Dear StockCentral Community!

I’m excited to present to you my analysis of East West Bancorp.  Amidst all the blood in the streets in the banking sector, I bought some of this stock with the belief that it was a quality company with a history of good growth and an attractive PE ratio (about 9 at the time I bought . . . about a month ago).

Since my purchase, the value of this stock has fallen 20%.  Ouch!  But my analysis, so far, suggests that my original basis for buying is still intact. 

I will start today by posting my stock study and describing how I approached it.  For the remainder of the week, I plan to dig beyond the stock study to examine some of the risks.  Let’s see if my current favorable opinion of this company holds up to my own continuing analysis and (even better) to your scrutiny and analysis!

By way of background, this bank primarily serves the Chinese-American community in Southern California.  It has about $11B in assets and a book value of about $1.2B, so it’s larger than a typical community bank but smaller than a typical money center bank.  What initially struck me about EWBC was its strong 10-year revenue growth of 24.8% and 10-year earnings growth of 20.7%.

Its loan exposure is largely in southern California real estate, but no sub-prime loans.  We’ll talk more about these “risk factors” during the week.

Let’s start with the front page of the stock study, which I have attached in various formats.  Despite 20%+ historic growth rates, I projected a much lower growth rate of 5% annually for the next five years.  This was in part influenced by preliminary Q1 2008 figures (not shown in the study) with earnings of 8 cents per share (for the quarter) and an analyst (RBC Capital Markets analyst Joe Morford) estimating 2008 earnings of $1.00 per share, a steep decrease from the $2.60 for 2007. 

So, I think there’s a pretty safe assumption that 2008 earnings will be down.  This is mainly due to management’s expectation of loan losses, based on current loans in default or delinquency, plus expectations for additional troubled loans going forward. 

Big question: are the recent loan loss provisions temporary or permanent factors?  Given the company’s conservative loan-to-value ratios, if you think the recession will last a year or two and then prices will plateau or rise, there’s good reason to believe that EWBC’s earnings will bounce back up to historic levels. 

If, on the other hand, you see worsening real estate prices for 5 or more years, then EWBC’s earnings could stay low, which would not be good for the stock price.

My assumption is that real estate prices will stabilize within the next two years, as they usually do as recessions pass.

Next question: could loan losses threaten to a) significantly reduce the asset base of the bank, or b) require the bank to raise dilutive equity?  I’m going to assume neither possibility is a significant factor for now, but this question warrants further discussion.   (Note: EWBC just announced an equity issue of about $150M)

So based on the above, I am considering 5% annual earnings growth an appropriate expectation for 5-year growth, assuming a year or two (or maybe three) of low earnings, followed by catch up to historic levels.

Turning to the back side of the stock study, I discarded the three highest profit margin and ROE figures in the past five years, based on the conservative premise that the happiest of past times will not return and as such, the lowest of these historic figures are the best prediction of the future.

Ditto for historic PE ratios:  the assumption of slower growth and expected higher inflation rates (which usually causes nominal interest rates to rise) should cause PE ratios to be unlikely to return to the headiest of historic levels.  On the other hand, a short recession and resumption of EWBC’s historic growth could cause the stock to appreciate well beyond my estimates. 

The 5-year PE range my study predicts is between 9.9 and 16.8.  Note that the current PE ratio of 5.5 is based on trailing earnings. . .the “leading” PE ratio based on an assumption of $1.00 annual EPS for 2008 suggests a PE ratio of 14.7, which is within the range suggested in my stock study.

The high price of 3.31 EPS x PE of 16.8 is $55.60.  Wouldn’t that be nice!  For the low price, I decide to go below what Toolkit recommended.  I took one analyst’s estimate that the price will go to 12, and took a haircut to it . . . to 10.  This would also suggest a PE of 10 at EPS of $1, which is pretty close to a reasonable worse case scenario (to get to this level, EWBC’s financial performance would have to show no improvement 5 years from now from 2008 levels, which I think is unlikely).

Even with this conservative low price, the stock study shows EWBC to be in the buy range with an upside/downside ratio of 9.4 to 1.

5-year potential (note the word “potential”) shows a 31.8% annual return including the expected dividend yield.

What do YOU think?

Robert

Thank you for presenting your view on EWBC.  I have not followed EWBC and thus my thoughts may reflect my lack of understanding of this bank.

EWBC seems to be a conservative bank catering to Asian American customers who are in general quite loyal and conscientous in paying their mortgage obligations.   However their recent increase in loan loss provisions indicates higher expected default rates.  So some of these customers likely have defaulted or are expected to default on their mortgage loans. S&P expects $130M of loan loss provisions in 08 vs 12M in 07 or quite a jump.

I understand home values in the area serviced by EWBC had some of the higher home price appreciations in the nation. Recently Robert Shiller of Yale indicated he expected home price depreciation of about 30% to adjust back to fair value after the recent real estate bubble. Thus far he said prices have dropped about 15%.  If this is accurate, it would seem there will be more bad news to come on future defaults and thus even higher loan loss provisions.  The fact that EWBC has stopped providing guidance suggests they are not confident of what additional exposures in their mortgage loan business may face.  I interpret this to indicate they do not know how low home values will fall.

It does seem EWBC is preparing to handle more bad news with their recent raising of $200M via their preferred stock offering. 

I see it being quite difficult to prepare an SSG for EWBC that one can be confident that it will be conservative until one is able to understand how bad future loan defaults and loan loss provisions that may be coming.  Your SSG does seem to be quite conservative although I do wonder if EWBC will soon see a high PE Ratio of 16.8 after the recent bad news. i.e. Will EWBC be valued by investors as a growth company or now more like a bank?  However even if the high PE only became 10 it would still seem EWBC may provide a superb return.

The key question to me is how bad will the non performing mortgage loan assets become?  If this remains moderate then the SSG indicates this company could provide a superb return over the next several years. But if these losses increase to a level to significantly affect the balance sheet it could indicate a rough time for EWBC.  Again I have not followed EWBC but this is my gut view from the little in understand.  

So in response to your question, should I buy more, my answer is I do not know. 

Dan Hess    

Hi robert, one thing I noted on SSG the PE's might be a little optimistic for the near future the average PE (Line 8) is 13.3. The current is 5.5 (Line 9) I would probably use those for a high and low for a company facing their uncertainty. I also removed the outliers you used in section two as they didn't seem to be too far out of line.

Dan,

> However their recent increase in loan loss provisions indicates higher expected default rates.
> So some of these customers likely have defaulted or are expected to default on their mortgage
> loans. S&P expects > $130M of loan loss provisions in 08 vs 12M in 07 or quite a jump.

The S&P report also states that, "The most severe losses were seen in the previously fastgrowing Inland Empire region of California.We expect provisions will remain historically high, but level off through 2008, as the company completes comprehensive appraisals on every land and construction loan in its portfolio.We are encouraged by EWBC's efforts to realign its balance sheet and reduce its loan-to-deposit ratio to 100%, from 115% at the end of the first quarter. Although credit quality has deteriorated, we believe EWBC's disciplined lending philosophy will keep future losses manageable."

Here's some details from the 2007 10-K:

"During 2007, we took advantage of several strategic opportunities to grow both domestically and internationally. Through our acquisition of Desert Community Bank ("DCB"), we established our presence in the Inland Empire region of Southern California. DCB was headquartered in Victorville, California and provided community banking services through nine branches throughout the High Desert area of San Bernardino County. This transaction was consummated in August 2007, several months after the opening of our first commercial banking center in this high growth area located in Ontario, California. As of the merger closing date, DCB had total assets of $583.8 million, net loans of $406.1 million, and total deposits of $506.7 million. The acquisition resulted in total goodwill of $91.1 million and core deposit premium of $14.9 million. All of DCB's systems have been successfully integrated into our infrastructure. DCB continues to maintain its name and operates as a division of the Bank."

It seems that due to the loan assets from a recent acquisition might be a  contributing  factor for S&P to raise  their  estimates for the  loan loss reserve for 2008. Anyway, I see an opportunity for growth in the future due to the company's exposure in the China market:

"We also made noteworthy strides in expanding our market presence in the greater China region. During the first quarter of 2007, the Hong Kong branch commenced operations as our first overseas full service branch offering a variety of deposit, loan and international banking products. Additionally, during August 2007, we opened a representative office in Shanghai, China. Similar to our existing representative office in Beijing, the Shanghai office broadens our international banking capabilities and extends our penetration into the robust greater China market. We continue to explore other strategic opportunities to broaden our presence overseas."

Bakul