ZION - Zions Bancorp's Low-Cost Deposits May Become More Of A Liability In 2023

Summary

• Zions posted strong fourth quarter results, with well above-average net income and pre-provision profit growth and good expense management.
• Commercial lending continues to be strong, and I like commercial lending as a category for 2023, but funding costs are a threat to profit growth.
• Zions has some of the lowest deposit costs in the peer group, and that may ultimately be to the company's detriment as it could antagonize customers, spurring increased deposit outflows.
• Zions looks quite undervalued on what should be attainable, if not beatable, estimates driving 3% long-term core earnings growth.

It’s not credit quality or loan growth that’s driving sentiment on bank stocks now, but rather how sensitive their earnings are to ongoing increases in the cost of funds. That’s an issue for Zions Bancorporation ( ZION ), as management seems to be taking a relatively optimistic view despite a lot of evidence to the contrary that funding costs are going to exceed past experience and recent expectations.

I’ve liked Zions due to the disconnect between the bank’s potential to generate good growth from its commercial lending operations and the low expectations embedded into valuation. While ZION stock has modestly outperformed the average regional bank since my last update (and has underperformed over the past year), I’m not as bullish as before, as I’m worried that management is simply too optimistic about their funding situation and that there is elevated risk to estimates for 2023 and 2024 on that basis.

A Strong Beat To Close The Year

There was little to pick at in Zions’ fourth quarter earnings, as the company did better than expected across all major line-items and value-drivers, but there were some issues in the balance sheet that I'll address in a moment.

Revenue rose almost 24% year over year and almost 7% quarter over quarter, beating expectations by more than $0.09/share. Net interest income rose 30% yoy and almost 9% qoq, beating by close to $0.10/share and coming in comfortably ahead of the average for regional banks this quarter (closer to 4%). Net interest income improved 95bp yoy and 29bp qoq to 3.53%, while earning assets declined less than 1%.

Fee income wasn’t as impressive, with a 2% sequential decline that was about $0.005/share worse than expected. Zions is sort of a middle-of-the-road case when it comes to non-spread income; it doesn’t generate nearly as much as banks like Comerica ( CMA ), but 17% of revenue (and 25% last year) is still quite a bit more than banks like East West ( EWBC ) and Signature ( SBNY ) that are in the same spread income ballpark. In any event, card fee, wealth management, and capital market revenue was basically flat.

Operating expenses rose about 5% yoy and declined 1% sequentially, beating by almost $0.07/share in absolute terms as well as by about 270bp in terms of efficiency ratio. At 53.3%, Zions is an efficient bank – not the best, but far from the worst.

Pre-provision profits rose 55% yoy and 17% qoq, another well-above average performance and $0.16/share above sell-side expectations. For the remainder of the $0.23/share core earnings beat, it was line-items like provisioning and taxes that contributed the most.

Good Loan Growth, And Growth Prospects, But Costs Are A Real Risk

The bull thesis on Zions has been based at least in part on the bank’s strong C&I lending franchise, particularly with smaller companies. That driver came through again this quarter, as Zions produced better-than-average sequential loan growth of over 3%, with over 3% C&I lending growth and surprisingly strong CRE lending growth (up 7%, with investor-owned CRE up 7%).

Loan yields continue to improve, rising 108bp yoy and 64bp qoq to 4.81%. Curiously, for an asset-sensitive bank, Zions’ loan beta of 36% isn’t all that high (Comerica is over 61%).

Funding is where things get more concerning for me. Zions took in a rush of deposits during the pandemic, and one of the major question marks going into this next phase of the cycle was whether the bank could hang on to them. So far, it’s not looking as good as I’d hoped. Deposits declined about 6% qoq overall, with non-interest-bearing deposits down a worse-than-average 8.6%.

Deposit costs remain very low, rising 17bp yoy and 10bp qoq to 0.20% versus a peer average closer to 0.75%, while interest-bearing deposit costs rose 36bp yoy and 22bp to 0.42%, also well below a peer average in the 1.1% to 1.2% range. Deposit beta is likewise rock-bottom at 5%, against peers closer to 20%.

I think Zions has been too slow in raising deposit rates and will end up paying for it (figuratively and literally). Banks like Cullen/Frost ( CFR ) have been active in raising their deposit rates even though they don’t really need to as part of their commitment to client service. While Zions does have an above-average weighting to business operating accounts (which are sticky and don’t tend to chase rates), management is also arguing that there isn’t much local rate competition pushing them to raise their rates.

That may be true, but it also assumes a relatively unsophisticated customer base that won’t be willing to move money to national/digital banks (like Capital One ( COF )) or look to put the money in Treasury bills. I’d also note that management hiked their cumulative beta target by 400bp since the last quarter. I’ve maintained from early in this cycle that many management teams were underestimating their deposit betas and I think Zions’ target of 18% when many peers are targeting mid-30%’s betas leaves them open to negative surprises.

As far as credit goes, Zions has a strong track record and I’m not concerned about the credit situation today – non-performing loan balances declined 11% qoq and classified loans declined 4% sequentially as well. I am slightly concerned about the above-average growth in investor-owned CRE, but this could also be Zions stepping up to lend in markets where many banks have stepped back unilaterally irrespective of specific credit quality.

The Outlook

Management disappointed the Street with guidance for net interest income growth in the high single-digits for 2023 that was below the mid-teens Street expectation. This is a case-in-point as to how higher funding costs (and a higher deposit beta) could bite the company and investors as 2023 progresses. While there are some banks with optimistic rate forecasts ( First Republic ( FRC ) is expecting rate cuts before year end), persistent inflation threatens an even more aggressive Fed cycle.

Those who’ve read my past articles on Zions know that I’ve liked a lot of the company’s strategic moves in recent years. I liked how aggressively the bank went after PPP loans and how active they were in trying to convert those transactions into long-term ongoing banking relationships. I also like the company’s investments into tech and its overall commitment to lending to smaller businesses. I don’t like the below-average Net Promoter Score (a measure of customer satisfaction), and underpricing deposits won’t help.

My core earnings estimate for 2023 is about 3% lower now, and that’s better than the roughly 6% average revision I’ve made for other C&I-oriented regional banks. I am concerned, though, that pre-provision profit growth could lag rivals. I’m currently expecting high-single-digit growth in FY’23, a little below the peer group, and I see downside risk to the mid-single-digits if funding costs are higher than I expect. Likewise, the 5%-ish three-year PPOP growth I expect isn’t so impressive compared to the group.

If there’s a bright side, it’s that the valuation already seems to factor in below-average growth. My core earning assumptions work out to 3% long-term growth from pre-pandemic levels, but discounting those earnings still gives me a fair value of over $60. Likewise, a below-average 9x multiple on my ’23 EPS estimate gets me to $57, while my ROTCE-driven P/TBV approach gives me a $59 fair value.

The Bottom Line

I think there’s a risk that management guidance will have to head lower in 2023 and I’m worried about the impact that may have on sentiment. On the other hand, sentiment isn’t all that robust anyway if 3% long-term core earnings growth can get me to a $61 fair value and the stock trades at around $51.

All of that makes for a difficult call. I do believe you can buy Zions here and do well over the longer term. But I also see some bumps along the road and not all investors want that sort of volatility.

For further details see: