On Tuesday night, Salt Lake City, Utah-based Zions Bancorporation (NASDAQ:ZION) closed at $19.61. With Q3 2012 tangible book value per share ("TBV-PS") of $20.24, that means ZION currently trades at 0.97x TBV-PS.
Some investors believe that 1x TBV-PS is a floor below which a bank shouldn't trade. Is this floor real, implying that current buyers of ZION enjoy an especially attractive risk-reward tradeoff, or is ZION's current valuation justifiable, implying that there's a risk ZION's stock price could stay where it is, or even go lower? As of mid-November, ZION's short interest percentage was 7.9%, down materially from its nosebleed high of 41% in mid-September 2008, but still well above that of many banks. The current short interest percentage of JPMorgan Chase (NYSE:JPM), the largest U.S. bank in terms of assets, is 1.3%. So there's still a large bet out there that ZION will trade materially lower from here.
The answer to the question of whether ZION is "cheap" or "cheap for a reason" lies in four areas: asset quality, asset growth, future earnings growth and valuation metrics.
I consider ZION's asset quality its strongest attribute. ZION's non-performing assets ("NPAs") are plummeting. At Q3 2012, NPAs were $1.37 billion, down nearly 57% from their Q1 2010 high of $3.18 billion. Non-accrual loans are falling not because they're being restructured, and not because of charge-offs. Loan quality genuinely appears to be improving. For the last eight quarters, the reduction in bad loans has exceeded the amount of net charge-offs. And ZION isn't aggressively harvesting "excess" loan loss reserves either. Currently, reserves are a conservative 68% of NPAs.
The largest U.S. banks haven't yet experienced the turn in asset quality that ZION has. I can only assume that investors are ignoring this fact because loans are a relatively low percentage of earning assets for these banks. That's potentially a mistake.
So if you're an investor who doesn't like banks because you're nervous about their asset quality, you should like ZION.
ZION's asset growth is a cause for concern. It's important to think about bank asset growth on a per share basis, because of how acquisitive many banks have been. Typically, when a bank completes a large acquisition, total assets increase meaningfully, but assets per share ("A-PS") grow only modestly, if at all, because large bank deals are generally stock-for-stock. ZION had the reverse problem in early 2009. Large operating losses obliged ZION to issue common equity to repair its capital ratios. As this capital was needed to fill a hole, rather than to be leveraged, ZION's A-PS plummeted. From Q1 2009 to Q1 2011, ZION's shares outstanding increased from 115 million to 183 million, a 59% increase that reduced A-PS by 42%, from $473 to $276. Since then, ZION's shares outstanding have remained basically stable while ZION's total assets have increased by 4.5% (implying 3% annualized asset growth) and A-PS increased by 4.3%.
But there's another problem. I've recommended focusing on A-PS growth rather than total asset growth because of how acquisitions can bloat total assets. But ZION's total assets peaked at $55 billion in Q4 2008. Q3 2012 total assets were $53 billion, meaning that total assets declined by 3.6% over the last 3 3/4 years (or by 1% if compounded annually). Maybe ZION chose to shrink, to help ease pressure on capital ratios. Or perhaps it chose to allow low-yield assets and high-cost liabilities to roll off. But the fact remains that asset shrinkage occurred, and that's a negative for valuation.
Future earnings growth
In 2006, its peak earnings year, ZION reported $579 million of net income to common, or $5.46 in EPS. ZION had 107 million shares outstanding at year-end 2006, versus its current 184 million shares outstanding, which is 72% higher. The mean 2012 sell-side EPS estimate for ZION is $1.22, implying expected net income to common of $224 million. ZION's 2013 and 2014 mean EPS estimates are $1.74 and $1.94, respectively, translating into aggregate earnings of $320 million and $357 million, respectively. So ZION's future earnings are expected to be well below those of 2006, even in 2014, but well above those of 2012.
What will make ZION's 2013 net income to common $96 million higher than 2012's? Redemption of ZION's $1.4 billion of TARP preferred equity will help. ZION received this funding in November 2008. It redeemed $700 million of the TARP preferred in March 2012, and the remaining $700 million in September 2012. The TARP preferred carried an annual coupon of 5%, meaning that its elimination will save ZION $70 million per year, less the yield on whatever assets ZION liquidated to fund the redemption.
ZION still has $1.1 billion of outstanding preferred equity, which I estimate has a blended coupon of 8.9%. So for ZION to hit the mean 2013 EPS estimate, it must earn $320 million (EPS x shares outstanding) plus $100 million (dividends on the remaining preferreds), or $420 million, on a current asset base of $53.1 billion. That translates into a 2013 return on assets ("RoA") of 0.79%.
Can ZION hit a 0.79% RoA? ZION delivered a 0.82% RoA in Q3 2012, mainly because it booked a negative loan loss provision (-0.01% of average assets, versus 0.08% in Q2 2012). The prior two quarters' RoAs were 0.68% and 0.69%. It seems like ZION will need provisions to be low or negative in the future to hit the RoA target. ZION's Q3 2012 reported net interest margin ("NIM") was 3.63%, down from 3.99% in Q3 2011, but many banks have experienced a NIM drop recently, and it doesn't seem likely that a major NIM increase will occur in the near term. ZION's overhead expense to average assets ratio was 2.96% in Q3 2012, down from 3.17% in Q3 2011. While a decrease in this ratio would boost RoA, such a decrease seems unlikely. Finally, at 0.87%, ZION's Q3 2012 fee income/average assets ratio isn't very high and doesn't appear poised for a rebound.
Could asset growth close the gap? More common equity means more assets and more earnings. But ZION's leverage has decreased over time, meaning it now holds more common equity relative to assets, and that dampens the earnings impact of common equity growth. ZION's tangible common equity/tangible assets ("TCE/TA") ratio got as low as 5.26% in Q1 2009. It had been hovering between 5% and 6% since Q4 2005. Since Q1 2009, ZION's TCE/TA has ratcheted upward, hitting a high of 7.17% in Q3 2012.
If ZION wants to hit $1.74 of EPS in 2013, it must earn a 0.79% return on average assets assuming 0% asset growth. If we increase the asset growth assumption to 5%, the required return on average assets falls, but only to 0.77%. Asset growth just doesn't help all that much.
In fact, more asset shrinkage may be better in the short run. I estimate that ZION's return on average tangible common equity ("RoATCE") in Q4 2013 will be 8.6%. If I'm right about the remaining preferred equity having a blended coupon of 8.9% (remember that's an after-tax yield), then it would be EPS accretive for ZION to liquidate assets and redeem this preferred.
I believe ZION will have to redeem the remaining preferred stock to hit the EPS targets.
Let's pretend that ZION does liquidate assets to redeem all currently outstanding preferred stock. Assume a pre-liquidation RoA of 0.75% and a 6% pre-tax yield on the assets liquidated to fund the redemption. That would lead to EPS of $1.93, and a return on tangible common equity of 9.5%. What price/TBV-PS multiple should I then pay?
It might be a little hard to believe that a 10% discount rate should apply to ZION, when the yield on the 30-year Treasury bond closed at 2.78% last night, because that would imply a company-specific risk premium of over 7%. But the fact is, if you look at where the largest, healthiest U.S. banks are currently trading, their valuations imply discount rates of 10% or higher. A 10% discount rate implies that ZION should trade at 0.95x TBV-PS, or slightly below where it's currently trading now.
Lastly, it's important to point out that ZION's quarterly dividend of $0.01 implies a current dividend yield of only 0.2%. If ZION does hit the mean 2014 EPS estimate of $1.94, and then adopts a 40% dividend payout ratio, its dividend yield would be 4.0% at the current share price. Not a bad low-risk return to receive while you wait and see if ZION's operating performance improves.
In conclusion, I think short sellers have this one wrong. In my opinion, ZION's current share price reflects a conservative, if not pessimistic, view of ZION's future operating performance. Future operating and valuation surprises are much more likely to be positive than negative.
Disclosure: I 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.