2023-04-25 09:56:49 ET
Summary
- Zions' Q1 EPS miss was due to non-recurring factors.
- Much of the deposit losses are a natural result of running down a COVID check deposit bubble.
- Zions actually operates better in higher interest rate environments, and the rate increases are nearly over.
- Zions has done an excellent job protecting itself against a possible recession by maintaining conservative lending standards.
- Zions will build an already healthy capital ratio.
Yes, Zions Bank (ZION) and its fellow regional banks have their issues today. But Zions has a number of positives investors seem to be overlooking.
I know they are being overlooked because of Zions' valuation. The stock is $28, and updated EPS estimates (Seeking Alpha) are $5.45 for this year and $5.40 for next year. That's a P/E ratio of 5.0, or a 19% earnings yield (E/P ratio). A 19% yield clearly suggests some pretty awful stuff lies beyond 2024 for Zions. Even the low estimate for next year of $4.43 generates a 16% earnings yield, which still forecasts lots of ugliness well after 2024. To put it in perspective, Zions seems priced for a permanent pandemic; it earned $3.02 in 2020.
Let's get the ugly stuff out in the open - at least all the ugly stuff I can imagine - and then I'll walk you through the positives.
Negative #1 - Zions' Q1 EPS fell short of forecasts
It reported $1.33 when analysts were expecting $1.51.
The positive - non-recurring expenses explain the shortfall.
Zions had two unusual expenses during the quarter. Adjusting for them, Zions' EPS was right around the expected $1.51. The first unusual expense was a tax adjustment that cost $0.06 per share. The second was Zions' decision to take a $45 million loan loss provision; I'd consider $25 million more than enough. That cost another $0.13 per share. More on the provision below.
Negative #2 - It lost lots of deposits
Zions lost $18 billion of retail deposits over the past year, for a 22% decline. During the quarter it lost $8 billion of deposits. That is a substantial and highly unusual decline. Essentially all of the decline during the quarter was from uninsured accounts holding over $1 million at Zion.
The positive - or rather, the explanation.
There is certainly no positive about losing that many deposits. But there is a logical explanation for a lot of the loss. First, take a look at this chart of quarterly changes in U.S. banking industry deposits:
Notice any unusual behavior? The roughly $3 trillion of COVID checks that were deposited in the bank by consumers and businesses and now are naturally being gradually withdrawn?
Zions' deposit level a year ago was unnaturally high. So, a large portion of its deposit loss over the past year was to be expected. The rest of it was due to other reasons:
Worries about uninsured deposits in the wake of the Silicon Valley Bank seizure. This is an irrational fear because the government paid essentially all uninsured deposits during both the early '90s S&L crisis and the '08 Financial Crisis. The government will certainly pay uninsured depositors in this year's crop of bank failures.
It is impossible to forecast changes in irrational behavior because it is, well, irrational, but as it grows more obvious that uninsured depositors won't lose anything, I expect this fear to fade. Just in case, though, Zions says that it has $38 billion of untapped cash sources, more than its total of uninsured deposits.
Shifts to money market funds to earn higher yields. When do we react to higher money market rates and move our money out of no- or low-yielding bank accounts? This isn't an automated process; it is variable based on when each depositor chooses to make the shift. Bankers measure the customer sensitivity to changing interest rates by a "deposit beta".
Zions' deposit beta last year was only 5%, meaning that their cost of deposits rose by only 5% of the actual rise in interest rates. Despite a monster rise in the 1-year Treasury yield from 0.4% to 4.7% last year, its deposit costs only rose 0.20% during Q4 '22 from 0.03% this prior year. But Zions estimates the deposit beta increased to 18% for Q1 '23, and its deposit cost rose to 0.47% from 0.20% the prior quarter. And it expects the deposit beta to approach 50% over the course of the year, probably sooner rather than later.
Negative #3 - A decline in its interest margin
As a consequence of its rising deposit beta, Zions expects its net interest income, which grew by 25% year-over-year during Q1, to fall by 7% in Q2 and roughly stay there over the next year. That expected decline takes $1.00 off of Zion's EPS.
The positive - the reduction will be modest, and the interest rate increases are nearly over.
Is a further sharp decline in Zions' interest income ahead due to rising interest rates? That is highly unlikely, for two reasons. First, Zions' business is "asset sensitive." To quote management in its Q1 earnings conference call :
"Loan durations are estimated to be 1.8 years and the deposit portfolio duration is estimated to be 2.9 years."
This means that Zions' assets reprice roughly every two years, while its deposits reprice every three years. So, management argues that a rise in interest rates is normally a positive for interest income.
Is management trying to pull the wool over our naïve eyes? History says no. Zions' interest margin rises and falls largely in line with fed funds increases, as this chart shows:
Second, few believe that the Federal Reserve is going to raise the fed funds rate much at all, including the Federal Reserve itself:
"The Federal Reserve will hike interest rates just one more time in 2023 before the central bank ends its inflation battle, according to its median forecast released Wednesday." ( CNBC ).
Worrying about rising interest rates is fighting the last war. Worrying about a recession is the next war. So let's turn to it.
Negative #4 - A recession could be around the corner
Could be. I'm not playing economist in this article.
Positive - Zions is prepared for a recession.
Check out this series of quotes from Zions' Q1 earnings conference call :
"We told investors at our 2020 Investor Day that we expected to be in the best quartile of net charge-offs as we go through the next recession."
"Since late 2017, we've grown commercial real estate ((CRE)) loans a total of 9%... well below the roughly 45% organic increase seen at the median of our peers. In order to engineer this slower growth, we've employed more rigorous underwriting standards than many of our peers."
"Only 1% of CRE loans have a loan-to-value ratio greater than 80%."
"We don't really have any consumer unsecured [loans] to speak of…"
These quotes underscore the fact that Zions is managing its protection against a recession rather well, the protection being its loan underwriting standards. And the numbers say this isn't just talk. Zions' "charge-offs" - write-offs of defaulted loans - were a miniscule 7 basis points last year, compared to 26 bp for the banking industry, which in turn was well below the 88 bp industry average since 1985. And hard to believe, but Zions' charge-off rate was even lower during Q1 '23 - a big fat zero .
Despite the cash loss of zero, Zions took a $45 million non-cash hit to earnings ($0.24 a share) by adding to its loan loss reserve. Does that mean Zions knows some big cash defaults costs are coming? Not necessarily. Take a look at Zions' cash and non-cash default costs over the past five years:
They seem to have very little relation to each other. That's because the size of a loan loss provision is a very subjective management decision, for Zions and for all banks. For example, in 2020 Zions set aside a lot of money, fearing a fierce Pandemic-driven recession. When that didn't occur Zions, like other banks, reversed a lot of the reserves. My suspicion is that Zions' big Q1 provision is an earnings management tool - as interest income declines, so will its loss provision.
So yes, Zions will take maybe a $200 million hit - about $1 a share - over the next 2-5 years on its $2 billion of office loans. But other than that, in my view only a major recession will create a problem for Zions, and very likely far less of a problem than for the great majority of banks.
Negative #5 - Zions' capital ratio has shrunk
Zions' "Tier 1" capital as a percent of risk-weighted assets was 11% at the end of Q1, down from 12% during '19 and '20. That doesn't sound like a lot, but I'm trying to find stuff to worry about.
Positive - Zions will be rebuilding its capital ratio over the next year.
The current 11% ratio that Zions reported in its Q1 earnings release looks something like this:
Zions' risk-weighted capital ratio should rise to 12% a year from now assuming that it:
- Earns $5.00 a share and maintains its $1.64 dividend.
- Reduces its securities portfolio by $4 billion, mostly due to bond maturities.
- Keeps its loan portfolio flat.
- Doesn't buy back any stock. It breaks my heart to say that when the stock is selling at that 19% earnings yield, and I'm sure it's killing management also. But the likely politically correct thing to do is to reduce investor anxiety which seems to be pretty high right now.
Wrap-up. This stock is dirt cheap. And dirt is pretty cheap.
A 19% earnings yield. A 5.8% dividend yield. I'll take my chances.
For further details see:
Zions Bancorporation: The Positives That High-Anxiety Investors Are Ignoring