Zions Bancorp: Weak PPOP Prospects Masking An Increasingly Interesting Valuation

One of my core investment principles is that valuation is not a driver - "cheap" stocks don't go up just because they're cheap, and likewise expensive stocks don't go down just because they're expensive. Zions Bancorp (ZION) is getting cheaper and cheaper, and I do believe that the Street is overlooking the significant changes management has made to the business over the last decade, but the market usually only believes credit improvement stories at the end of a cycle and Zion's pre-provision profit (or PPOP) growth prospects over the next few years are not very good. I wrote previously that I didn't think Zions was set up to perform well, and the shares have fallen another 10% since then, underperforming the peer group. The prospective returns are getting pretty attractive now, but I do still worry that weak growth leverage over the next few years will remain a headwind to share price appreciation.

Lackluster PPOP Performance, But Otherwise A Pretty Typical Quarter

While Zions did beat expectations in the third quarter, it came largely from lowering provisioning, and the market has not been paying for that on a reliable basis. Looking at core PPOP, Zions was basically just in line this quarter, and eroding credit metrics are going to keep some investors cautious or negative on the name.

Revenue was flat from the year-ago quarter and up 4% this quarter, good for a 1% beat. Like most banks, there was more strength in the fee-generating businesses than in the spread business. Net interest income fell 2% yoy and 1% qoq (a 2% miss), with net interest margin down 42bp yoy and 17bp qoq on weakening loan yields and excess liquidity; Zion's 12bp NIM miss was one of the worst I've seen so far. While reported fee income rose 6% yoy and 26% qoq, "core" growth was more on the order of 7% qoq, though not all analysts/investors use the same definition of core. Either way, this was a beat relative to expectations.

Expenses remain quite well-controlled, falling 1% yoy and rising 2% qoq, with an efficiency ratio in the high 50%'s (Zions met expectations here). Core pre-provision profits were flat yoy and up 5% qoq, only meeting sell-side expectations in a quarter where many banks have posted healthy beats. Tangible book value per share rose 7% yoy and 2% qoq, the CET 1 ratio came in at a pretty healthy 10.4%.

Credit Is A Mixed Bag

Zions' credit situation takes some effort to untangle. While a lot of the reported numbers don't necessarily look so great, I think the underlying situation is probably better than it looks and definitely better than the Street is reflecting in the valuation.

Provisions declined 67% qoq, driving Zions' quarterly beat, and while management did modestly boost its allowance for credit losses (or ACL), it posted a modest reserve release. Excluding PPP loans, the ACL/loan ratio rose slightly to 1.91%, with a 5.4% ratio in the energy book. Next to banks like PNC (PNC) and U.S. Bancorp (USB), Zions does look modestly under-reserved, but it's worth remembering that Zions has no card business and the small business loans Zions writes often have personal guarantees attached that collateralize the loan beyond just the business itself.

Non-performing loans increased 8% qoq, driven by commercial real estate, and classified loans rose 11% qoq, while 30-day delinquencies declined slightly (from 0.7% to 0.5%). The non-performing asset ratio remains high (0.68% versus 0.62% in Q2), and higher still when including TDRs (1.04% vs. 0.98%), but again it's worth remembering that Zions has a long history of lower actual loan losses relative to non-accrual numbers.

Charge-offs rose 68% qoq, with the charge-off ratio increasing 15bp to 0.38%, and energy charge-offs jumped to 3.5%. Pandemic-stressed business charge-offs also remain high (1.7% charge-offs), but management believes the majority of charge-offs are still to come in 2021.

Back on the positive side, deferral requests have plunged, and only a small fraction (1%) of loans that received deferrals remain delinquent. Zions still has over 8% loan exposure to pandemic-stressed businesses (largely in CRE), and 5% of its loan book is energy, where non-accruals have risen from 2.7% to 3.2%, but 75% of those loans remain current.

Here's how I would look at all of this. Zions has a riskier-than-average loan book, but historical loan losses are usually not as bad as the initial non-accrual figures would lead you to assume. I do think Zions should have reserved more than it has, and I do worry that losses could be higher in 2021 (particularly with energy and small businesses), but I can't deny that stimulus efforts have helped bridge borrowers over this demand shock, and further stimulus should further mitigate the risks to Zions' loan book.

The Outlook

While I'm pretty comfortable with the credit/capital situation, I'm not as sanguine about spreads and PPOP. Management expects further NIM pressure, as loan yields have a little further to fall and there's really nothing more the bank can do on the funding cost side. Zions is also modifying its remaining PPP loans to 5-year terms (from two years), dropping the yield from around 3% to 1.7% and creating another 10bp-15bp of yield pressure.

As a reminder, Zions was exceptionally aggressive on PPP loans - it's the 37th-largest bank in the country, but was the ninth-largest writer of PPP loans, as management believed this was a one-time opportunity to grab new small business customers. Time will tell if they retain that business, but even with the near-term impact of weaker spreads, I think it was a risk worth taking.

I continue to see poor near-term PPOP growth prospects for Zions, and the roll-off of some rate hedges starting in 2022 won't help. I see PPOP declining in 2020 and 2021, and 2022 looks at-risk to me as well. This isn't a new concern for me, though, and my core earnings growth assumptions haven't changed either (sub-1% growth over the next five years, around 3% growth longer term).

The Bottom Line

Between discounted core earnings and ROTCE-driven P/TBV, I do believe Zions is starting to drift towards "too cheap to be ignored". Here's where my early comments about valuation come into play though - while I do think Zions is priced for a mid-teens long-term total return that looks pretty attractive now, the market may yet be slow to warm to a bank that is likely to post weak PPOP for a couple of years and sub-10% ROTCEs. Patient investors may want to take a look, and I have to admit that it's tempting to flip this to a "Buy" idea just on the basis of the valuation discount getting too large.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.