Diving Into Columbia – Here’s Why (NASDAQ:COLB)

Merger Background

• On October 12, 2021, Columbia Banking System, Inc (NASDAQ:COLB) and Umpqua Holdings Corporation (NASDAQ:UMPQ) announced a merger of equals.
• The joint press release included impressive financial numbers justifying the merger. My view is that these numbers are reasonable.
  • Target a 15% Return on Average Tangible Book Value
  • Target a 1.3% Return on Average Assets
  • Expect “synergized net income” of $700 million+
  • Cash EPS accretion expected to be 25% for Columbia and 11% for Umpqua.
  • GAAP EPS accretion expected to be 23% for Columbia and 8% for Umpqua.
  • Expect to generate $260 million in “excess capital” when fully merged.
  • Target 12.5% ($135 mill.) reduction in combined non-interest expenses; highly achievable.
    • COLB NIE 3Q 2021 = $257.7 mill. 3Q 2021 YTD = $343 mill. annual, COLB NIE 3Q 2022 = $301.9 mill. 3Q 2022 YTD = $401.5 mill. annual
    • UMPQ NIE 3Q 2021 = $560.7 mill. 3Q 2021 YTD = $745.7 mill. annual, UMPQ 3Q 2022 = $540 mill. 3Q 2022 YTD = $718 mill. annual.
    • Combined 3Q 2021 annual = $1.09 bill. * 12.5% = $136 mill.
    • Combined 3Q 2022 annual = $1.19 bill.

Stock Price Action Since Merger Announcement

Since October 11, 2021, the day before the Columbia-Umpqua merger was announced, Columbia’s shares are down -27.5% and Umpqua’s shares are down -18.5%. In comparison, the S&P Regional Banking ETF (KRE) and the S&P 500 are down -14.4% and -8.2% respectively (as of 1/18).

Regulatory Approval Process Did Not Help

When I wrote the “Sell” article in November 2021, I did not foresee regulatory approval getting dragged out 15 months. The prolonged regulatory approval process heightened investor risk as it introduced yet one more variable to the merger equation.

I wish I knew more about the reasons for the delay, but I am guessing that the Democrat-controlled FDIC put the two banks through a number of hoops that banks did not have to pass through prior to 2021.

To put the Columbia/Umpqua 15 months in perspective, the much larger and more complex merger that formed Truist Financial Corp (TFC) was announced February 7, 2019, and received regulatory approval on November 19 of the same year. The merger closed in December 2019.

Key Points from November 2021 “Sell” Article

My article included my thoughts on what I am looking for before investing in Columbia:

1. The new bank must maintain Columbia’s strategy and business model.
2. The new bank must maintain Columbia’s risk profile.
3. Price to Tangible Book <1.5x.
4. Purchase Price Target: $27-$29.

January 2023: What We Know & Don’t Know

Sources: Columbia’s October 3Q 2022 earnings call and 3Q 10-K:

Merger Disruption

Per Columbia CEO, CFO, and COO:

• Regulatory Approval: The “protracted approval timeline has allowed for additional planning and scheduling of [MOP] conversions and things.”
• Separate Companies: “It’s been a few months since you’ve seen me, but my hair continues to get whiter. And I think part of that is the challenge that we have is we’re still running two separate companies.”
• Loss of Key Employees: “I think the pace or the number of departures in the third quarter were much lower than what we saw in the second quarter. Nothing that, I’ll say, from a customer-facing perspective or direct support of our production capacity elevates to the threshold we’ve put in place of regrettable attrition or turnover.”

Loan Production/Relationship Banking

• C&I and CRE Loans: “There’s still transactions that are going on. There’s plenty of C&I. There’s plenty of CRE as well. And as I mentioned, we’re trying to hold the discipline to pricing and then certainly have always followed our discipline with Andy at the helm of our conservative underwriting and being prudent on that, knowing that, yes, the environment could change dramatically on us. And I think we’re in a good position there.”
• Relationship Banking: “We also continue to bring in some new relationships. It’s not as — not at the same pace and level that we are accustomed to historically, but we’re still winning new relationships. And I think that’s really important and a sign to how not only our bankers, but our clients are seeing the opportunities of the pending combination and the products and services and the complete set that we’ll have going forward, and they’re making those moves now.
• Competition: “And then there’s some other things that we can do as we bring on new business. I know our competitors would probably love for me to open the playbook up and tell them what that is. But it’s just a comprehensive approach to making sure that the clients are taken care of, communication’s open and they’re supported throughout the entire process if we’re moving from one system to another.
• 1-4 Family Mortgage Loans: “… Our mortgage team, which has never been a huge source and it’s very important to what we do, but that’s very interest rate sensitive.”

Deposits, Net Interest Margin

• NIM Spread: “Obviously, the margin trends have been very favorable. We continue to hold the line on deposit pricing as best we can. I think the team is doing really good on that front. Looking at the spot rates between June 30 and September 30, our total cost of deposits was only up 4 basis points between those two. So that leaves us a lot of room to see better expansion on the earning asset yield. So good overall trends.”
• Investment Portfolio Run-off: “… we continue to take about $60 million a month off the investment securities portfolio in terms of cash flow to fund loan growth. And that gets a pickup of about 300 basis points on that trade, and that continues to expand.”

Key Points

• Management is focused on blocking-and-tackling. This is very good and not surprising given Columbia’s and Umpqua’s seasoned and capable management team.
• Since there will be at least 17 months between merger announcement and closing (scheduled February 28, 2023), merger dust is settling, and the two banks should be well prepared for Day 1.
• Seeing NIM expansion is not surprising given Columbia’s superior relationship banking model which is associated with low-cost core deposits. Seeing loan growth is great news and evidence, I hope, that Columbia/Umpqua bankers are laser-focused on existing clients who are often under-served during a merger transition.
• Employee turnover, as expected, spiked post-merger announcement for all the usual reasons (pay differentials, heightened competitor/headhunter solicitations, fear of job loss). Management expresses confidence that turnover concerns have abated. Time will tell, as often, employees have retention agreements that keep them locked into the bank until merger close, or a time soon after.

Why I Bought COLB-UMPQ Shares

My decision to take an initial position in Columbia is based on the following:

• Merger Numbers Compelling: I have not seen any evidence that Columbia has backed-off on the target numbers outlined in the merger announcement. I find those target numbers compelling and potentially so rewarding as to mitigate the risks from the inevitability of merger disruption. In addition, I believe merger risks have decreased considerably given the amount of time that has passed since announcement. Also reducing risk is the fact that shares now sell at a price 17% lower than when I wrote the November 2021 article.
• Merger Logic Compelling: As I wrote in my first article, the merger between a Portland, Oregon large community bank and a Tacoma, Washington large community bank makes pre-eminent sense for anyone who knows the geography of the Northwest US. No more than 2.5 hours on I-5 separates the two cities. Not only are the markets of close geographic proximity, the two banks have similar branch footprints. The merger will create a true regional bank with the potential to expand banking relationships with clients across the Pacific Northwest.
• Exposure to Pacific Northwest Economy: My diversified bank investment portfolio currently has little direct exposure to the Pacific Northwest, although I do pick up some through JPMorgan Chase & Co (JPM) and Bank of America Corporation (BAC) both of which have significant presence in Oregon and Washington.
• Potential to Grow Market Share: As of 9/30/22 per the FDIC, BAC has leading deposit market share in WA (21.1%) and JPM third (12.9%): in Oregon, BAC has third deposit market share (13%) and JPM fourth (11.2%). In contrast, Umpqua has the fifth largest deposit market share in OR at 9.6% and 13th share in WA at 1.0%. Surprising to me is that Columbian holds a greater share of deposits in OR (5.13%) than in its home state of WA (4.10%). Both Oregon and Washington are dominated by big banks, so I like the chances of the new Columbia carving out a true local market niche.
• Pacific Northwest Deposit Funding Costs Favorable to US: One reason I want more exposure to Oregon and the state of Washington is because of the region’s deposit strength. Costs of deposits in both states is considerably lower than the rest of the country as of 3Q 2022 per the FDIC. My research shows that banks headquartered in Washington and Oregon typically have deposit funding costs that are ~15 bps favorable to banks headquartered in the rest of the US. I expect this cost advantage to persist, if not widen, in 4Q and 2023.
• Columbia and Umpqua are Low Cost of Deposit Banks: As I have written about several times in recent months, when interest rates go up, I want to own “Have” banks whose net interest margin benefits from rising interest rates. Per Columbia’s 3Q 2022 10-K, the bank saw its NIM expand by 31 bps quarter over quarter. Umpqua’s NIM expanded even more: 47 bps. Those are meaningful numbers that bode well for 4Q reporting.

Why I bought UMPQ last week, not COLB:

• UMPQ shares are essentially selling at par (.5958 conversion) to COLB shares which indicates that there is no arbitrage opportunity associated with the transaction at this late date.
• UMPQ pays a dividend of $0.21 that goes X-Div on Jan. 20. This dividend payment is equivalent to a 4.94% annualized dividend yield (at the blended average cost of the shares acquired last week).
• In the scheme of things, the price differential is inconsequential, but I squeezed out an estimated 2.5 cents of extra dividend per share by buying UMPQ versus COLB.
• When the merger closes, dividend payments will change (I presume) to the current dividend payment rate of Columbia ($0.30/quarter/share) which is equivalent to a 4.21% annualized yield at $28.50/share.

Monitoring Risks

My original criteria for investing in the new COLB included:

• Target price: $27-$29.
• Price to Tangible Book: <1.5x
• Adoption of Columbia business model and risk profile.

Price/Margin of Safety Risk: My first goal was achieved with an initial investment cost per share <$28.50. Is it possible share price will decline further? Of course. I am prepared to double my position in COLB when/if the price declines to $26.50 (<$16 UMPQ).

Tangible Book/Interest Rate Risk: I do not anticipate that my second goal (P/TBV <1.5x) will be achieved, as both banks have seen tangible book value erode reflecting an accounting convention that marks-to-market certain investment securities. While this accounting treatment does not impact EPS, it does create adjustments to tangible book. Likely, tangible book for both banks will decline again in 4Q, and therefore, I expect the P/TBV to be well above 1.5x of the new combined bank come March. I will be monitoring this phenomenon closely as it impacts virtually all banks. For Columbia, interest rate risk is a two-edged sword as rising rates reduce tangible book (for now) but expand net interest income. If/when interest rates fall, the adjustments to TBV will go the other way.

Columbia Business Model/Risk Profile: This is the risk that concerns me the most. Only time will tell how the board will steer the company. But based on the continued presence of key Columbia executives, I am encouraged that the board understands the advantage of not changing course. In addition, it appears, at least so far, that Umpqua’s income statement and balance sheet have undergone more material changes during the past year than at Columbia, (although Columbia has seen a big jump in pay as I predicted). I hope investors are seeing Umpqua transform its business model and risk profile to align to that of Columbia. Time will tell, but one thing is for sure, if the two companies cannot quickly and unequivocally align business models and risk profile, share price will lag the market given the uncertainty such conditions create for investors. The burden here is on the board.

Merger Execution Risk: This risk looms large for all mergers, but it is elevated with a “Merger of Equals.” I view the risk of the bank failing to meet expense targets as low; rarely do banks fail to meet merger expense targets. Of graver concern is a failure to maintain revenue momentum. Loss of key customer-facing personnel contributes to this risk, as well as the distraction that inevitably occurs when key managers turn their attention from clients to merger issues. Mitigating this risk is that the new Columbia is somewhat unique as it will be the only local “regional” bank operating in WA and OR. If the bank can carve out a niche as a high-touch relationship bank, Columbia has a big opportunity to gain market share in not only deposits, but also wealth management, corporate cash management, and commercial banking. Flawless execution and true relationship banking are the keys. As a new investor, I would trade off certain expense goals short term for the long-term annuity benefit of growing customer count and client wallet share.

4Q Earnings Reports

Columbia reports January 24. Per Ycharts:

• Six analysts (1 Buy, 1 Outperform, 4 Hold)
• Target price 1 year: $34.83 (range: $26.97 – $37.59).
• 4Q EPS estimate: $0.6083 (-29% past 30 days)
• 4Q EPS GAAP estimate: $0.718.

Umpqua reports January 23. Per Ycharts:

• Six analysts (2 Buy, 4 Hold)
• Target price 1 year: $20.05 (range: $17.87 – $22.00).
• 4Q EPS estimate: $0.5356 (+2% past 30 days)
• 4Q EPS GAAP estimate: $0.5356

I would not be surprised to see a small Earnings beat from Columbia. Similar “Have” banks (those benefiting from low-cost core deposits and loan portfolios positioned to benefit from rising rates) have beaten analyst estimates so far this month.

Caveat

The foregoing is my opinion which I share for the purpose of getting feedback and questions that challenge my ideas and assumptions.

Every investor needs to do his/her own due diligence before investing as well as determine their risk profile. I am risk-averse, preferring to invest in the nation’s best banks which reliably earn returns exceeding cost of capital.