Umpqua Holdings: Drifting Up With A 5.3% Yield

Oct. 21, 2019 12:53 AM ETUmpqua Holdings Corporation (UMPQ)11 Comments
Herding Value profile picture
Herding Value
854 Followers

Summary

  • $27.9 billion-asset Umpqua Holdings is one of my higher risk/higher income “deep value” bank stock holdings.
  • The bank is suffering from a margin squeeze, but earnings are holding up fairly well.
  • The dividend looks sustainable at a "worst case" adjusted 64.7% for YTD 3Q 2019.
  • The bank’s recent price of $15.86 per share equates to .81 x book, 1.41 x tangible book, a P/E of 9.9, a forward P/E of 10.8 and a 5.30% yield.
  • At 5-year lows in P/E and price x tangible book, UMPQ is a reasonable buy for value investors with a 3-5 year investment horizon.

I have a position in Umpqua Holdings Corporation (NASDAQ: NASDAQ:UMPQ) that’s down 9.28% as of October 18, 2019. I consider it one of my higher risk/higher income “deep value” bank stock holdings - and I watch it pretty closely.

Source: Vancouver Business Journal

My chief concern is whether earnings will support continued payment of dividends because I like getting paid to wait for valuation to catch up with value. So, am I going deeper under water or will value begin to emerge from the depths? I’m going to review the recently announced third-quarter earnings to see.

UMPQ: Quick Review

If you’re new to UMPQ, besides having one of the stranger names in banking, it’s a $27.9 billion-asset, Portland, Oregon-based community bank. The bank has significant deposit market share in Oregon, Washington and Northern California, but also maintains branches in Idaho and Nevada. In another time and place, UMPQ would have been called a savings and loan, as only about 24% of the loan portfolio as of September 30, 2019, consisted of “true” commercial bank loans, the rest is real estate of one sort or another. I find the bank interesting primarily for its location in the faster-growing Pacific Northwest, potential as a bite-size M&A target, progressive customer service culture, relatively conservative management and, of course, its dividend.

Down In a Relative Sense

Over the trailing 12 months as of October 18, 2019, the stock was down 19.98% compared to 4.21% for the Invesco KBW Regional Banking ETF (NASDAQ: KBWR). Back on September 1, 2019, the stock was down 26.6% compared to 19.3% for the ETF; so in relative terms, although I am personally now down less, its price under-performance has increased!

ChartData by YCharts

Let’s take a look at the most recent nine months' performance of the bank - and peek at the most recent quarter - and see if we can identify the weak spots; and for those of you “fast money” traders, remember, I am primarily a 3-5 year buy-and-hold investor.

3Q 2019: A Blah Quarter

Here’s how the October 16, 2019, UMPQ Press Release described UMPQ’s 3Q 2019:

If you look closely, you’ll see net income and EPS were down compared to both 2Q 2019 and 3Q 2018. That’s not what I would call a good result. Rather than walk you through 3Q 2019 alone, which wouldn’t provide you any perspective if you’re not following the bank, I’m going to focus on where UMPQ stands after three quarters of 2019 - and work in commentary on 3Q 2019 around the edges.

Earnings Comparison

After reformatting and some condensing, here is a comparison of the nine months ended September 30, 2019, to the prior period:

In the financials above, from top to bottom, I’ve highlighted “good” numbers in green and “bad” numbers in yellow.

Net Interest Income: Running Hard to Stay in Place

Running hard to stay in place describes UMPQ’s YTD 3Q 2019 net interest income; the bank reported a $2.6 million or 0.37% increase period over period. That’s not much of an increase for a bank that grew assets 8.7% over the same period. Incidentally, 3Q 2019’s net interest income did a little better; increasing $1.8 million or 0.80% over sequential 2Q 2019 - a good sign. On a YTD 3Q 2019 basis, the problem is not in interest income where the first green area marks a solid increase of $68.7 million or 8.80% over the prior nine-month period. There were increases in both the average balance and yield of the loan portfolio; YTD 3Q 2019 compared to YTD 3Q 2018, the average loan portfolio balance was up $1.3 billion or 6.5% and the average yield was up 15 bps to 5.02%. That’s decent growth, so what’s the problem?

Like so many banks I review in this rate environment, the issue is fast-rising interest expense squeezing the net interest margin. The first item in yellow indicates a mammoth 97.5% rise in cost of deposits from $62.6 million to $123.6 million, an increase that coincides with a period when the yield curve was heading toward inversion. Let’s check the structure of deposits and see exactly what accounted for this increase. Funding growth seems to be a bit of an issue as management pushed interest-bearing accounts, specifically MMDAs and CDs. Between YTD 3Q 2018 and YTD 3Q 2019, the average balance of money market accounts increased $812.2 million or 13.2% - and the rates paid popped 50 bps from 0.44% to 0.94%. Average balances of more expensive time deposits went up $607.1 million and the cost of these time deposits also soared 61 bps, from 1.65% to 2.26%. The second yellow area shows the impact of rising deposit expense on overall interest expense which was up $66.1 million or 74.1% over the prior period.

To summarize, long-suffering savers benefited at the expense of UMPQ’s net interest margin. The net interest margin dropped 22 bps from 4.00% YTD 3Q 2018 to 3.78% YTD 3Q 2019. There are some signs of stabilization as the net interest margin dropped just 7 bps between 2Q 2019 and 3Q 2019. UMPQ resembles an old savings and loan; funding short and lending long. For much of the first three quarters of 2019 the inverting yield curve raised short rates on deposits relative to longer or slower-adjusting yields on loans. Management “made it up in volume” as the difference between average interest-earning assets and average interest-bearing liabilities widened slightly to $8.0 billion YTD 3Q 2019 compared to the prior period. If the margin continues to compress, and management can’t continue to offset it with asset/liability management, net interest income comparisons will start to turn negative.

Did We Really Need That Loan Loss Provision?

Just when I thought we’d scrape by with a miniscule increase in net interest income, management drops the hammer with a YTD 3Q 2019 $17.6 million or 45.4% increase in the loan loss provision over the prior period indicated in the third yellow area. Ouch! As a result, net interest income after the provision was down $15.0 million or 2.3% over the comparable period. As CEO Cort O’Haver explained during the 3Q 2019 Conference Call:

We've traditionally historically operated with a pretty short fuse relative to problem credits and that hasn't changed under my leadership, our credit folks are instructed if we see an issue just deal with it as quick as you can and run it through and if we can collect it later great.

Management increased the provision to match higher loan production and react to what CFO Ron Farnsworth called “a small uptick in net charge-offs.” Management might be looking farther ahead as I don’t see any signs of credit quality deterioration.

In spite of the pain, I applaud management for targeting an allowance equal to 1.00% of loans and leases for 2020. The $23.2 million provision for 3Q 2019, an increase of $3.9 million from the prior quarter, was part of the effort to build reserves to that level. At 3Q 2019, the allowance for loan and lease losses was $156.3 million, or 0.73% of loans and leases, up slightly from $151.1 million, or 0.72% at 2Q 2019. For comparison purposes, UMPQ’s FDIC peer group average at 2Q 2019 (most recent data available) was 1.15%. The effort to build reserves was hampered by a 3Q 2019 charge of $3.6 million related to one account working through the system.

UMPQ seems pretty well reserved when you consider that the total $161.4 million allowance for credit losses (including reserves for unfunded commitments) was 226.0% of nonperforming assets at 3Q 2019 compared to 148.9% at 3Q 2018 when NPAs were actually $28.3 million higher. At 3Q 2019 quarter-end NPA’s were only 0.25% of total assets, compared to 0.28% at 2Q 2019 and 0.37% at 3Q 2018. Although management has not said as much, I suspect they might be on board the recession in 2020 boat.

Residential Mortgage Banking Revenue

The fifth yellow-marked area shows that residential mortgage banking income declined from $103.1 million in the prior period to just $67.8 million. Fluctuating interest rates slammed this business: mortgage originations for sale declined 11%, the margin on loans sold dropped 25 bps, and there was a $34.4 million write-down of the value of mortgage servicing rights (“MSR”). In general, MSRs lose their calculated present value when rates fall as loans prepay faster than previous assumptions, hence the write-down.

There was a welcome bounce back in 3Q 2019, however, as revenue from the origination and sale of residential mortgages was $31.4 million, an increase of $8.3 million from the prior quarter. The increase reflected a sequential-quarter increase of 21% in for-sale mortgage origination volume and an increase of 40 bps in gain on sale margin. Given the choppy rate environment, it’s unlikely that this is a sustainable trend.

Gain on Sale: Turning Plastic Into Earnings

The sixth yellow area highlights a classic raid on the old cookie jar; UMPQ sold all of its holdings of Visa Inc. Class B common stock (NYSE: V) for a one-time gain of $81.9 million during Q2 2019. That gain, plus some other gains, produced the rather extraordinary $85.5 million in securities gains used to offset the decline in mortgage banking income, the $7.2 million loss on the sale of some debt securities and the $11.4 million decline in other income (see below).

In another harvesting of embedded gains, on July 19, 2019, UMPQ signed an indication of interest to sell MSRs for $3.7 billion of mortgage loans with an expected 4Q 2019 close. With minimal impact on 2019, this transaction enables UMPQ to realize gains that might evaporate with further MSR write-downs.

Other Income

Finally, the last item highlighted in yellow is a decline in other income, down a sizable $11.4 million from the nine-month prior period. Management blamed a $7.9 million decline in the value of a swap derivative on falling long-term interest rates during the period. There was also a closely related $4.6 million decrease in debt capital market swap fee revenue, due to the timing of loan originations.

Non-Interest Expense: Orwellian Initiatives

YTD 3Q 2019, management squeezed a $25.4 million or 4.52% decline out of noninterest expense; the bulk of it, $11.9 million in salaries and benefits, coming from UMPQ employees visiting a new office on Monday and another $5.0 million in reduced occupancy costs due to branch closures.

Source: kykn.com

According to CEO O’Haver on the 3Q 2019 Conference Call:

Our operational excellence initiatives continue to generate results. Collectively they have contributed to $26 million or 5% decline in our total management expenses when comparing year-to-date 2019 to year-to-date 2018.

The “operational excellence initiatives” O’ Haver mentioned are essentially a combination of traditional cost-cutting and the bank’s “Go-To Banking” platform. Here’s how The Financial Brand described “Go-To Banking” on October 8, 2018:

Following a 10-month pilot, Umpqua is launching a system wide rollout of its unique “human digital banking” platform that it calls “Go-To Banking,” a mobile app that essentially puts a banker in everyone’s pocket. All you have to do is press a button and you can be chatting with your own dedicated personal banker. You could call it an “anti-bot alternative” - Umpqua’s countermeasure to combat fintechs and other competitors who are aggressively pursuing tech-heavy, AI-saturated strategies.

As far as I can tell, “Go-To Banking” means you can text a dedicated UMPQ customer service representative who will, in theory, solve all of your banking problems, sort of a “concierge” approach to mobile customer service. It apparently requires fewer staff. Here’s O’Haver again on the 3Q 2019 Conference Call:

Phase 2 of our operational excellence initiatives are underway. It will continue to progress made to date on reducing non-interest expense. In addition, recognizing the broader rate environment, management is currently reviewing additional opportunities for a Phase 3 initiative, currently sized and at additional 3% to 5% of our expense base. I look forward to providing detail on those components and timing of those efforts starting on the January call.

As Go-To adaption builds momentum, we continue to optimize our physical footprint. Last quarter we announced that we would be consolidating an additional eight locations. This will bring our store rationalization number to 65 since Q3 of 2017. As always we continue to measure and evaluate performance on all stores and as highlighted previously we are seeing solid deposit growth across the board. Our focus for the rest of the year is to continue to deploy Go-To, grow deposits and finish the previously mentioned consolidations. We will provide an update on future store rationalization plans in early 2020.

I include all of this “CEO-speak” about what is basically firing people, closing branches and replacing both with technology as it has a bearing on how efficiently management is operating UMPQ. UMPQ faces the problem faced by most emerging regional multistate “community” banks; how to cost-effectively provide all the bells and whistles of modern banking while lacking scale economies enjoyed by larger banks with similar geographic footprints. Typically, this leads to bloated efficiency ratios. The “Go-To Banking” program is an interesting attempt to address this issue - although painful for employees who lose their jobs.

Cost-cutting appears to be working as UMPQ’s efficiency ratio YTD 3Q 2019 was 56.31%, down significantly from 61.29% for the comparable period in 2018. This doesn’t tell the whole story as revenue, the denominator for the ratio, was “artificially” boosted by a few one-time gains, thereby lowering the ratio. UMPQ has a way to go as, in comparison, its FDIC peer group reported a 54.37% average efficiency ratio for the first half of 2019.

Is the Dividend Sustainable?

To help manage my stress level, the table below has become a regular quarterly “quick and dirty” analysis where I assume the worst wherever possible. Here’s my table:

When I performed this analysis YTD 2Q 2019, I calculated a 50% payout ratio on unadjusted numbers (calculated as dividends per share divided by EPS), now I get 51.4%. Obviously, both those numbers rely heavily on the one-time gain on the sale of Visa shares. At that time, I opined that if “they don’t have more MSR write-downs, an analytical imponderable involving a rate forecast, then maybe the true worst case based on YTD 2Q 2019 is really a payout ratio of 65% to 70%.” The other one-time, non-cash and up-and-down items I considered as adjustments appeared to generally cancel each other out, at least for a “quick and dirty” analysis like this one. As of today, I think the adjusted 64.7% above represents the bank’s payout ratio pretty well and, so far in 2019, I would consider UMPQ’s dividend as sustainable, but - with the same caveat as for YTD 2Q 2019 - pretty close to the edge of the comfort zone.

Conclusion

Since January 2019, UMPQ’s stock has been range-bound between roughly $15 and $18 per share; there’s no earnings momentum and surprises might be to the downside. The bank’s recent price of $15.86 per share, however, equates to .81 x book, 1.41 x tangible book, a P/E of 9.9, a forward P/E of 10.8 and a 5.30% dividend yield. In addition, look at the charts below:

ChartData by YCharts
ChartData by YCharts

UMPQ’s trading at 5-year lows in P/E and price x tangible book. I repeat what I said after 2Q 2019, the bank looks like a reasonable buy at the current price. UMPQ is located in the Pacific Northwest, has a clean balance sheet that is arguably improving, a conservative management focused on progressive customer service, potential as a bite-size M&A target and that dividend which - for now - looks sustainable. Patience over the next 3 to 5 years will be rewarded.

This article was written by

Herding Value profile picture
854 Followers
Former corporate executive.

Disclosure: I am/we are long UMPQ. 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.

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