One of the biggest trends in bank stocks over the past 18 months or so has been the relative outperformance of bank stocks where the predominant theme was cleaning up the balance sheet and simplifying the business. Investors in banks like Bank of America (NYSE:BAC), Synovus (Nasdaq:SNV), and Zions Bancorp (Nasdaq:ZION) have all beaten the market by a healthy margin over the past year, but the question is how much more juice there is to be squeezed from that orange. In the case of Zions, for instance, there's ample scope to reduce funding costs, but fierce competition in lending could delay the progression of real earnings and ROE improvement.
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A Look Back At The First Quarter
Although Zions reported a gaudy-looking earnings beat for the first quarter, the actual underlying quality of earnings and business are not so good. Zions got a large benefit from releasing loan loss reserves (turning its provision expense to a positive contributor), but actual operating revenue declined by basically the same low single-digit percentage as for most banks. Likewise, Zions isn't making breathtaking progress on expense reduction, resulting in an efficiency ratio that is high relative to its peers (high is bad) and double-digit declines in pre-provision net revenue (the bank version of operating income).
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Will Competition Mitigate Capital Clean Up?
One of the bigger concerns I have about Zions is the apparent increasing competition for loans in its operating area. Zions did pretty good relative to most other lenders this quarter, with 3% period-end loan growth, including 5% growth in its large commercial lending book (nearly $20 billion)
Unfortunately, regional rivals like U.S. Bancorp (NYSE:USB) and Wells Fargo (NYSE:WFC) are also growing their loan books, and it sounds like they're competing more fiercely on pricing. Whether this is due to the banks' desire to make up for declining mortgage banking revenue is largely moot, the point stands that Zions is seeing more price pressure on lending.
At the same time, Zions is looking to significantly improve its balance sheet. The bank has already repaid its TARP funds and started to redeem other expensive funding sources, but it still has considerable work to do in replacing pretty costly preferred, trust preferred, and subordinated debt with cheaper sources of funds. Ultimately I have no reason to believe that the company won't be successful in these efforts, but the declining loan yields will mitigate some of the benefit in the near-term.
What Will The New Zions Look Like?
One of the interesting things about Zions as a stock is the considerable difference in opinion among analysts about Zions' long-term profitability. Although it's certainly not unusual to see long-term ROE estimates differ among analysts, the difference between the high and low estimates is nearly 70% with this bank. Suffice it so say, that sort of range makes a big difference when trying to estimate the stock's current fair value on the basis of long-term ROE.
On a fundamental level, Zions still has a solid business plan. The bank has a meaningful presence in states (Arizona, Texas, and Nevada) with good long-term population trends, as well as a good core footprint in Idaho and Utah – states where I'm not sure new entrants really want to invest major funds. While Zions is weaker than I'd like in California and Washington, the bank is nevertheless big enough in California to have a sizable commercial lending business there.
Many of Zions' rivals are stepping up their commercial lending activity, but time will tell if they are really intending to stick with those businesses for the long-term. In the meantime, Zions should have meaningful opportunities to reduce its operating costs, improve its non-interest sources of income, and reduce its cost of capital. In the short term, though, the bank is likely to see the same spread and lending pressure as almost every other peer bank.
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The Bottom Line
The biggest issue I have with Zions today is basically the same issue that I have with other “clean up stories” like Bank of America and Synovus. While these shares have certainly outperformed as it is clear the companies are no longer on the brink, there are still very real doubts about the banks' long-term earning power and their ability to hold deposit and lending share without resorting to self-defeating price competition. Remember, Zions got itself into trouble for a reason and shareholders had to pay the price (notice the near-doubling in the share count from pre-bubble levels).
If Zions can regain a 10% ROE within five years, fair value on these shares is about $27. On a more immediate basis, the company looks basically fairly valued according to return on tangible assets and BV/ROE (adjusted for cost of equity). That's not enough undervaluation to excite me, particularly when better banks like U.S. Bancorp and Wells Fargo are cheaper today.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.