Oregon's Umpqua (NASDAQ:UMPQ) is something of a case-in-point as to why I'm reluctant to overpay for stocks (and bank stocks in particular). When I last wrote about this high-quality bank back in 2014, I thought the shares looked expensive. Since that time, the shares are actually down about 5% - rare for most bank stocks and all the worse when compared to the performances of regional rivals like East West (NASDAQ:EWBC), Washington Federal (NASDAQ:WAFD) and Pacific Continental (NASDAQ:PCBK).
What's worse is that even after this run of underperformance, the shares still don't look all that cheap. Not only is Umpqua not all that asset-sensitive, it also lacks real leverage in more than a handful of major markets. Add in a loan book that is overweighted to commercial real estate and multi-family residential lending, an elevated cost structure (which is liable to be tough to tame) and weakening yields, and it's a tough near-term outlook. While there is definitely room for improvement, Umpqua may find it hard to go much above 10% ROE in the foreseeable future, and that limits the value proposition today.
A Franchise That Is High-Quality In Some Respects, Not So Much In Others
Umpqua's network of over 300 branches stretches from Seattle to San Diego, and the bank has long used a "high-touch" consumer-focused model that has led to consistently good scores in consumer surveys and loyal deposit account holders. Over 40% of the bank's deposits reside in Oregon, where it is the fourth-largest bank in the state with over 10% share. California is next with nearly 30% of the bank's deposits, but its 0.4% share makes it a minor player in the state as a whole. Washington is the third major market, holding about 27% of deposits, where Umpqua's 3.4% share is good for the number seven spot.
Umpqua's deposit base skews rural (about 60% of deposits) and the bank's position in major metro areas is not all that impressive. Portland, Oregon, is the company's largest metro market (with over 20% of deposits), where it holds about half as much share as it does in the state as a whole and the #6 market position. Eugene, Oregon, is a stronger market (nearly 17% share), but it is a smaller player in other major metro areas like Seattle (2% share, #10 market position) and Sacramento (2% share, #11 market position). If there's a bright side to this, it's that Umpqua is still largely a commercial lender and it doesn't take a large branch network or significant deposit share to drive commercial lending in most metro areas. What's more, it does create a leverage opportunity if and when the bank can pair its lower-cost rural deposit base (where it sees less competition) with faster loan growth in metro areas.
While Umpqua's retail-driven approach is a plus in terms of creating a loyal, low-cost deposit base, that "low-cost" comes with an asterisk - Umpqua pays less for its deposits than its average peer, but its operating costs have long been higher and management has struggled to drive its efficiency ratio below 60% and realize the hoped-for synergies from its virtual merger-of-equals with Sterling back in 2014.
Other quality issues surround the loan book and where/how Umpqua generates revenue. Umpqua is more concentrated in CRE lending (around a third of the loan book) than similarly sized peers (where the average is closer to 20-25%). While improving C&I lending has been a big item on the "to do list," Umpqua has only recently lifted its C&I lending closer to peer averages. While the level of residential mortgage lending is pretty typical, Umpqua is a very active multifamily residential lender; this is an odd type of lending, where most banks have small presences (below 10% of loans) but a few like Signature (NASDAQ:SBNY) and New York Community Bancorp (NYSE:NYCB) regard it as a core operation). Although Umpqua still has room to go on CRE lending before reaching regulatory restrictions, the bank has been actively selling CRE loans to manage exposure while trying to increase the mix of C&I and mortgage loans.
Looking at how Umpqua generates its revenue, the bank is significantly exposed to mortgage banking - a volatile source of revenue that seems to cycle from boom to bust almost on a quarterly basis.
Can Umpqua Drive The Needed Improvements?
Management at Umpqua has been saying the right things for some time, but delivery has come up short. Costs have remained stubbornly high and I do wonder whether the bank's commitment to a high-touch model limits how much leverage it can really hope to achieve. Still, the lack of leverage from the Sterling deal is a little alarming considering the many M&A transactions in the bank's history. Given that, I'm not sure investors would greet additional M&A with much enthusiasm, though there are some opportunities in California, and perhaps Nevada, Washington and Arizona that would be worthwhile.
I'm also concerned about the bank's spread income outlook. While Umpqua has been increasing its asset sensitivity, it's still not very asset-sensitive. What's more, management has had some challenges in managing the excess liquidity that has come from deposit growth. Last and not the least, not only has loan growth been fairly lackluster (up 6% YoY/flattish QoQ in the last quarter), but the yield on new originations has been down in the 3.6% to 3.7% range - a fact that will lead to ongoing spread compression in the coming quarters, where NIM has already dropped from 4.75% in the third quarter of 2014 to 3.95% in the last third quarter. Management has been trying to increase its mix of variable-rate loans and that should help if/when rates rise.
While credit quality was below peer levels in the years immediately after the housing bubble popped, the bank has since reversed and become a relative outperformer. The level of non-performing assets to loans is very manageable (in the 0.2%s) and while the level of reserves to loans is on the lighter side, the level of reserves to non-performing loans is very strong (over 480%).
I like how the company has taken its 2013 acquisition of Financial Pacific and run with it - growing the leasing and equipment financing business nicely over the past few years. While an acquisition here probably isn't too likely given the multiples in the segment, I do think there is more opportunity for Umpqua to grow this business in the coming years. I likewise think that the multifamily lending business is a good one - the level of non-accrual and special mention loans is very low and the yields are pretty good; plus, it's a type of lending other banks don't really want to do.
Management doesn't sound too keen on a whole bank acquisition, which means lending growth is really the only way to profitably deploy the excess capital on the balance sheet. That carries some issues given spread compression, but I don't think it is likely that management will meaningfully increase the dividend or do major buybacks in the near term.
I'm concerned about how Umpqua will drive attractive growth in the coming years. There's definitely the potential to better leverage expenses and the roughly 250bp-300bp improvement in efficiency ratio in the last quarter is largely responsible for the double-digit YoY and QoQ growth in pre-provision profits. But I'm not so confident about the prospects for above-average spread income growth, and I worry that the mortgage banking business will be consistently inconsistent. Maybe Umpqua will exceed my expectations with C&I lending growth - the potential is certainly there to do better, though the loan/deposit ratio is already over 90%.
All told, I'm looking for mid-single-digit earnings growth from Umpqua, and expense leverage is the most likely driver of upside beyond that level. That works out to a double-digit ROE down the road, but it is hard to see Umpqua posting really attractive ROEs without more significant changes in the model.
The Bottom Line
Discounted back, and looking at other valuation approaches like ROTCE-P/TBV, I think fair value pretty much tops out in the mid-teens today. Umpqua is far from the only bank that appears to be trading above its fair value today, and it is at least plausible that the new administration could push through regulatory changes that are more favorable for financial institutions. That said, I just haven't seen the excellence in execution that would encourage me to pay up for Umpqua, so it remains a stock that I just cannot get excited about given its valuation.
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.