UMPQ - Umpqua Marking Time Ahead Of A Major Merger

• Umpqua shares have modestly lagged other regional banks as investors await the close of the Colombia merger and as weaker mortgage banking offsets healthy core lending.
• Lending grew nicely above industry averages in Q2, and merging with Colombia should help resolve some pressure from an elevated loan/deposit ratio.
• The merger with Colombia is a complementary transaction that should significantly upgrade both banks' commercial lending franchises; the deal should close in Q3'22.
• Mid single-digit core organic earnings growth can fuel double-digit annualized return potential on a post-merger basis.

When I last wrote about Umpqua ( UMPQ ) in February, I said that while I liked the long-term potential of the bank after its pending combination with Columbia ( COLB ), the short-term set-up wasn't so great. Between pressures on the mortgage banking business, non-exceptional asset sensitivity, and limited expense reduction and capital return options pending deal close, I was concerned that the shares may not be set to outperform, and so it has been, as the roughly 13% decline in the share price has modestly underperformed the regional bank group (by around 5%).

I still like the long-term prospects for the bank. Mergers of equals (or MOEs) always carry above-average execution risk, but the synergy and cross-selling opportunities seem legitimate and likely to build value. Not only will the combination extend both banks' operating footprints, but it will also create complementary product offerings in commercial lending as well as enhanced operating scale. At a point where banks are still generally out of favor, I like what I see with double-digit long-term annualized return potential at today's price.

Mortgage Banking - What The Market Gives, It Can Take Away

Mortgage banking has long been a volatile line-item for most banks with significant operations, and that includes Umpqua. The fact that a decline in mortgage banking was expected doesn't change the fact that a 31% year-over-year decline (and 50% quarter-over-quarter) in reported revenue is a big headwind for the business.

Core origination and sales revenue declined 63% yoy and 10% qoq on an 11% qoq decline in origination volume, while servicing revenue rose 4% both yoy and qoq. Other non-interest income line-items helped cushion the blow a bit (card fees, for instance, were up 2% yoy and 20% qoq), but it nevertheless drove a 39% yoy and 4% qoq decline in adjusted non-interest income for Umpqua in the second quarter.

Management is now talking openly of considering "strategic alternatives" for the mortgage banking business, though I wouldn't expect anything to happen until the Columbia deal is finalized and the integration process gets underway.

As I discussed in a recent piece on First Republic ( FRC ), this is just part of how mortgage banking operates at most banks. When times are good, many banks flood into the space and/or add significantly to their employee count to originate and sell as much volume as possible. When the tide turns, revenue and profits fall sharply and banks layoff those workers. There's nothing inherently wrong with this as long as a bank can get in and out nimbly and generate good full-cycle profits, but the reality is that most bank investors don't like volatile earnings streams and will penalize banks (in the form of lower multiples and/or higher discount rates) that generate significant business from volatile lines.

Core Operations Showing Some Positives

Apart from the mortgage banking turbulence, I think underlying earnings performance at Umpqua has been pretty good over the last two quarters. Like most banks, Umpqua has seen not only a benefit from higher rates, but a stronger/earlier benefit than initially expected. Likewise, loan demand has remained pretty healthy.

Umpqua saw a 21bps year-over-year and 25bps quarter-over-quarter improvement in net interest margin in Q2'22, the latter just slightly ahead of the industry average. Loan yields improved by 15bps, and Umpqua saw total deposit costs stay consistent at a very low level (6bps), as the bank offset declines in time deposits and other interest-earning deposits by running down its cash balance back to pre-pandemic levels.

Loans grew close to 7% qoq on an ex-PPP basis, and the 18% ex-PPP year-over-year growth was well ahead of the low-teens growth of the average bank. Looking at the sequential loan performance, there was particular strength in home equity lending (a smaller category for Umpqua), multifamily (up 10% to $4.8B or, about 20%), and residential mortgage (up 9% to $5.2B). With multifamily in particular, management called out the possibility that loan growth was artificially high, as borrowers tried to get in ahead of rate increases.

Total deposits declined 2% qoq, with non-interest-bearing deposits up 1%. With cash back to pre-pandemic levels and a comparatively high loan/deposit ratio, funding costs and deposit beta will be challenging in the coming periods. Umpqua has a strong track record of retaining and keeping core deposits, but loan growth will require funding. With Columbia having a much lower loan/deposit ratio (around 63% versus 94% at Umpqua), that's a non-trivial near-term advantage to the deal, particularly as Columbia's interest-bearing deposit cost is similar to Umpqua's, and the bank has likewise historically enjoyed good core deposits.

The Outlook

Like most bank deals, the Umpqua-Colombia deal has seen a longer evaluation process, but the deal should close in the third quarter, with meaningful cost saves starting in 2023. While I do think Umpqua's loan growth was likely higher in Q2'22 than real underlying demand, I see a strong outlook for commercial lending over the next 12 months. Rate sensitivity isn't superior here, but that's less of a driver now as we're well into the rate cycle and discussion is starting to turn toward when the Fed may resume rate cuts ( Comerica ( CMA ), for instance, is starting to lock in rates with swaps ).

I've done some model fine-tuning, mostly adjusting for delayed costs saves due to a slower merger close and weaker mortgage banking, offset by better loan growth, NIM improvement, and net interest income growth. Net net, though, over the long term nothing has really changed. I'm still looking for long-term core earnings growth from the combined banks of around 5% to 6%.

The Bottom Line

Between discounted core earnings, ROTCE-driven P/TBV, and P/E, I think fair value for Umpqua shares is still in the low-to-mid $20's, and I think investors can reasonably expect a double-digit annualized return at today's price. While Umpqua could still be off many investors' radar for a few more quarters, I think the long-term potential here is still attractive relative to many banks.

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