Higher Rates Can't Come Fast Enough For Zions Bancorp

Zions Bancorp (ZION) has enjoyed an ongoing recovery trade this year, alongside many other lower-quality banks, as investors have turned to names where improved capital and cost structures could lead to earnings growth in the face of poor loan growth and spread trends. I happen to think that many of these investors are giving this bank a little too much credit; the recovery trade idea has certainly worked out (Zions has clearly outperformed other bank stocks like U.S. Bancorp (USB) and Wells Fargo (WFC)), but won't last forever. In particular, absent a significant increase in interest rates (and relatively soon), I think it will be difficult for this bank to continue outperforming its regional and market cap peers.

A Disappointing Third Quarter Turns The Tide

While Zions is still an outperformer for the year-to-date, this bank's stock has been lagging since it reported a generally disappointing set of results for the third quarter. Operating revenue declined 4% as the company saw more than 15 basis points more spread compression than the Street expected. Making matters worse, Zions gets far less revenue from fees than its peers (about one-quarter), depriving it of a high-margin source of income that has benefited the likes of U.S. Bancorp and Wells Fargo.

Zions has also been making only mediocre progress with its expense structure; expenses were basically flat from the year-ago period, and the efficiency ratio (a measure of non-interest expenses relative to revenue) stands above 70 - a very high level for a bank (U.S. Bancorp is in the low 50s, Wells Fargo is in the high 50s, and Comerica (CMA) is in the mid-60s).

Last and not least, loan growth remains stubbornly sluggish. Commercial lending turned down slightly in the quarter, and although consumer lending was up nicely (about 2%, which passes for nice these days), that has never been an area of focus for this company.

Can Things Get Better? Yes, But...

There are at least two significant aspects to the Zions model and story that could lead to better results - higher rates and lower costs. Due to the low contribution of fees to operating revenue (only Comerica is really in the same ballpark) and the fact that Zions' loan book is tilted heavily towards commercial lending (which tends to be variable-rate), Zions is among the most rate-sensitive of the larger banks. If rates stay sluggishly and stubbornly low, Zions is likely to see more compression and weak profits. But if rates go up by 200bp, net interest income would likely grow at a mid-teens rate.

I also believe that the potential is there for Zions to reduce its cost structure. Zions is still spending a lot of money fixing problems that came about (or became noticeable) as a result of the collapse of the housing bubble and the new financial regulations. To that end, management discussed in its 10-Q filing that it still needs to improve its internal stress testing and risk management policies to be compliant with CCAR standards in 2014.

But there's another element to the cost story. Zions continues to refine and improve its capital structure, as improving sentiment about the bank's fortunes allows it to replace expensive sources of funding with more affordable new issues. This too should improve bottom line performance and returns.

Standing in the way is increasing competition. Comerica is just as focused on commercial lending as Zions and highly focused on markets like California and Texas. At the same time, banks like Wells Fargo and U.S. Bancorp have been looking to increase their commercial lending activities. Zions management mentioned seeing its rivals getting "more liberal" with their lending standards, and it is also true that Zions doesn't have the same sort of niche focus that has been helping lenders like First Republic (FRC) and City National (CYN) in California.

Expectations Versus Execution

There is definitely ample skepticism left about Zions future, as the bank seems to have one of the highest implied costs of equity in the larger bank space - more than 300 basis points higher than U.S. Bancorp and almost 200 basis points higher than Wells Fargo. On one hand, that's a risk factor … but it also suggests that the bank could see meaningfully lower credit costs and higher valuation if management can take the right steps to convince the Street that this is a new and very much improved operation.

I'm still skeptical. Zions has a good footprint in attractive markets like Arizona, California, and Texas, but this wasn't a particularly great bank before the credit crisis and the steps Zions had to take to survive have left some scars. I certainly can't rule out the possibility that Zions will get those higher interest rates it needs, but today's U.S. economy just doesn't feel so strong to me to expect a big move in rates any time soon. Likewise, I believe increasing competition in lending and a long, slow recovery are going to make it hard to really increase commercial lending (at least not without getting creative and/or taking on some risk).

I value Zions, in part, on the assumption that the bank will recover to 10% returns on equity in 2017. That puts me basically in the middle of what is an uncommonly wide range of long-term sell-side forecasts (from the mid single-digits to the mid teens). I likewise value Zions on a multiple of tangible book value based on near-term returns on equity and returns on equity net of the cost of capital. Those metrics give me a range of fair value from $25 to $30, with my excess returns model squarely in the middle at $27.50.

The Bottom Line

Right now, I'm a big believer in going with banks that have proven high-quality franchises or particularly valuable niches that the Street still doesn't fully appreciate - it has worked pretty well with ideas like Eagle Bancorp (EGBN) and CenterState Banks (CSFL) and well enough with the likes of JPMorgan (JPM) and BB&T (BBT). I will certainly acknowledge that Zions has levers to pull to deliver better performance in a tough banking environment, but I don't see the combination of low valuation and high probabilities of success that would make me want to own the shares. So though I can't ignore the possibility that the recovery trade continues for Zions after this recent pause, I still think there are better and better-valued banks out there to buy.

Source: Higher Rates Can't Come Fast Enough For Zions Bancorp

Disclosure: I am long BBT, JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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