MTB - Zions Bancorp Q1 Preview: Asset Sensitivity - A Larger Risk In 2023 And 2024

2023-04-17 13:19:14 ET

Summary

• Zions has been slow to raise deposit rates in this cycle, and above-average deposit outflow and faster-rising funding costs remain important risks to the near-term outlook.
• Above-average asset sensitivity isn't a positive driver at this point, as loan yields have softened and deposit costs are accelerating.
• Zions has a high-quality core deposit base, decent liquidity, and strong capital ratios. Zions has a CRE and office CRE book that's about normal for its peers.
• Banks as a group are short on positive drivers now, and Zions' asset sensitivity is a risk to the 2023/24 outlook, suggesting a weaker-than-average near-term outlook.
• Zions is likely meaningfully undervalued now, but it will take time for the shares to recover.

In what has been an awful market for bank stocks since the failures of SVB and Signature Bank, Zions Bancorp ( ZION ) has underperformed, losing about 40% of its value since my last update vs. a roughly 25% drop in the large and regional bank groups. Although Zions doesn’t have the same liquidity and solvency risks that the failed banks had, Zions does have elevated asset sensitivity at a point in the cycle where that's likely to be a handicap, and I continue to believe that there is outsized risk here to deposit costs.

I do think that the share price move with Zions stock has been excessive, but I also believe that Zions has a worse-than-average near-term outlook, and that’s compared to a bank sector that as a whole has a pretty poor outlook given weakness across the major drivers (funding costs, loan growth, fee growth, expenses, provisioning/credit, and capital). While I can make an argument that patient investors will see a recovery in the share price over time, and possibly outperformance, it’s harder to argue for that patience when so many bank stocks now trade below fair value and many of those have some combination of lower risk, higher long-term upside, and/or better near-term operating leverage.

Asset Sensitivity Is A Larger Risk

One of the big risks I see to Q1’23 earnings and the outlook for 2023 and 2024 in general is Zions’ larger-than-average asset sensitivity, as I think there are trends working against the company on both the asset and liability sides of the balance sheet.

On the asset side Zions has a lot of rate sensitivity, as more than half of its loans and 40% of earning assets reprice in three months or less. While the Fed may not be completely done with rate hikes yet, the yield on the five-year Treasury has nevertheless moved from about 4% at the end of Q4’22 to 3.7% today. With that, I could see some downside risk to the 3.4% average sell-side estimate for Q1’23 net interest margin. This also could lead management to look to use some hedging to reduce asset sensitivity in the near term.

I see more risk on the liability side. Zions ended the year with well below-average deposit costs, including an average cost of interest-bearing deposits of 0.42% vs. a peer average of 1.15% to 1.3% (depending upon which banks you include as peers). Management has argued the combination of an above-average mix of business operating accounts (which don’t tend to chase rates, as that’s disruptive to business operations) and low competitor rates in its operating footprint can continue to sustain below-average deposit costs and deposit betas through the cycle. Perhaps, but I’m more skeptical. For starters, I think businesses are now going to be more careful about their uninsured deposit balances given the failure of SVB, and I think management’s focus on local competition could be shortsighted – maybe the Zions customer base is less sophisticated, but given how easy it is now to move money to national savings accounts (or buy Treasury securities), I think being slow to raise deposit costs could ultimately cost Zions more in the long run.

I see a risk that Zions could report period-end deposits below $70B (vs. $71.7B in Q4’22), with greater deposit outflows driven by low deposit rates and a desire on the part of some business customers to mitigate uninsured deposit risk. With many regional and smaller banks looking to build up their liquidity, I expect more competition for deposits, and Zions could end having to hike their rates more than average to compensate for this outlook – said differently, I think banks like Cullen/Frost ( CFR ) will find that raising deposit rates before they had to will be cheaper in the end than what Zions is doing, as I see a real risk of Zions having to scramble to stem above-average deposit outflows and then pay up to regain/rebuild lost customer satisfaction.

Costs And Capital Requirements Are Likely To Be Higher

Zions is a fairly efficient bank, but I do see some added stress on operating costs in the near term. First, wage inflation appears to be a persistent challenge and I don’t see a lot of room to close branches or reduce staffing levels from here without also impacting the customer experience. I also expect higher regulatory and compliance costs from here. Deposit insurance costs will likely head higher, and I wouldn’t be surprised to see efforts to raise deposit insurance levels (which would likewise increase deposit insurance costs).

I believe there also could be higher capital requirements as a result of this latest shock to the system. Right now, banks below $700B in assets aren’t required to include unrealized gains/losses in their available-for-sale (or AFS) securities portfolios, but that could well change. Were that to happen, Zions would still be classified as well-capitalized (with a CET1 of 7.9%), but it would be a smaller buffer than management would like, and it would likely restrict capital returns. As is, I expect management to be cautious on capital returns for the near future – I think the dividend should be fine, but buybacks and dividends hikes are likely on the back burner for the time being.

Weak Drivers, But Not Without Some Positives

There are some aspects to the Zions story that aren’t so bad, and I don’t want to leave the impression that this is a “bad bank” (as opposed to a bank that isn’t well-positioned for the current environment, which I believe to be the case).

While the level of cash on the balance sheet (as of the bank’s last update) wasn’t exceptional at 5%, it was still a little better than average (M&T Bank ( MTB ) is among the more notable large banks with more cash on hand). While securities make up an above-average percentage of assets at Zions (26% versus a median closer to 20%), unrealized losses aren’t an issue.

I also don’t see many concerns about credit. Zions’ exposure to commercial real estate (or CRE) lending is about average at 23% of loans, and office CRE loans make up about 4% of loans, 3% of earning assets, and 35% of tangible equity. Those are higher ratios than you’ll find at banks like Bank of America ( BAC ) or PNC ( PNC ), but relative to its peer group, Zions has average to slightly below-average leverage to office lending. Moreover, Zions has a long track record of conservative underwriting, and I’m not concerned about ticking time bombs in the CRE portfolio.

Zions also still has a pretty good deposit base. The ratio of uninsured deposits is only a bit higher than average (at 53%), and the average balance of around $50K is likewise a bit below average. Basically, I think Zions has a “barbell” deposit base, with a sizable core of consumer and small business deposits that are unlikely to leave, coupled to a commercial deposit base that the bank actively grew through/during the PPP loan program. While I do see risk of deposit flight here given low rates on deposit accounts, all in all I see a good mix of low-cost, granular core deposits. I do note, though, that the ratio of cash+AFS to demand deposits is below average; while that would in theory make the bank more vulnerable to a run (less cash on hand to handle depositor withdrawals), the fact that the Fed will lend against securities at par greatly reduces the risk of a crippling run here.

The Outlook

As I said above, I think the near-term outlook for banks as a whole is not good. Funding costs are rising, loan growth is weakening (due both to a slowing economy and the need to better manage liquidity), fee income growth is soft, expenses are higher, and credit costs and capital requirements are likely to increase from here.

Specific to Zions and this quarter, I do think the bank will come in around the average sell-side estimate for pre-provision profits (around $352M to $357M), but I do see downside risk to net interest margin and/or deposits – a key unknown to my mind is whether Zions has started paying up for deposits (reducing NIM) or whether they will see elevated deposit outflow (and possibly more reliance on funding sources like FHLB advances). For the year, I see risk to the net interest income outlook, as I expect higher deposit costs, and I’m not as confident that earning assets will reprice higher as I was a few months ago.

At this point I’m declining to remodel Zions – it seems foolish to do so when the bank didn’t offer meaningful intra-quarter updates (as is normal for the bank) and there are so many unknowns right now. That said, I do still believe Zions can generate a low single-digit long-term core earnings growth rate, and while my fair value estimates will likely be lower post-Q1’23 earnings, I’d be surprised if the shares weren’t still undervalued to a meaningful extent.

The Bottom Line

I think Zions is basically and fundamentally a good bank, but a bank that isn’t particularly well positioned for the challenges of the current cycle. In particular, I believe funding costs are a key risk item, as is the bank’s overall asset sensitivity. I do think the correction in the share price has been excessive, but I can understand why investors wouldn’t want to own a bank with sub-optimal growth leverage at a tough point in the cycle. By the same token, though, bank valuations are quite low now and I fully expect Zions to be more than just a survivor. I think there are better picks for the next 12-24 months, but I can also understand why more patient investors would want to own these shares for the longer term.

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