ZION - Zions Bancorporation: Compelling Buy As Net Interest Margin Stabilizes

2023-10-04 12:28:38 ET

Summary

• Zions Bancorporation's shares have been affected by the failures of other banks, but it remains attractive due to its stable net interest margin and strong underwriting profile.
• The bank's deposit costs have risen, causing a squeeze on net interest income, but there are signs of stabilization in deposits and funding costs.
• Zions has a strong loan book and credit quality, with limited exposure to commercial real estate, making it well-positioned to weather a downturn.

Shares of Zions Bancorporation ( ZION ) have been battered over the past year, like most regional banks. The failures of Silicon Valley Bank and First Republic Bank have raised funding costs across the sector, and ZION has been no exception. However, with net interest margin beginning to stabilize and a sturdy underwriting profile, ZION screens as particularly attractive at current levels.

First, for those unfamiliar, Zions is a regional bank that primarily operates in the western part of the nation, as you can see below. While it operates across several states, Salt Lake City is the core of the business, accounting for about a quarter of assets and income, which is a positive as Utah consistently ranks as having one of the country's strongest economies. Uniquely, ZION operates a series of different brands across markets, essentially acting as an amalgamation of community banks. This decentralized community approach has resulted in strong ties with local businesses and favorable credit performance, though it does lead to an additional layer of management, which may add to noninterest expense.

In the company's second quarter , it earned $1.11, which was down from $1.33 last year as interest income fell, and salaries rose by $17 million. I would note that the company had $13 million in severance expense in Q2 as it rationalizes headcount to reduce operating costs, which should help to lessen operating expenses going forward.

However, the squeeze on net interest income is the main item to focus on and a challenge plaguing the industry. Last year, as the Federal Reserve raised interest rates, banks only passed on a fraction of those increases to customers while their floating rate loans reset higher, causing NIM to widen. This year, banks have paid up for deposits quickly, reversing these gains. Sequentially in Q2, deposit costs rose $138 million, outweighing the $65 million increase in loans. NIM has compressed from 353bp in Q4 2022 to 292bp in Q2 2023, reducing net interest income from a high of $720 million to $591 million.

As you can see below, deposits have fallen over the past year from $81 billion to just under $70 billion. This has entirely been driven by noninterest-bearing deposits, which fell over 25%. With more of its deposit share interest-bearing, and rates going up, its funding costs have risen by 107bp this year to 127bp.

Fortunately, we are starting to see some signs of stabilization in deposits. Average deposits fell 0.7% sequentially in Q2, but they were up 7.4% on an end-of-period basis. About 2/3 of Zions' business is with small and medium-size companies, who maintain operating accounts (like those used to make payroll) at ZION. These accounts are generally in the noninterest-bearing bucket, given the constant flows in and out of them. Considering the ability to earn 5+% in a money-market fund, these customers have likely worked down balances to keep the bare minimum in these accounts, though there is a floor eventually as certain cash buffers need to be maintained to meet operational needs.

Additionally, with total funding costs only at 20bp in Q4 2022, ZION was perhaps being too aggressive in passing on so little to customers. After all, the Fed funds rate was 4.33% at the end of last year. This left it vulnerable to customers leaving for higher-yielding deposits elsewhere, forcing the bank to catch up aggressively from March-June of this year. From the company's September update , it seems the bank has caught up sufficiently.

Deposits have now risen for three straight months through August. The 14bp increase in funding costs is also the slowest increase since March. Even with these higher funding costs, NIM has stabilized and actually risen back to 2.96% in August. We will likely see funding costs rise somewhat further into Q4, but the majority of the headwind has likely occurred. Additionally, with deposits now rising, ZION likely does not need to keep paying up for deposits and could even afford modest attrition, in my view.

This is partly because Zions' asset base generates substantial liquidity, which it is wisely tapping. Like most banks, it maintains a large securities portfolio of high-quality fixed income. Zion has not been reinvesting all of its maturities, instead allowing the portfolio to shrink naturally. In Q2, its securities portfolio fell by $600 million to $23.9 billion. Securities now account for 30% of assets from 36% a year ago. The portfolio has just a 3.7-year duration, meaning it will continue to mature relatively quickly.

As these assets mature, its deposit needs decline. Or if it does reinvest proceeds, it can do so at higher rates. The mark-to-market loss on these securities is housed in accumulated other comprehensive income (AOCI) where it has a $2.93 billion loss. As these bonds mature, this should begin to decline next year, though I expect a sequential deterioration in Q3, given the rise in rates. Importantly, with the securities portfolio shrinking as a share of assets, the likelihood of ZION ever needing to realize losses is low.

As these securities are lower-yielding, their shrinking weight is helping to offset the rise in deposit yields to keep NIM stable in recent months. Conversely, Zion has seen modest loan growth, 1% sequentially due to multifamily lending. Loan yields have risen from 3.67% last year to 5.65% this past quarter as they are mostly tied to the fed funds rate. Its loan book is where Zions stands out.

We have seen many banks significantly increase provisions for credit losses this past year, from Capital One ( COF ) to M&T Bank ( MTB ) as the economic cycle ages. Zions' credit quality has remained remarkably strong. Last quarter, it took a $46 million provision for credit loss, similar to last year's $41 million. The net charge-off rate remains extremely low at 9bp. As such, even without significant provisions, its allowance for credit loss is $711 million, or 1.25% of loans from 1.04% a year ago. As you can see below, its nonperforming loans have actually fallen over the past year.

Its total allowances now nearly match its "classified loans"-these are loans management is watching with particular scrutiny for having problems even if not yet delinquent. While most banks are seeing a natural deterioration in credit quality, ZION is seeing some improvement. I believe some of this is due to its community-first nature that allows it to know the businesses it is lending to quite well.

Even more so, we know commercial real estate is a serious area of concern, and banks are large commercial real estate lenders, but Zions is much less so. CRE accounts for just 23% of its loans-and office is just 17% of that (for about 4% total exposure). 2/3 of its office exposure is suburban. There are zero delinquencies in its office exposure currently, but the bank is not being too casual. 4.3% are on its classified list.

As you can see below, ZION has barely grown its commercial real estate portfolio over the past decade, growing its loan exposure less than 75+% of banks. This leaves it among the best-positioned banks to weather a CRE downturn, should one occur.

The bank is also solidly capitalized with a common tier-one equity ratio of 10%, in line with peer averages. Given its stronger-than-average credit quality, this is a strong capital position. This enables the company to pay a securely covered 4.9% dividend. I would not expect to see buybacks until capital reaches 11% or AOCI's loss falls below $2 billion, given economic uncertainty and management's conservatism. This means buybacks are more likely a 2025 story than a 2024 one, in my view.

At its August rate of NIM, the bank has about $4.40-$4.60 in earnings power over the next twelve months, holding credit provisions constant. Even if we assume a further 15bp in NIM compression, going toward the May lows, ZION should earn around $3.90-$4.00.

That gives shares a "base case" multiple of 7.3x and an 8.5x multiple, assuming that further tightening in NIM. This is an attractive valuation in my view, especially as we have seen NIM stabilize since Q2, and its loan book is particularly strong with limited CRE exposure. Shares are also trading right around the book value of $32.69. Tangible book value is $45.30. Now, this excludes AOCI. And while these losses will not be realized in all likelihood, that is a risk, and so I expect shares to remain structurally below this level for at least the next 12-18 months.

I would look for shares to trade to about $40 or around 9x earnings, or 0.9x tangible book value, which essentially applies a 50% weight to the AOCI losses, recognizing their existence but accounting for the fact this will shrink as bonds mature. Given the strength of the franchise, I think this is still a cheap valuation but believe investors should expect some "cheapness" to remain structurally, following the crisis earlier this year.

A $40 price target still represents about a 23% upside, with a 5% dividend, for a compelling total return opportunity. If we were to see a renewed funding crisis, we could see profits get squeezed further, but even under a replay of May's squeeze, shares would trade just 10x earnings at $40. A wider economic downturn that causes material credit losses is also a risk, but given ZION's low CRE exposure, its loan book is conservatively positioned. I believe ZION offers a strong return profile relative to its risks, and investors should consider buying shares here.

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