Western Alliance: Q1 Deposit Growth Is A Cause For Optimism (NYSE:WAL)

Shares of Western Alliance Bancorporation (NYSE:WAL) have recovered strongly from their banking crisis lows of a year ago, up about 69%. Shares though did fall about 1% on Thursday after-hours in the wake of its Q1 earnings report, likely in part due to some profit taking. Since recommending shares as a buy in October, WAL has returned 37%, doubling the S&P 500’s return. Given this strong rally and with new financial results in hand, now is an opportune time to re-evaluate WAL. I remain bullish.

In the company’s first quarter, Western Alliance earned $1.72 in adjusted EPS, beating consensus by $0.05. The bank’s net interest margin (NIM) came in at 3.60%, down 5bps sequentially and 19bp from last year, as deposit costs rose and excess liquidity on its balance sheet dragged down asset yields. WAL has been carrying excess liquidity on its balance sheet for over nine months now, which is understandable given the pressures it felt a year ago. Still, its franchise has recovered admirably and that should enable more aggressive capital allocation this year.

In Q1, deposits rose $6.9 billion sequentially to $62.2 billion, up 31% from a year ago after it experienced significant deposit flight in the wake of Silicon Valley Bank’s failure. While Western Alliance had a sizable share of tech clients like SVB, it did not have the duration mismatch and capital shortage problem. As such, after the initial panic, which WAL withstood, customers have come back to WAL, leading to steady and sizable deposit gains.

Still, WAL is paying more for deposits. While total deposits are up 31%, noninterest bearing deposits (NIB) are up about 11% while high-costs CDs are up nearly 67%. This unfavorable mix shift has increased Western’s funding cost. Beyond that, the higher rate environment has increased deposit costs across the industry. Interest-bearing deposit costs of 3.67% were up 11bps sequentially and 88bps from a year ago.

Now, importantly, we are seeing signs these pressures are moderating. Interest-bearing deposit costs are rising more slowly than six months ago. Plus, in Q1, we saw a favorable mix shift with CDs up just $600 million while NIB deposits rose $3.9 billion. With WAL aiming to grow deposits back above $66 billion, which appears quite plausible given the strong jump we just saw, this recent mix will be quite attractive to NIM.

Additionally, rebounding deposit levels will allow WAL to continue to right-size its funding mix. Having shown the resilience of its deposit base, there is lessened need to carry excess liquidity to hedge against a shock. This is critical because wholesale funding can cost 5-6%, so even replacing it with 3-4% interest-bearing deposits will reduce funding costs. In Q1, WAL paid down $1 billion of borrowings during the quarter, bringing its total to $6.2 billion, down substantially from last year’s $15.9 billion at the height of the crisis. Still, there is scope for further paydowns over the next few months, especially with its loan-to-deposit ratio back to a healthy 81.5%. Moving its funding mix back toward deposits should help reduce its interest costs in coming quarters.

During Q1, WAL grew loans by about 0.8% to $50.7 billion. It did not reduce loans in keeping with deposit flight last year, which is not functionally possible for a bank, and so it is not growing loans as quickly during the deposit recovery, which is why deposit growth has helped bring its loan-to-deposit ratio back to healthy levels. With WAL targeting $4 billion of loan growth this year, we should see the pace of lending increase.

Credit quality remains solid, though it has degraded somewhat. 0.53% of assets are nonperforming, up from 0.4% in Q4 and 0.17% a year ago. WAL’s credit profile is buoyed by the fact 20% of its loan portfolio is credit protected via government guarantees or cash collateral. This makes me comfortable with its $383 million in reserves, up from $378 million last quarter. I would also note charge-offs continue to be muted, in keeping with the company’s history of strong underwriting.

One item I continue to monitor is that about 19% of its portfolio is in non-owner occupied commercial real estate(CRE). Given the pressures on CRE, there is the potential for some losses here. I think it is important to note that WAL has been shifting its loan exposure, with essentially all incremental lending going to corporations and virtually none to CRE. This gradual pivot should reduce the risk of losses. I do see some risk provisions continue to rise, but given WAL’s very strong common equity tier 1 (CET1) ratio of 11%, I view this exposure as manageable.

Now, with deposits rising substantially but loans only rising modestly, WAL’s liquidity position grew further. Its securities and cash portfolio is up to $19.7 billion, up $5.4 billion sequentially and $6.9 billion from last year. 52% of its securities and cash portfolio is in unencumbered, highly liquid assets. These are cash-like assets, which can be used to pay down wholesale borrowings or make loans. Given the growth here, its portfolio yield of 4.66% was down 33bps sequentially, dragging on NIM.

Meanwhile, its loan yield is up to 6.77%, up 12bps sequentially, or 211bps above its securities and cash. As WAL uses this cash to either pay down wholesale borrowing, to make loans, or to buy higher-yielding fixed income securities, we should see NIM expand and net interest income rise. I would reiterate, WAL has gone a long way to repositioning its balance sheet, paying down essentially $9 billion of wholesale borrowings over the past year, but there remains further opportunity. WAL’s balance sheet is extremely liquid and safe, leading it to under-earn its potential. With deposit flows solid, I expect management to tackle this over the next six months.

While management continues to target 5-10% net interest income growth this year, assuming it pays down about $2 billion of funding per quarter, I would expect it to grow at the top end of the range. Additionally, there appears to be an increasing chance the Federal Reserve cuts rates fewer than 2 times this year, which would be a further tailwind for net interest income.

The one negative in the quarter is that the company now expects non-interest expense to rise 6-9% from last year, rather than the 0-2% previously. In Q1, we saw salaries and benefits rise about 3% year-on-year to $155 million, so it appears some further acceleration here is possible. One offset is that noninterest income has been performing strongly. Mortgage banking activity revenue rose to $92 million from $57 million in Q4 and $73 million a year ago. Given the rate environment, this year-on-year growth is impressive. WAL did $9.7 billion in production and has $9.8 billion in rate-lock commitments. With mortgage rates rising further, we may see a dip in production. However, that should increase the values of its $65.6 billion servicing portfolio as mortgages stay outstanding for longer.

We may see one more quarter of NIM compression in Q2 (I expect NIM to be +/-2bp of Q1’s 3.60%), but we are near, if not already at, the turning point. Importantly, while many banks need a cooperative rate environment to boost NIM, WAL has plenty of “self-help” options here outside of the rate environment, paying down debt and deploying excess liquidity. Management has been understandably doing this is in a methodical way, rather than all at one time, prudent given the events of the past 15 months. Still, as this progress continues, we should see earnings continue to rise with increased expenses being more than offset by net interest income. With these levers at its disposal, WAL should still be able to earn about $8 this year, with quarterly earnings running above $2/share in H2.

That still leaves shares trading about 7x earnings. Investors are clearly still viewing WAL as a “riskier” bank given last year’s crisis, depressing its earnings multiple. However, the fact WAL could withstand a shock of that magnitude and bounce back so quickly is really a testament to the durability of its model in my view; plus, a repeat of last year’s banking crisis seems unlikely. With regional bank stocks trading 10-12x earnings, I see room for WAL to close this valuation gap gradually as it continues to grow deposits, though I still expect it to trade at some discount to peers. I would be a buyer still, as you can buy a solid bank at a cheap valuation. Over time, I would expect this discount to continue to narrow, which can push shares toward $70 (or 9x earnings). As such, I would use any weakness in response to somewhat higher expenses as an opportunity to add WAL.