41-43%.  (EWBC’s efficiency ratio is calculated as the non-interest expenses divided by the net interest income.)  Provision-for-loan-losses in 2012 is running at about a $70MM annual rate (compared to $95MM for 2011), and income tax rate runs approximately 35%.  Putting this all together yields the following core earnings and cash flow:

 

Interest-earning Assets

$20,000,000

Net interest margin

* 3.66%

Net interest income

 = $732,000

Efficiency ratio

*(1-43%)

Operating income

=417,240

Provision-for-loan-losses

-70,000

Pre-tax income

=347,240

Income tax

*(1-35%)

Core net income

=225,706

 

 

Mkt Cap (11/27/12)

=$2,990,000

P/E

=13.2x

 

 

Core Net income

$ 225,706

Provision for loan losses

+70,000

Core free cash flow

=295,706

P/FCF

=10.1x

 

 

 

 

VII. Consensus View vs. Disparate View, Multiple Ways to Win:

 

Most street analysts viewed EWBC as a hold with a positive outlook until some just recently upgraded to buy/outperform.  They project ~$1.89 and ~$1.95 for EPS for 2012 and 2013, respectively.  They view EWBC’s strong loan growth with conservative underwriting and deposit growth as positives, but point out that core NIM has slipped slightly lower.  Not surprisingly, this is a very simple and short term earnings based outlook on the company, which I think omits several long term considerations and ways to win, as follows:

 

  1. EWBC holds capital levels well in excess of the new Basel 3 requirements.  A rough estimate indicates there is more than $800MM of excess Tier 1 capital.  This gives EWBC plenty of capital space to increase loan growth in attractive areas, or return money to shareholders.  Clearly, EWBC sees the situation similarly as they announced a $200MM share buyback in 2012, which they completed by the end of Q3.  In addition, EWBC announced on their 3Q call, that they plan an additional $200MM of share repurchases in 2013 and to increase the cash dividend to an annual rate of $0.60 per share, roughly a 3% cash dividend yield.

 

  1. The FDIC assisted transaction was a winner for EWBC because they were essentially paid to double the size of their franchise, take out their largest competitor and become the dominant player in their niche industry.  All positives for EWBC, and well understood by the sell-side.   I think a more subtle effect that may not be fully appreciated is that the FDIC is still scheduled to pay EWBC $368MM as of 9/30/12 ($511MM as of 12/31/11).  This essentially is as good as cash, but does not get recognized as such in Tier 1 Capital at the moment because it is still a receivable.  When it is paid to EWBC, it will immediately improve capital levels allowing EWBC to support more loan growth or more likely support more return of capital to shareholders.

 

  1. The median multiple for the top 40 banks by market cap is roughly 12.5x earnings and EWBC trades roughly in line with those banks.  Many of these banks, however, are not growers.  EWBC is now the dominant player in a niche industry with enormous tailwinds.  According to a Pew Research Center Report, if current trends continue, US population will rise to 438 million by 2050 compared to 308 million in 2010, roughly a 9% clip per decade.  Asian Americans are now the largest group of immigrants coming to the US and are projected to grow from 17.2 million to 41 million by 2050, roughly a 24% clip per decade.  Very few banks besides EWBC, or any business for that matter, are in as good a position to benefit from this type of extreme growth in their client base demographic (retiring baby boomers come to mind as an exception), and yet the market is ascribing an average multiple to them.

 

  1. The banking industry as a whole reached its current level of deposit interest expense several Fed rate cuts ago.  However, due to the Fed’s continual cuts and QE ad infinitum, long-term interest rates which affect the rates that banks can charge customers for loans, have been continuously pressured lower.  The Fed may not raise rates for some time, but if they do, it will certainly benefit banks’ NIMs.  EWBC does an interest rate sensitivity analysis which indicates that a positive 200bps move in rates would have an immediate 8.5% positive impact on Net interest income.  (The positive impact is due to the significant amount of variable rate loans in the portfolio.)  That equates to a $40-60MM boost to earnings.            

 

VIII.       Primary Risks                                               

 

The primary risk to the EWBC long is actually documented in a recently published book, “The Immigrant Exodus.”  The book’s thesis is that the US needs to do more to make the immigration process easier, especially for the educated and entrepreneurial types.  For example, immigrants on a H1-B visa must be sponsored by a specific employer.  This makes it difficult to change jobs, take a risk on a new business venture or force a promotion, as the downside is deportation.  If the US continues to make immigration difficult, the enormous tail wind supporting EWBC may decide they prefer Singapore or Canada instead of the US.  The second biggest risk is from competition.  Currently the only bank of substance that competes directly in the space is Cathay General (CATY).  CATY tends to have their branches located near EWBC and offers the same types of products.  Given EWBC is now twice the size with twice the coverage and resources, it is unlikely that CATY will be able to take market share.  I think the main market encroachment risk is from the major banks, BAC, JPM, WFC, deciding to focus on the Asian American population.  The other risks are more typical to all banks: general economic slowdown, an uptick in bad loans, decrease in rates, etc.       

 

IX. Conclusion, Fair Value for EWBC

 

Assuming EWBC’s interest earnings assets grow by 5% per year, you have $22,050,000 in assets by 2014. I think 5% is a conservative amount given the normal growth in the economy (2%/year), inflation (2%/year), the excess growth in the Chinese American population above the base line growth in the US population (1.6%/year), the FDIC receivable turning into cash, and the excess Tier 1 capital.  I also assume that the Company goes through with its announced $200MM share buy back in 2013 and will continue returning excess capital to shareholders in the form of an additional $200MM share buy back in 2014.

 

2014 Interest-earning sssets

$22,050,000

Net interest margin

* 3.66%

Net interest income

 = $807,030

Efficiency ratio

*(1-43%)

Operating income

=460,007

Provision for loan losses

-70,000

Pre-tax income

=390,007

Income tax

*(1-35%)

Run-rate net income

=253,505

 

 

Share count

140,000

Less share buybacks ($21.3/sh)

-18,800

Final share count

121,200

 

 

Run-rate net income

=253,505

~Multiple in 2012

13.2x

Projected market-cap (12/31/14)

=3,346,266

2014 Share count

/121,200

2014 Share price

$27.61

2 years of cash dividends

$1.20

Total share value

$28.81

 

 

2014 premium over today

35%

Simple annualized return

16.2%

 

 

 

The 35% growth in the stock through 2014 is my best conservative guess at the likely returns.  I believe EWBC can win in multiple ways: through a realization of the projected Chinese immigration, through the realization of cash payments from the FDIC, and through an increase in interest rates.  What I like most about EWBC, however, is: the significant downside protection through the vastly expanding client base, the correct side of the current interest rate skew and the commitment to share repurchases due to the significant excess cash at EWBC.  I can’t be sure when or how the stock may go up, but I am very confident that there is significant support in the stock to protect the downside.

 

X.    Series A 8% Non-Cumulative Perpetual Convertible Preferred Stock:

 

Just as an FYI and more an idea for PAs, EWBC has an outstanding listed preferred security (EWBCP) which could be an interesting way to participate in EWBC.  Banks get better regulatory capital treatment for noncumulative preferred stock (as opposed to cumulative), so most securities of this nature will not require a payback of future dividends in a liquidation scenario.  However, no common dividends are allowed to be paid until all preferred dividends are current, so in most scenarios, this is effectively a cumulative preferred stock.  The preferred is convertible into 65 shares of the common and has a liquidation preference at par.  The security is illiquid and has a wide bid/ask.  On the lower end of the bid/ask range, the security can be purchased for a slight premium to the common, which I believe is a good trade. 

 

The one caveat is EWBC is allowed to force the convert starting on May 2013 under certain circumstances.  According to my reading of the prospectus, these circumstances are as follows: the common stock trades at higher than $20 for any 20 trading days within any 30 trading day consecutive period, the last day of which the Company declares their desire to force the convert. 

 

Clearly EWBC has financial and Tier 1 Capital incentives to force the convert.  In addition, every time I’ve spoken to management about the preferred, they always mention the conversion date.  Putting it all together, I think it’s safe to say, that as soon as possible after May 2013, EWBC will convert the preferred to common.  In the meantime, for small amounts, there may be interesting arbitrage entry points into the EWBC through the preferred.     

 

 

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Catalysts:

-          Cash windfall from FDIC payments

-          Significant share buybacks

-          Dividend increase

-          Recognition and increased headline focus on Asian American immigration surpassing Hispanic immigration

-          Fed increasing rates

 

Risks:

-          Harsh immigration incentives deterring emigrating Chinese to more immigrant friendly countries

-          Increased competition from copy-cat banks entering the market

-          General economic slowdown

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