Diligence Matters

1 Response to "Diligence Matters"

• Italo Mendonca

  May 31, 2023

  Adding further research/commentary based on member Robert Brammer’s question on Zions’ declining deposits. On May 29, 2023, Robert mentioned “[…] you do not discuss the sharp decline of 23+% in their core deposits for the past five quarters. They have increased their non-core deposits by more than a factor of ten in that period to offset the decline in core deposits. This will increase their costs and may slow their earnings growth.”

  Here’s our response:

  Robert, your question/concern is extremely valid. I think the answer is two-fold: first, the trends you’re pointing out in deposits, both core and non-core, represent more of a return to normality than anything else. If we’re looking strictly at the last five quarters, the trend we observe is incomplete – it misses the fact that deposit growth during the pandemic was unprecedented, and we’re likely just seeing the ‘unwind’ of some of this growth in an environment of higher interest rates. Deposit numbers still look healthy compared to before the pandemic.

  Second, As Zions’ CEO mentioned in the last earnings call, this may be a case of ‘the Fed giveth, and the Fed taketh away’. In other words, as the Fed changed course from its zero-interest-rate policy, it is unavoidable that non-core deposits would rise as depositors look for the highest return on their capital and forget about brand loyalty to some extent. And this is probably the case across the industry, not just with Zions.

  I think you’re 100% right in that this increase in the cost of funding could slow earnings growth in the near and medium term. Our view on Zions comes from the fact that the market expectation for earnings growth (as expressed by the price-to-economic-book value metric) is too pessimistic. At 0.2, Zions’ PEBV implies that earnings will permanently fall by 80% – we think this is too extreme given the company’s track record and growth trajectory. Here are a few reasons why we like the risk/reward for Zions:

  – though the total cost of deposits is indeed going up, both net interest income and net interest margin (which paint a more complete picture of the bank’s core business) are on the rise. Net interest margin increased from 2.60% to 3.33% from 1Q22 to 1Q23, and net interest income rose 25% YoY to $679 million in 1Q23.

  – Zions’ retention of uninsured deposits compared to its peers is a testament to the bank’s low exposure to risky sectors of the economy, such as venture banking. Whereas the sum of PacWest and Western Alliance’s uninsured deposits made up 124% of Zions’ uninsured deposits in 4Q22, that figure dropped to 75% in 1Q23 as uninsured deposits of the former two effectively halved.

  – According to S&P Global, Zions had the lowest average cost of total deposits and cost of total funding, among a group of regional banks and large U.S. banks. The cost of total deposits in 2022 was ~25 bps below the peer median, and under higher interest rate environments (Fed Funds > 3%), Zions’ cost of deposits and total funding has averaged ~40 bps below the peer median. We see this as a great competitive advantage that will shield net interest and NOPAT margins in the medium term.

  – The exposure to concentrated accounts with large balances is much lower for Zions compared to its peers. At the end of 2022, Zions’ average balance for accounts exceeding $250k was $1.1 million – much lower than the $1.5 million peer average, and Silicon Valley Bank’s $4.2 million. The top 25 largest uncollateralized deposit accounts made up just 3.7% of total deposits. Consumer accounts have minimal exposure to balances >$25 million, and commercial accounts have virtually no exposure north of $200 million.

  – Commercial Real Estate is indeed a ‘canary in the coal mine’ that we’re watching closely. One of the reasons we picked Zions as a Long Idea was the company’s decision to rein in CRE lending when times were good. From the 1Q23 earnings transcript: “Since late 2017, we’ve grown commercial real estate (CRE) loans a total of 9%… well below the roughly 45% organic increase seen at the median of our peers. In order to engineer this slower growth, we’ve employed more rigorous underwriting standards than many of our peers”. The company’s CRE Office loans (a vulnerable sector within CRE) stand at less than 4% of total loans. We think Zions stands to benefit from its disciplined underwriting now that the tide has turned.