Banc of California Bets on Short-Term Pain

Key Points

• Banc of California reported a second-quarter net loss of $251.3 million as it voluntarily repositioned securities and sold loans to reset its balance sheet.
• Despite the headline loss, core trends improved, with loan and deposit growth, higher net interest income, and declining classified and delinquent loans.
• Analysts maintain a Moderate Buy consensus with a $21 average price target, though execution of management's margin and income targets remains unproven.

Banc of California NYSE: BANC has presumably gotten used to surprises. Its investors apparently have not.

After spending the past few years absorbing the larger and more troubled PacWest, Bank of California is still cleaning its books. This summer, the bank delivered another jolt to investors, this time one it chose rather than one that was forced on it.

For investors, the second-quarter numbers looked messy on the surface level. But the story underneath deserved a more patient read. The recent three months, and the guidance provided, painted a more positive picture, though execution still has yet to be proven.

Banc of California Takes a Strategic Hit

The second-quarter report surprised investors. The Los Angeles-based bank showed a net loss available to common shareholders of $251.3 million, or $1.61 per diluted share, in the opposite direction of Wall Street's expectation, which called for a profit of 40 cents per share. Shares fell about 12% after the announcement.

But a closer look shows this was not a credit blowup. It was an orchestrated reset.

Management had voluntarily repositioned $2.3 billion of lower-yielding securities, generating a $256.7 million pre-tax loss on the sale, while also initiating a sale of roughly $827 million of selected commercial real estate and multifamily construction loans and retiring $385 million of subordinated debt ahead of a costly interest-rate reset.

Executives described the underlying, core earnings power of the bank as closer to 39 cents to 40 cents per share, even after all that noise.

Core Trends Tell a Healthier Story

Strip out those one-time items, and the operating trends underneath looked considerably healthier.

Net interest income came in at $250.5 million for the quarter, and average loans grew 2.3% sequentially, or roughly 9% annualized, with loan production of $2.8 billion at a weighted average yield of 6.39%. Total deposits climbed to $28.1 billion, up about 12% annualized.

Credit quality, often the bigger worry for regional banks, improved rather than deteriorated. Classified loans fell 31% from the prior quarter to $582.8 million, and delinquent loans dropped 50% to just 0.72% of loans held.

Management Targets a Stronger Finish

The investment case now rests on management successfully converting this quarter's pain into future gain. Executives are guiding for the net interest margin, which slipped to 3.13% in the second quarter, to climb back about 3.3% after the targeted loan sale.

They are targeting pre-tax, pre-provision income of $125 million to $130 million for the fourth quarter, along with a return on average tangible common equity of 11.5% to 12.5% by the end of the year.

Capital continues to build as well. Common equity tier 1 ratio at 9.25% is slated for a targeted climb to 9.5% to 9.6% at the end of the third quarter. In addition, Fitch Ratings upgraded the bank's long-term deposit in May, signaling a vote of confidence in the balance sheet's direction even amid a messy quarter.

The board also raised the quarterly common dividend 20% to 12 cents in February and reaffirmed it again in August, for an annual yield of about 2.6%.

Analysts Remain Positive on the Stock

Analyst coverage remains notably upbeat despite the second-quarter shock. Currently trading around $18 per share, the stock is down about 6% year-to-date, though up roughly 10% over the past 12 months.

Still, analysts are positive on the stock, as a consensus rating places it at a Moderate Buy. With 11 analysts following the stock, two have assigned a Strong Buy to the shares, six rate it a Buy, and three recommend Hold.

With an average 12-month price target sitting at $21, that’s a roughly 15% upside from current trading levels. The highest price target is $24 per share, while the lowest is just $10.

Execution Risks Remain

Some skepticism, though, is still warranted.

The bank's growth thesis now depends on execution. Management still needs to close the remaining piece of its $827 million loan sale, successfully redeploy securities proceeds into higher-yielding assets, and hit the promised margin expansion on schedule.

Banc of California also remains heavily concentrated in Southern California commercial real estate and business banking, a market it shares with regional competitors including Western Alliance Bancorporation NYSE: WAL and East West Bancorp NASDAQ: EWBC, leaving it more exposed than a diversified national bank would be to a regional economic slowdown.

The Next Two Quarters Will Be Critical

Put simply, this is a bank that chose short-term pain for what management insists will be a longer-term gain. So far, Wall Street mostly believes them.

For investors comfortable buying into a story mid-transition, the combination of a growing dividend, an improving credit book, and analyst price targets nicely above today's share price makes this a stock worth watching.

The next two quarterly reports are likely to be the real test. If management delivers the promised margin expansion and hits fourth-quarter targets, today's share price could look cheap in hindsight.