Umpqua Undervalued Ahead Of Columbia Merger, But Expect Rerating To Take Time (UMPQ)

The Street hasn’t been particularly fond of bank M&A for some time now, and that’s understandable – a lot of banks fail to achieve the promised synergies and shareholder value creation, but few bank executives ever admit to it. Given that mergers of equals are even more complex and challenging (particularly from a workplace culture standpoint), it’s likewise understandable why the market is even more skeptical – and to be fair, recent major deals like Truist (TFC) haven’t exactly argued fiercely that that skepticism is unfounded.

This brings me to Umpqua (NASDAQ:UMPQ). I’ve liked this bank for a long time, and while I think the merger with Columbia (COLB) has an above-average chance to succeed, I nevertheless expected the Street to take a “wait and see” attitude toward the shares. And so it has been, with Umpqua shares down about 10% since my last update, underperforming its peers.

It’s going to take time for the merger to produce tangible benefits, and in the meantime, I see above-average risk of more complicated quarterly reports that challenge investors to dig through to find the “real” earnings. I believe that hassle is worthwhile, though, and I believe these shares are worth buying below the low-$20s into the close of the Columbia merger.

A Messy And Complicated Quarter

There were more than the usual number of unusual and non-core items in Umpqua’s results, so core results (at least as I calculate them) deviate more than normal from reported results. Likewise, as no two analysts ever seem to make the exact same adjustments, I expect a range of views on the “real” underlying results.

Revenue rose more than 14% year over year and almost 3% quarter over quarter by my approach, missing expectations by about 2% (or $0.03/share). Given the complexities of the quarter, referencing results to sell-side expectations is more challenging than normal this time around.

Net interest income rose about 31% yoy and 6% qoq, driven by 86bp yoy and 13bp qoq of net interest margin improvement (to 4.01%), offset by a little more than 1% of sequential earning asset contraction. Adjusted non-interest income fell 39% yoy and 17% qoq, with weaker mortgage banking doing most of the damage.

Operating expenses were down slightly from the year-ago period and up about 3% sequentially. Pre-provision profits rose 36% and about 2% qoq, and it looks like Umpqua was a little light off the Street here.

Slower Loan Growth, But Good Deposit Cost Performance

Loans grew 2.5% from the prior quarter, decelerating from the 4% growth in the third quarter and nearly 7% growth in the second quarter, and coming in a little lower than I’d expected. C&I loans grew about 2%, CRE loans about 1%, and multifamily loans by 4%, while mortgages grew 3%. Loan yields continue to improve, rising 98bp yoy and 51bp qoq to 4.92%.

Management guided to low-to-mid single-digit loan growth in 2023 and that seems reasonable in the context of what other companies are saying about the loan environment. Like many banks, Umpqua pointed to generally still-positive trends with C&I lending, but I would expect to see weaker mortgage demand in 2023, and it looks as though the company has pulled back some on CRE lending. I would also expect to see a healthy demand environment for multifamily lending, so this can be a growth driver in 2023 as well.

Deposits rose 1% sequentially, with “core” deposits down 3% and non-interest-bearing deposits down about 7% at quarter-end. I’m a little disappointed in that figure, as I expected to see Umpqua’s high-quality deposit base hold up a little better. Even so, non-interest-bearing deposits are close to 40% of total deposits (which is very good), and deposit costs remain quite low.

Interest-bearing deposit costs increased 66bp yoy and 53bp qoq, driving total deposit costs up 40bp yoy and 32bp qoq to a very good 0.46%. Total cumulative beta is around 10% now, and Umpqua’s interest-bearing deposit beta (around 16%) is well below the total deposit betas for many banks, so the company continues to execute well here. Even so, time deposits increased nearly 68% sequentially, and no bank is really out of the woods yet with respect to funding costs.

Credit remains clean, while non-performing loans did increase about 16% sequentially, it was from a low level, likewise with non-accrual loans. Charge-offs headed higher (from 0.11 to 0.19) largely due to the company’s small-ticket equipment leasing business (FinPac) but are still at comparatively low levels and I’m not concerned about credit at this point, though I do expect higher provisioning and charge-offs in 2023 and 2024.

The Outlook

I’ve discussed the merits of the Columbia merger in the past and I’m not going to recapitulate that here other than to say I continue to believe that the logic of the deal is sound. Columbia brings a strong deposit franchise (an even better deposit beta than Umpqua!), as well as a good commercial lending franchise focused on smaller businesses that should be highly complementary to Umpqua’s business.

The long review period for this deal (16 months) has given management plenty of time to plan for the integration of the two banks, and management expects the conversion to take place in the first quarter – quite quickly after close relative to typical bank deals. Hopefully, this extended planning period will lead to a smoother integration process, but the company will have more than just deal integration to work on, as the company is also restructuring its mortgage banking business away from a gain-on-sale model and toward a more conventional retail model.

My core expectations haven’t changed, and I’m still expecting long-term organic core earnings growth around 4% to 5% from the combined entity. I’d also note that the extended review period for the merger has allowed more capital to build up, and I believe there could be more dividend/buyback activity in 2023.

Between discounted long-term core earnings, ROTCE-driven P/TBV, and P/E (the latter using a 9.5x multiple on my ’23 EPS estimate to reflect some integration risk), I believe fair value is in the low-to-mid-$20s today.

The Bottom Line

I continue to believe that Umpqua is undervalued and I also continue to believe that it will probably take some time for this situation to improve. The Street is likely to take a “wait and see” attitude about the merger, and it will take at least a year to really see material benefits from the deal. For investors willing to be patient and wait out the reversal in sentiment, I think this is a good name to consider today.