COLB - Columbia Bank Getting Far Less Credit Than It Should

2023-10-21 10:24:01 ET

Summary

• Columbia came through with strong third quarter results on an adjusted basis, including stronger net interest margin and better operating cost leverage.
• On the negative side, credit losses are growing in the leasing book, the office portfolio is large (though different than typical office portfolios), and unrealized security losses are significant.
• The bank's low-cost deposit base, synergy between small business and middle-market lending operations, cost leverage, and attractive geographic footprint support a bullish case.
• Columbia shares look undervalued on a mid-single-digit earnings growth expectation.

I can understand why investors are still not bullish on bank stocks, given what’s going on with the yield curve, the economy, and regulation. I can likewise understand skepticism around names like Citigroup ( C ) where there’s built-up resentment and doubt that the bank will ever turn around. What I don’t get, though, is why there’s so much skepticism around Columbia Banking System (COLB) following the close of the merger of equals with Umpqua.

Down more than a third since my last update , Columbia did miss second quarter results on softer earning asset yields, the third quarter was noisy with charges and add-backs, and the size of the office CRE portfolio and unrealized securities losses is large, but the core drivers (a low-cost deposit base, synergy between small business and middle-market lending operations, deal synergies, and an attractive geographic footprint) remain. It’s also worth noting, I think, that many West Coast banks have likewise been hit hard, including Banc of California (BANC), East West (EWBC), and Western Alliance (WAL).

With the very weak performance of the share price, I’m getting more bullish on this name. There’s still outsized credit risk as well as deposit price risk, and management my flub the integration, but I think the shares are meaningfully undervalued below the mid-$20’s.

A Noisy Quarter, But A Good One

There are moving parts to Columbia’s earnings now than for a normal bank, and there can be legitimate differences of opinion as to what should or shouldn’t be added back to drive “core” earnings. To that end, I don’t agree with adding back amortization, but the reality is that you get a misleading view of performance relative to published sell-side estimates if you don’t.

Because of impact of the merger, I’m only discussing quarter-over-quarter comparisons unless otherwise specified.

Revenue came in well this quarter, while flat on a sequential basis, it was about 2% (or $0.04/share) better than the Street expected. Net interest income declined less than 1%, beating my more than $0.03, as core net interest margin outperformed (declining 2bp to 3.91%). Earning assets declined 1% qoq in a quarter where declines have been relatively common.

Fee-based income was one of the messy areas. Using management’s adjusted numbers, this line-item improved over 5% from the prior quarter and exceeded expectations by about $0.01, though I cannot guarantee that all analysts calculated their estimate as management does.

Operating expenses offer the same challenge, though there seems to be more consistency or agreement among analysts. In any case, including the add-back of amortization, opex declined 4% sequentially, beating by more than $0.07/share.

Pre-provision profits rose almost 4% sequentially, beating by close to $0.12. Provisions were higher than expected, taking back more than $0.04/share. Tangible book value per share declined 5% sequentially, and unrealized securities losses remain meaningful.

Restructuring The Business, A Quarter At A Time

From a big-picture perspective, the long-term story at the new Columbia is about driving synergies across the combined operations between Columbia’s historical strengths in small business lending and healthcare lending (practitioners and offices) and Umpua’s strength with larger customers, including equipment financing, middle market lending, and corporate/capital market offerings like asset-backed lending, loan syndication, and acquisition finance.

Still, there’s a lot of work that management wants to do in adjusting the business to fit with the new unified plan. That includes reducing non-relationship business lines, and the bank sold jumbo mortgages and mortgage servicing rights in the quarter to drive that goal.

Loans grew 0.3% qoq on an end-of-period basis, lagging the overall banking sector a bit. C&I lending grew 0.7% outpacing the sector average, while CRE lending as I define it (excluding construction and multifamily) grew slightly (up 0.3%) and lagged the sector. Multifamily lending increased 1%, construction increased a surprisingly robust 9% (surprisingly in that many banks are reducing exposures here), and mortgage lending declined 2%.

On the subject of CRE, Columbia does have quite a large office CRE portfolio at around 8% of total loans. I do think the details matter, though. First, about 40% of the portfolio is owner-occupied and around 15% are healthcare offices. Loan to values are low (56%), though likely to increase as new appraisals roll through, and the portfolio is overwhelmingly in suburban markets – Columbia doesn’t have a lot of multi-tenant high-rises in central business districts, and that’s where there’s a lot more pressure.

Loan yields improved about 13bp (to 6.08%). About 15% of the overall loan book reprices over the next 12 months and should provide yield uplift opportunities.

On the deposit site, overall deposits rose 2% qoq, better than average, and non-interest-bearing deposit attrition was more mild than for most banks at -3%. Columbia still sports exceptionally low deposit costs despite intensively competition for those deposits – total deposit costs increased 24bp to 1.23%, while interest-bearing deposit costs increased 37bp to just 2.01%.

Columbia’s cumulative beta is only 37% - one of the lowest among the banks I follow – and this is likely to increase given where deposit costs are trending. While management arguably doesn’t have to increase deposit rates, I think they should take a page from Cullen/Frost (CFR) and consider doing more on a proactive basis to maintain happy (and loyal) customers.

The Outlook

Management is already ahead of schedule on driving synergies and cost reductions, and that’s a good start to what will be at least a one-year process. Over the longer term, successfully cross-selling to the customer bases will be critical; I’d note that First Citizens (FCNCA) acquired CIT in part to upgrade its capabilities for larger customers, and I see some of the same synergy potentials here as legacy Columbia clients will no longer outgrow the bank’s capabilities.

Still, there are risks. Although Umpqua talked a lot about its retail customer experience, the reality is that it was a more cost-focused bank. Columbia, though, has always taken a more service-oriented approach, and integrating the two cultures will present some challenges.

There’s also risk, or at least the perception of risk, in the securities portfolio. Securities are a significant part of the asset base (around 18%) and the duration is long at 5.7 years. Most similarly-sized banks with meaningful securities portfolios have durations around 4 to 5 years, with banks like M&T ( MTB ) below 2 years and First Citizens below 3 years. Unrealized losses are meaningful - $876M million, or almost 30% of tangible equity. I’m not worried about a blowup here, particularly with the Fed backstop in place (lending against securities at par), but that doesn’t mean it’s not a concern to many investors.

I’m expecting organic growth of around 4% to 4.5% over the next five years and closer to 5% over the long term, and I am a believer in the operational and financial synergies of the deal. Given those deal synergies, I expect Columbia to be one of the relatively few banks with strong operating leverage in the coming year. That said, it’s still a challenging operating environment today, with ongoing risks to credit (particularly in leasing) and loan growth.

Running the valuation exercises, I find Columbia shares too cheap. Discounted core earnings (with that aforementioned 4%-5% long-term core growth rate) suggest a fair value above $30, and I get a similar result based on a high-teens ROTCE in FY’25 (supporting a P/TBV of over 2.2x). If I take my $3.15 FY’24 EPS estimate and apply an 8x multiple (well below the 9.9x I use for larger banks, let alone banks truly comparable to Columbia), I get a fair value of $25.

The Bottom Line

Obviously the Street doesn’t see it the way I do. I can appreciate the concerns about accelerating deposit beta, higher credit losses in leasing and office, and the losses in the securities portfolio. Likewise, I understand that the Street is much more skeptical about merger synergies these days, but I believe that’s more than reflected in the share price, and I think this is a contrarian name to consider.

For further details see: