The Zions Dilemma: Where Low Default Rates, Inefficiency, And Market Flux Intersect

Investment Thesis

Zions Bancorporation (NASDAQ:ZION) presents a nuanced investment opportunity in the current banking landscape. While it boasts an impressive loan performance and a solid capital foundation, it struggles with efficiency issues, notably high financing costs and potential market-driven challenges. Its recent investment strategy pivot highlights its portfolio's inherent risks and opportunities.

While the bank's share price carries a potential upside—about 33% based on our analysis—external factors such as persisting inflation, global tensions, and rapid fintech evolution can affect its trajectory. Balancing these factors and arriving at an expected return of 14%, we recommend a HOLD on Zions, allowing investors to benefit from its stable dividend yield amidst anticipated market volatility.

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Company Insights

In our ongoing series on regional banks, we turn our focus to Zions Bancorporation. We begin with an overview of this bank holding company, highlighting any financial irregularities. We then delve into a forward-looking valuation, comparing Zions to its industry peers. The analysis concludes with assessing its risk-return profile as an investment opportunity.

Overview

Zions Bancorporation ranks among the top 15 of approximately 270 publicly listed US regional banks, boasting a market capitalization of around $5 billion. Headquartered in Salt Lake City, Utah, the bank and its subsidiaries predominantly serve the Western United States. With over a million customers, ZION operates over 400 branches, complemented by online, mobile, and digital services. The company employs nearly 10,000 full-time equivalent staff.

Below is ZION’s peer group ranked by total assets. The light green area shows the expected net interest margin (NIM) for 2024E, which indicates the efficiency with which each bank uses its interest-bearing assets to generate income.

The company operates through seven independent bank divisions, each having its local brand and management; see the bottom right pie in the chart below. The company supports brand autonomy with product pricing and customization to boost customer contentment and community ties. However, risk management, strategic goals, and tech are organized centrally.

The other three pies in the chart below show the company’s loan profiles and non-interest income by customer and product segment.

Assessing the qualitative strengths of a regional bank can be tricky. Public customer reviews may be inconsistent or lean towards negative experiences. Moreover, we cautiously approach customer experience consultancies due to their limited transparency and scope.

Like TripAdvisor or Google Reviews for travel and local businesses, Glassdoor lets employees openly review their employers. While the platform enforces strict data integrity standards and its insights are raw, careful interpretation can yield valuable findings.

• Overall rating: 1-5★ (5 being best).

• CEO approval: up to 100%.

• Business outlook positivity: up to 100%.

ZION doesn't fare particularly well in this analysis. However, some individual subsidiaries show a somewhat better performance. Key criticisms include excessive risk aversion, overly dense middle management, isolated work practices, and below-average compensation.

Interest Income & Investments

ZION's net interest income has been stable annually, as shown in the chart below. However, there was a noticeable decline from the first to the second quarter of 2023. Although the bank experienced increased earnings from variable loans, these were offset by higher interest expenses on deposits and borrowings. The reduction in interest-earning investments due to maturing contracts further intensified the issue. On the bright side, this presents an opportunity to reinvest in higher-yielding assets.

Regarding the bottom line, the drop in profits can be attributed mainly to the reduced net interest income mentioned above and to slightly increased non-interest expenses driven by layoffs and higher FDIC insurance costs.

The comprehensive loss for 2022, illustrated by the orange line in the chart below, resulted from unrealized losses in the investment portfolio, which we will briefly address next.

Over 80% of ZION's investment portfolio comprises agency-guaranteed mortgage-backed securities (MBS). Before year-end 2022, these assets were classified 100% as available-for-sale (AFS). As a result, the full markdown to fair value following the sharp 2022 interest rate hikes was recognized as a $2.7 billion other comprehensive loss, significantly affecting ZION's equity value. This point is vital to understand when evaluating equity/book value multiples.

In contrast, many peer banks had an even split between AFS and hold-to-maturity (HTM) classifications, which buffered them against such significant declines in capital due to unrealized losses.

In 2022, ZION evenly categorized its investments between AFS and HTM, as illustrated in the left chart below. Since the $2.7 billion markdown in the AFS segment happened before this change, the unrealized gains/losses for HTM show zero, as represented by the green line on the right. The “missing” $1.3 billion can be found on the balance sheet and in footnotes.

We are confident that these unrealized losses will remain so and diminish as these investments mature. The chart's orange line on the right will revert from -$1.34 billion to 0, and the green line is anticipated to accrete from 0 to $1.3 billion, effectively showing an unrealized gain in the investment schedule. Interest income and, thus, net income will be artificially enhanced due to those HTM investment accretions over the following years, which is a nuance to note when using revenue or earnings multiples for valuations.

In concluding this section, we present a direct efficiency ratio comparison: ZION versus its industry counterparts. Through a scatter plot, we highlight two key efficiency metrics: the net interest margin (NIM), which relates net interest income to assets such as loans and investments, and the efficiency ratio, indicating non-interest (operational) expenses as a percentage of total net revenues. According to the 2024E consensus estimates, ZION lags notably with a NIM of 2.95% and an efficiency ratio of 65%, positioning it in the bottom quartile for both metrics.

Loan & Lease Portfolio

ZION's loan and lease portfolio experienced a robust growth of 4.5% from 2018 to Q2 2023. The bank has maintained an impressively low rate of non-performing loans throughout each segment. Although there was a noticeable uptick in consumer loans in 2020, it decreased to 0.35%. Consistent with the whispers among its employees, ZION exhibits a risk-averse stance on the credit front. It remains to be seen if this conservative approach can sustain such growth rates.

Furthermore, when benchmarked against its peer group, ZION excels in the metrics for non-performing loans and net charge-offs, recording figures of 0.28% and 0.09%, respectively — placing them in the top-performing quartile. We've visually represented this distinction with a scatter plot below.

The bank's strength is not limited to just low non-performing loans. ZION also boasts an impressive coverage ratio, reflected in an allowance for credit losses (ACL) that is 4.1 times the current NPLs. This ratio places the company again in the top quartile of its competitors, as the following chart illustrates.

Customer Deposits & Liquidity

The scare tactic involving customer deposits is familiar to us and was reserved for Silicon Valley and Signature Bank, which had 94% and 89% uninsured deposits, respectively. These banks, among other issues, lacked immediate cash resources to manage rapid withdrawals.

However, in the wake of this year’s regional banking crisis, the Fed launched the Bank Term Funding Program. As a result, all peer banks now have immediate liquidity sources that exceed their total uninsured deposits. ZION's liquidity-to-uninsured deposits ratio stands at 149%.

The company experienced a surge in customer deposit withdrawals in 2022 after significant increases in 2020 and 2021, as shown in the chart below. However, customer deposits have stabilized, with a noticeable increase in the most recent quarter. From 2019 to Q2 2023, the CAGR stands at 7.8%, and uninsured deposits have been reduced to just 40% of total deposits.

Capital Management

ZION's regulatory capital ratio, Common Equity Tier 1 (CET1), reflecting the bank's core equity over its risk-weighted assets, stands at 10.0%. This strength is because unrealized losses from its AFS investment securities do not factor into this ratio.

Likewise, the bank's leverage ratio is at a commendable 8.0%. These figures place the bank comfortably in the lower-middle range compared to its peers and notably surpass the minimum requirements of 4.5% and 4.0%, respectively.

Comprehensive Analysis: Valuation, Growth, and Dividends

Growth Analysis

We've depicted the earnings and revenue growth of Zions and its peer group in a scatter plot, utilizing the Compound Annual Growth Rates (CAGRs) from 2023E to 2025E consensus estimates.

ZION's annual earnings growth rate of 1.8% stands notably higher than most of its peers. However, the bank's revenue growth, at 0.5%, falls towards the lower end of the group's range.

Dividend Perspective

ZION's dividend yield of 4.9% is performing somewhat averagely compared to its peer group. However, when considering the entire US market, including non-financial institutions, its yield currently ranks in the 85th percentile, as indicated by the second chart below.

While the forecasted dividend growth for 2023E-2025E at 1.8% trails the average of its peers, it's noteworthy that the payout ratio is a robust 39%. This allows room to increase the payout without compromising net income earmarked for retained earnings, ensuring liquidity, capital ratios, or strategic growth.

Compared to its dividend yield history over the last ten years, ZION's current dividend yield is in the 95th percentile, as indicated in the historical chart below.

Valuation

Shifting our focus to valuation, the chart below illustrates the P/E and P/S valuation multiples for ZION and its industry peers. The grey dots denote the present market positions of each bank, while the orange and green dots represent the 90th and 10th percentiles based on the last ten years (L10Y). Notably, all banks are trading near the lower end of their L10Y valuation range.

This historical analysis, which provides upper and lower percentiles, allows us to observe typical patterns of multiple contraction and expansion over time.

The following chart zooms into the exact multiples but forward 2024E. ZION boasts an earnings multiple of 7.9x, positioning it in the middle of the pack. In contrast, its revenue multiple 1.6x is notably lower than most of its peers, indicating potential for expansion.

Transitioning to book values, the subsequent chart outlines the P/TBV and P/B valuation multiples for Zions and its peers. Much like the initial valuation chart above, the grey dots pinpoint the current trading positions of each entity. In contrast, the orange and green dots indicate the upper and lower valuation percentiles based on L10Y.

Zooming in on the 2024E multiples, ZION holds a tangible book value multiple of 1.12x, positioning it slightly above the median. However, its book value multiple of 0.90x is notably higher than most of its peers, indicating limited immediate upside potential.

One could argue, though, that ZION's book value multiples are artificially boosted due to its relatively high equity adjustments resulting from its temporary AFS unrealized losses, meaning that there is no actual valuation premium relative to its peers.

Verdict

After thorough qualitative and quantitative analysis, as well as comparing Zions Bancorporation both on its own merits and relative to its peers, and considering both historical and forward data, we recommend the following estimated multiple ranges for 2024E to set a price target for ZION:

P/E 24E: 9.5x - 11.5x

P/S 24E: 2.0x - 2.4x

P/TBV 24E: 1.35x - 1.60x

P/B 24E: 1.10x - 1.30x

In our final valuation chart, we apply each multiple range to today's share price to determine a fair price range for each metric. Ultimately, we suggest a share price target of $46, representing a potential upside of 33% from today's price.

Risk-Reward

In today's climate of high-interest rates and escalating global tensions, the spectre of potential disruptions looms large. Inflation might be more persistent than the market anticipates; the looming threat of a recession is ever-present. ZION could be vulnerable to fintech disruption if it fails to keep pace with technology and competitive pricing.

Given these challenges, our task is to quantify how these risks could impact the current share price, how likely these developments are, and how they relate to a potential 33% share price increase supported by a reliable dividend yield of 4.9%.

Doomsday Share Price Projection

In light of these scenarios, valuation multiples could plummet to historic lows, as depicted in the chart below, potentially driving the share price down to $24, representing a negative 30% change from today's price.

Expected Return

Our estimates assume a 70% probability that the share price and multiples will revert to the mean, while a more pessimistic doom scenario has a 30% probability. The dividend yield is considered separately and contrasted with either inflation or the discount rate. Based on these probabilities, we arrive at the following simplified expected return (ER):

ER = (70% * 33% Capital Gain) + [30% * (-30%) Capital Loss] = 14.1%

Conclusion

Zions Bancorporation presents a compelling yet cautious investment case, with an expected return of 14%. While the upside potential exists, external pressures warrant a HOLD recommendation only, allowing investors to benefit from its stable dividend yield amidst anticipated market volatility.