Umpqua Bank: Buy The Ice Cream And Wait For A 4.50% Yield

Summary

• Umpqua Bank is a “tweener;” not a community bank, not a major regional, with no critical mass anywhere in its geographically widespread service area.
• The bank is well-run; well-capitalized with excellent credit quality and a good deposit base, but hampered by lower-than-average returns to shareholders.
• Investors will be waiting for management's new strategic plan or M&A to boost performance.
• At $20-21 per share and a 3.8% yield, the stock is not a compelling buy.

Umpqua Holdings Corporation (NASDAQ: UMPQ), headquartered in Portland, Oregon, is the parent company of Umpqua Bank, a $25.7 billion-asset regional bank headquartered in Roseburg, Oregon with 311 bank branches in Oregon (102), Washington (99), California (89), Idaho (15) and Nevada (6). UMPQ also owns a stock brokerage subsidiary, Umpqua Investments, Inc., with 12 locations in Oregon, California and Washington, and Pivotus Ventures, a banking think-tank located in Silicon Valley.

Where Can I Cash My Paycheck?

The thriving timber industry in the Roseburg, Oregon, area in the 1950s led to the formation of South Umpqua State Bank in 1953 in Canyonville, Oregon. According to the UMPQ website, the bank was started in order to give local people working in the timber industry a place to cash their payroll checks.

(Source: Umpqua website)

Milt Herbert, one of the bank's founders, is the second from the left in the photo above.

The bank grew slowly through the ensuing years until the December 2000 purchase of VRB Bancorp, Rogue River, Oregon, parent of Valley of the Rogue Bank, for $54.0 million. The deal increased UMPQ's assets to $750.0 million with 27 branches.

Like many banks, UMPQ then began a series of acquisitions that would finally create the bank of today. The largest and most transformative of these acquisitions was the April 2014 $2.0 billion acquisition of Sterling Financial Corporation, parent of Sterling Bank, the second-largest bank in Washington, which increased the bank's assets to more than $22.0 billion and total branches to 394 before closings and consolidations.

Pictured below is UMPQ's headquarters in Portland, Oregon; the former headquarters of the Benjamin Franklin Savings & Loan, which was seized by regulators in 1990.

(Source: Wikipedia)

Corporate Culture: "The World's Greatest Bank"

UMPQ is known for a unique, almost eccentric, customer-focused corporate culture where employees answer the phone saying, "Thank you for calling the world's greatest bank. How may I help you?" As Micah Solomon wrote in Forbes:

With a customer service and customer experience obsession not often seen in the retail banking industry, Umpqua Bank is held up as a customer experience gold standard even by its competitors; in my own work with retail banks and financial institutions as a consultant on the customer experience, I refer retail banking clients back to (and hear banking clients themselves refer back to) Umpqua Bank as a pinnacle of customer experience-driven, customer service-focused, retail banking.

UMPQ's unique corporate culture is largely the vision of one man, in a sense the real founder of the modern UMPQ, long-time CEO Ray Davis.

(Source: American Banker)

Davis became CEO of South Umpqua State Bank in 1994, when the bank had $140.0 million in assets and 5 branches. According to American Banker:

Recognizing that Umpqua could never compete with larger banks on price, convenience or technology, he differentiated the bank by instilling a service culture that took cues from the likes of Nordstrom and Ritz-Carlton.

What exactly is it like to bank at a UMPQ branch? Please forgive the long quote, but the Seattle Times put it this way:

Visitors to the new Umpqua Bank branch on Capitol Hill can be forgiven if they do a double-take and mistake the place for a fancy hotel, an Internet cafe or an art gallery. Smartly dressed employees greet them at the door. At a sleek, wide-open counter, customers get a chocolate with their receipt - whether it's for a bank deposit, or for the purchase of board games made by a local business. In one corner, the public can help themselves to free coffee and free Internet access on three PCs. In another corner is artwork depicting artists with Seattle ties who revolutionized modern dance. Music plays softly in the background.

Below is a picture of a UMPQ bank branch.

(Source: Placewright Design)

Davis would eventually write a 2007 book entitled Leading for Growth: How Umpqua Bank Got Cool and Created a Culture of Greatness. He served as CEO for 23 years, retiring on December 31, 2017, after serving one last year as executive chairman. He was elected to the honorary role of Chairman Emeritus in January 2018.

The Winds of Change

Sometimes, when a charismatic leader leaves an institution, there is vacuum; a period of transition, adjustment and perhaps drift. After 23 years with the same CEO, UMPQ seems especially vulnerable. The bank is still a small institution; $25.7 billion in assets is not much in an era when Citigroup (NYSE: C), the smallest of the four largest banks in the US, has $1.84 trillion in assets.

UMPQ's retail banking franchise, arguably its crown jewel, is spread over 5 very large western states, and according to recent FDIC data, the bank's roughly $7.8 billion deposits, or 10.2% market share in its home state of Oregon, only qualifies for fourth place. The company seems stuck in the "tweener" category; no longer a community bank, but not really a major regional either. Looking closely at 2017's performance, we can sense the drift. Cort O'Haver, the new CEO, a relative newcomer with about 7 years at UMPQ, most recently as President of Commercial Banking at Umpqua Bank, and a career stretching back to much larger competitor US Bank, will face many challenges.

2017: A Disguised Down Year

Would any long-serving CEO want to leave the bank he created in a down year? If not for net income being bolstered by a tax benefit from the revaluation of deferred tax liabilities in connection with the Tax Cuts and Jobs Act of 2017, that's exactly what would have happened.

UMPQ reported net income of $1.11 per diluted share, or $245.9 million, in 2017, up 5.7% from $1.05 per diluted share, or $232.8 million, in 2016. Pre-tax income, however, was down about 6.5%, or $23.7 million, to $342.0 million from $365.7 million year over year. UMPQ was able to show an increase in net income, due primarily to the revaluation of the net deferred tax liability. Taxes declined 27.7%, or $36.8 million, from $132.7 million in 2016 to $95.9 million in 2017 as the company's effective tax rate dropped from 36.3% to 28.1%. Adjusted for the same effective rate incurred in 2016, UMPQ's net income would have been down about 6.4%, or $15.0 million, to $217.8 million, or $0.98 per diluted share, from $232.8 million, or $1.05 per diluted share, in 2016. This would have been the first down year for EPS since 2014.

Comparing 2016 and 2017

The proximate causes for the $23.7 million decline in pre-tax income were: 1) a $21.6 million decline in residential mortgage banking revenue, 2) a $13.3 million increase in salaries and employee benefits and 3) a $9.2 million increase in other expenses. A deeper, underlying cause is the stagnation in net interest income after the loan and lease loss provision, up only 1.2%, or $9.2 million, year over year.

Mortgage banking is extremely important to UMPQ, providing 14.3% and 12.5% of all income before expenses, other than the provision for loan losses, in 2016 and 2017, respectively. To borrow a phrase, if you live by mortgage banking, you die by mortgage banking; volatility comes with the business. As a prime example, mortgage banking revenue was up 26.5%, or $33.1 million, from $124.7 million in 2015 to $157.8 million in 2016, but down 13.7%, or $21.6 million, the very next year. The decrease was market-driven in volume and pricing; loan sales were down 14%, and the margin recognized as gain on the sale of loans fell to 3.51% from 3.72% in 2016. This decrease in revenue was partially offset by $4.6 million in increased loan servicing income and a $2.7 million smaller loss on the write-down to fair value of mortgage servicing rights ("MSR"). In the previous year, the $33.1 million increase in revenue was largely the result of a 14% increase in loan sales.

The 3.1%, or $13.3 million, increase in salaries and employee benefits resulted from increases in insurance costs, employee profit sharing and retirement benefits, as well as an increase in full-time equivalent employees. A portion of the increase resulted from increased compensation for staff at Pivotus, UMPQ's Silicon Valley research center. Interestingly, Pivotus contributed $2.5 million in "collaboration income" to 2017 non-interest income. There is not much to criticize in a 3.1% increase in compensation costs in an economy with a rapidly dropping unemployment rate.

Other expenses increased 19.9%, or $9.2 million, in 2017 as compared to 2016 due to a $2.6 million increase in brokered deposit fees, a $1.3 million increase in exit and disposal costs related to branch consolidations, a $1.5 million increase in charitable contributions and a $1.1 million increase in net non-performing loan expenses. The only mild worries here are the increased amounts being paid to brokers for procuring large CDs and the higher expenses related to non-performing loans.

The following table provides a complete comparison of the 2016 and 2017 income statements.

UMPQ has been suffering from margin compression. Net interest income after the provision for loan and lease losses was $812.6 million in 2017, up 1.2%, or $9.7 million, from $802.9 million in 2016. The small gain was the result of volume changes as the net interest margin declined from 4.04% to 3.90% year over year due to an 11 bps decline in the yield on interest earning assets, combined with a 3 bps increase in the rate on interest-bearing liabilities as a percentage of earning assets. Average interest earning assets increased $1.2 billion, or 5.6%, from $21.0 billion in 2016 to $22.2 billion in 2017, compared to the $384.0 million, or 2.7%, increase in interest-bearing liabilities from $14.3 billion to $14.7 billion over the same period.

The consensus wisdom is that gradually rising rates are a good environment for bank earnings, but so far, that does not appear to be the case for UMPQ. Net interest income after the loan and lease loss provision peaked in 2015 at $835.0 million when the net interest margin was 4.44%. While the composition of interest earning assets and interest-bearing liabilities has not changed materially over the 2015-2017 period, the yield on interest earning assets dropped 49 bps, while the cost of interest bearing liabilities rose 11 bps, producing a 60 bps decline in net interest spread and a 54 bps decline in net interest margin during a period of generally rising rates.

As the table above indicates, a rapidly falling average loan yield has been the primary reason for the decline in net interest spread and margin. On average, loans and leases comprised about 80% of interest earning assets in 2015 and 82% in 2017. The average yield on loans fell 71 bps over the same period. It appears that older, fixed-rate real estate loans at higher yields have been refinancing or maturing out of the loan portfolio and have been replaced by new fixed-rate loans with lower rates or floating-rate loans with tighter spreads. The net interest margin is showing signs of stabilizing, however, as the loan portfolio yield declined 55 bps from 2015 to 2016, but only 16 bps from 2016 to 2017.

UMPQ has been able to grow loans and deposits at a reasonably strong pace. Since the Sterling Financial acquisition in 2014, loans and leases have increased at a 7.7% CAGR, from $15.3 billion in 2014 to $19.1 billion in 2017. Deposits grew at a 5.6% CAGR, from $16.9 billion to $19.9 billion over the same period.

(Source: UMPQ Q4 2017 Earnings Presentation)

UMPQ's 95.6% loan to deposit ratio is on the high side of its 93.4% average since 2014, but the bank has traditionally relied on efficient deposit funding for its loans. According to a recent Forbes article:

A combination of prudence and regulatory requirements suggests that for a traditional bank, the LDR should be around 80-90%.

While the company has been emphasizing commercial and industrial loans to achieve some diversification, the loan portfolio was 75% real estate-related at the end of 2017.

Credit Quality: Excellent

Although some credit quality ratios ticked up slightly in 2017, UMPQ's asset quality appears excellent. The bank has a strong credit culture, as evidenced by repeatedly receiving FDIC approval to take over failed banks.

(Source: UMPQ Q4 2017 Earnings Presentation)

Retail Banking: A Lasting Competitive Advantage?

There is no doubt that Ray Davis's unique customer-focused retail banking strategy helped UMPQ transcend its small-town southern Oregon roots, but has it produced a lasting competitive advantage? To test whether the retail banking strategy is working, we can explore employee and customer attitudes, average deposits per branch, core deposits as a percentage of total deposits, reliance on brokered CDs, cost of deposits versus peers and non-interest expense.

Social media allows us to take some admittedly unscientific samples of bank employee and customer attitudes. The bank's employees - most of whom labor in the branch network - provide a lukewarm assessment. UMPQ's website career section tells employees to "Be part of a bank that invests in you," but on Glassdoor, a sampling of 241 employees give the bank an overall 3.1 rating (out of 5), compared to 3.5 ratings for huge competitors Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC) - not known for being warm, fuzzy places - where the number of employee reviews exceed 19,000 each. Sampling Yelp reviews for UMPQ branches in various cities produces the same dispersion of results as for any other bank, with the exception of a series of four- and five-star branches located in Seattle.

An old banking rule of thumb was that branches over $50.0 million in deposits were profitable and branches over $100.0 million in deposits were ideal. Many of UMPQ's branches are in rural or small-town locations. As a result, its 311 branches' average of $64.1 million in deposits compared to the $131.0 million average for all FDIC-insured institutions as of June 30, 2017 - with the proviso that the FDIC average is skewed by the big city mega-branches of money center banks.

Turning to core deposits (per the FDIC: the sum of demand deposits, all NOW and ATS accounts, MMDAs, other savings deposits and time deposits under $250,000, minus all brokered deposits under $250,000), UMPQ's retail network maintains a significant advantage over a Peer Group of 23 similar banks with between $20.0 billion and $30.0 billion in assets.

As of December 31, 2017, 92.8% of UMPQ's total deposits were FDIC-classified core deposits, compared to 84.7% for the Peer Group average. The bank benefits from a sizable advantage in non-interest bearing deposits, e.g., no-interest checking accounts, which comprised 33.0% of total deposits versus 26.7% for the Peer Group. Counting non-interest and interest-bearing demand deposits, UMPQ's advantage was even larger, with all checking accounts accounting for 44.9% of total deposits, compared to 28.8% for the Peer Group.

Note that the Peer Group was also more dependent on "hot money," with large CDs greater than $250K and brokered deposits accounting for 5.7% and 12.0% of deposits, compared to 3.1% and 4.6%, respectively, for UMPQ. Although not broken out in the table above, as of December 31, 2017, total brokered deposits comprised $930.9 million of UMPQ's total deposits, down 6.9% from $1.0 billion in 2016.

In 2017, UMPQ's average cost of interest-bearing deposits was just 35 bps. In comparison, mammoth BAC, with arguably the best branch network in the US consisting of about 4,500 "financial centers," reported an average cost of interest-bearing deposits of 28 bps. Including non-interest bearing deposits - in effect, the cost of all deposits gathered by the branch network - UMPQ paid 24 bps as the average rate on all deposits in 2017, compared to BAC's 15 bps. Expressed in a manner encompassing all funding sources, in 2017, the bank's cost of funding earning assets (per the FDIC, the annualized total interest expense on deposits and other borrowed money as a percent of average earning assets on a consolidated basis) was just 28 bps, compared to the 51 bps Peer Group average.

It's apparent that UMPQ's retail branch network, even though widely scattered and lacking dominant deposit share in any market, is better than that of its same-size competitors at gathering low-cost deposits. The network, however, does come at a cost. Compared to its Peer Group, UMPQ's non-interest expense was 2.87% of average assets versus 2.53% in 2017. The bank also had a higher efficiency ratio in 2017 than its Peer Group: 62.50% versus 55.14%. Surprisingly, BAC reported a 62.67 efficiency ratio in 2017. While there may be multiple reasons for these higher ratios, e.g., UMPQ's brokerage and mortgage banking operations, they are at least indicative of higher costs to serve customers, especially the Peer Group data, where differences in operations tend to cancel each other out.

With more core deposits, more non-interest bearing deposits, fewer brokered deposits and a lower overall cost of deposits, UMPQ's retail branch network maintains some significant advantages over that of its same-size Peer Group. Although our "social media" data is subjective and unscientific, employee and customer attitudes toward the bank appear mixed. While UMPQ appears to give back some of its low-cost deposit advantage in higher operating expenses, the branch network's deposit cost advantage is worth something on the order of $51.0 million per year before accounting for incrementally higher branch network costs, if any, compared to its Peer Group.

Performance: EPS, Dividends, Shareholder Returns and Capital

The table below presents statistics associated with different ways to measure UMPQ's performance for shareholders and its capital position.

Reported EPS increased at a 4.8% CAGR, from $1.01 per share in 2015 to $1.11 per share in 2017, shadowed by dividends per share, which increased at a 4.7% CAGR from $.062 to $.068 over the same period. As we discussed earlier, EPS would have decreased to $0.98 per share without the revaluation of deferred tax liabilities in connection with the Tax Cuts and Jobs Act of 2017. Other things being equal, the new, lower 21% corporate tax rate should obviously help UMPQ's earnings in 2018. The dividend payout ratio reported for 2017 was a reasonable 60.71% but would have edged into questionable territory at about 69.39% without the GAAP adjustments required to conform to the new corporate tax rate.

On September 14, 2017, UMPQ increased its dividend 12.5% from $0.16 to $0.18 per share. On March 15, 2018, the bank announced a surprising additional increase in its dividends per share of 11.1%, from $0.18 to $0.20 per quarter, for an $0.80 per share annual rate. Without further increases, 2018's payout should be $0.78 per share. Based on 2017's reported EPS, this would equate to a 70% payout ratio. Ron Farnsworth, CFO, stated during the Q4 2017 conference call that the bank was sharing about 35-40% of the increased cash flow resulting from the new lower tax rate mandated by the Tax Cuts and Jobs Act of 2017 with shareholders as increased dividends.

UMPQ lags its FDIC Peer group in returns on assets and equity. For the year ended December 31, 2017, the Peer Group average ROA and ROE were 1.09% and 8.96%, respectively. UMPQ reported an ROA of 0.98% (0.87% adjusted) and an ROE of 6.20% (5.49% adjusted). According to the St. Louis Fed, the average ROE for all US banks in 2017 was about 9.17%. UMPQ reported an 11.45% (10.15% adjusted) return on tangible (omitting goodwill, etc.) equity compared to the Peer Group's 12.8%.

Umpqua Next Gen: No, It's Not a New Chinese Smartphone

Bank management clearly realize that UMPQ's financial performance is unexceptional. Accordingly, during the Q2 2017 conference call, CEO O'Haver introduced Umpqua Next Gen. No, it's not a new Chinese smartphone, it's a revitalization plan for the bank:

Our goal is to modernize the Company to become an even smarter or customer centric and more profitable bank. It represents an evolution of Umpqua Bank, not a change to its core strategy. We'll transform how we do business providing a unique customer experience, offered seamlessly across [the bank] and delivered in a way that benefits customers, associates and shareholders.

During the Q3 2017 conference call, O'Haver elaborated:

At the center of this is a new strategy we're calling human digital banking; this strategy uses technology to build our Umpqua's customer centric brand and culture to differentiate us in the market place with a new competitive advantage. Through Next Gen we'll activate our mission providing personalized banking for all anytime, anywhere. Our goal is to come out an even smarter, more customer centric and more profitable institution. We believe the benefits to our shareholders, customers and associates are significant. A big part of this strategy will include reducing and redeploying expenses across the organization and becoming more efficient in our delivery.

The end goal is to raise ROA and ROE to the 1.2-1.4% and 14.5-17.0% ranges, respectively, depending on the rate environment. To achieve higher returns, management plans to target net interest margins of 3.65-3.75% in a flat rate environment and 3.90-4.00% in a rising rate environment, while reducing the efficiency ratio to the low to mid-50s, once gain dependent on the rate environment. The recipe? The well-worn path of cost cuts, branch consolidation and growth in ancillary non-interest income product lines. The following slide from the Q3 2017 conference call provides more detail:

(Source: UMPQ Q3 2017 Conference Call)

Management deserves credit for taking action to improve shareholder returns. Time will tell if this recipe is as tasty as a cup of that free coffee.

(Source: leoketel.com)

Plenty of Capital

UMPQ meets the FDIC regulatory definition of a "well-capitalized" bank, easily exceeding the threshold ratios for that designation. As a result, its returns on equity are somewhat penalized by "excess" equity in the denominator of the capital ratios. For example, at the end of 2017, the bank's Tier 1 capital and total capital ratios were 11.07% and 14.06%, compared to the 8.00% and 10.00% thresholds.

Valuation

At its closing price of $20.98 per share on April 2, 2018, UMPQ sells for 18.9x 2017's reported $1.11 per diluted share EPS and 15.5x the consensus 2018 estimate of $1.35 per diluted share. Based on year-end book and tangible book value per share of $18.24 and $9.98, price-to-book is 1.15 and price-to-tangible book is 2.10.

UMPQ data by YCharts

The dividend yield was 3.81% based on the March 15 increase to $0.80 per year and 3.72% based on the expected 2018 payout of $0.78 per share.

Conclusion: Buy the Ice Cream

UMPQ is a well-run bank; well-capitalized with excellent credit quality and a good deposit base, but hampered by lower-than-average returns to shareholders. Mortgage banking has provided a boost to income, but rates are generally conceded to be rising, and accordingly, the rate of SFR borrowing will slow and mortgage banking income may decline.

The bank is drifting a bit after the departure of charismatic CEO Ray Davis, and management deserves credit for taking action with the Next Gen plan. While Next Gen is a laudable effort, it is doubtful if it will be enough.

UMPQ is a "tweener;" not a community bank, not a major regional, with no critical mass of deposit market share anywhere in its geographically widespread service area, and nothing to really distinguish its product offerings - other than a unique retail branch culture. With 75% of its loan portfolio in real estate loans and a strong bank core deposit franchise, UMPQ's balance sheet is like a combination of an old savings and loan with a community bank.

In terms of strategy, the company could 1) find more "bolt on" small bank acquisitions to build share in, for example, the Portland or Seattle areas, 2) acquire or merge with another Sterling-type bank; maybe Zions Bank (NASDAQ: ZION), with a complementary footprint, or 3) become a target for a bank with a similar footprint seeking to take the next step; perhaps U.S. Bank (NYSE: USB) as it seeks to move into the first tier from its perennial fourth place spot in US banking.

At its current $20.98 price per share, the stock is not a compelling buy, as an investor will be waiting for Net Gen to boost performance or for M&A activity to provide significant returns. On the other hand, the board of directors' agreement to quick successive dividend increases indicates confidence - or a payout strategy that's over its skis. After Q1 2018, if there is better earning visibility and the stock drops to provide a 4.50% or better yield, it may be time to reconsider, but for now, buy some Umpqua Ice Cream, not the stock.

Analyst’s 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.