Stocks Investment

Umpqua Holdings: Balancing Act Before Dividend Cut

Umpqua’s (NASDAQ:UMPQ) 2Q 2020 was a balancing act with a big bang in mortgage banking balanced by the shrinking margin and another huge credit loss provision. Management fought hard for unsustainable earnings; sustainability, of course, being very important in Oregon.


As a long-time shareholder, I have always appreciated UMPQ’s position as the largest independent bank in the Pacific Northwest with its $29.6 billion in assets, conservative management, focus on real estate lending and customer service and, at least until COVID-19, a clean balance sheet. Then banks worldwide were hit by margin compression as rates plummeted to near zero followed and exacerbated by a building credit quality tsunami thanks to COVID-19.

Let’s Talk First Quarter: A Washout

UMPQ’s 1Q 2020 was a washout with a net loss of $1.8 billion or negative $8.41 per share due primarily to a huge $1.8 billion goodwill write-down, but there was also an outsized $118.1 million provision for credit losses. Parsing that provision, $53.1 million was due to a one-time “catch up” adjustment as the bank implemented the forward-looking CECL loss provision methodology.

That wasn’t all. Compared to sequential 4Q 2019, net interest income before the provision was down $8.3 million as the net interest margin slipped another 10 bps to 3.41%. This slippage is a continuation of the seemingly endless margin squeeze that has been hammering UMPQ and nearly all U.S. banks. Mortgage banking, the sword that cuts both ways, was down hard; $16.5 million or 48.5% less than 4Q 2019.

Attempting to “normalize” earnings in this environment is tough, but backing out the write-down and the “catch-up” adjustment and using a four-quarter trailing average for mortgage banking income and a 24.9% tax rate, I come up with a rough estimate of adjusted 1Q 2020 net income of $19.5 million or $0.09 per share. The frightening part of this is that there really wasn’t anything else that looked out of line.

Could “normalized” earnings really be running at a $0.10 per quarter rate? Probably not, but let’s set this sobering thought aside for a moment and take a look at the balancing elephant that was UMPQ during 2Q 2020.

Let’s Talk Second Quarter: Was the Bounce-Back Real?

UMPQ bounced back 2Q 2020 with reported net income of $59.2 million or $0.24 per share. The market seemed to like the quarter:

ChartData by YCharts

What are investors thinking?

Was the small move up in the stock price justified? Let’s review some key points from the “bounce back” and see what we decide.

Net Interest Income: The Margin Squeeze Continues – and Accelerates

Net interest income did not bounce back, instead continuing its long slide as the margin squeeze accelerated. Net interest income before the provision dropped $6.0 million or 2.8% from 1Q 2020 to 2Q 2020. As the table below shows, it was not pretty.

The huge $21.5 million or 8.0% sequential quarter drop in interest income was due to a steep 47 bps drop in the average yield on loans and leases held for investment from 4.58% 1Q 2020 to 4.11% 2Q 2020. Although the average balance of loans and leases held for investment increased $1.2 billion or 5.8% over 1Q 2020, the bulk of the increase came from $2.0 billion in low rate, but essentially risk-free Paycheck Protection Program (“PPP”) loans written during the quarter. Here’s Slide 5 from the UMPQ 2Q 2020 Earnings Presentation describing UMPQ’s participation in the program.

Source: 2Q 2020 UMPQ Earnings Presentation

Notice the yield on these loans? Nowhere to be seen. It’s 1.00%. Loans funded before June 5 have a two-year maturity, and those funded after June 5 have a five-year maturity. In any case, payments are deferred for six months. The value to UMPQ is in the fees: 5% for loans of not more than $350,000; 3% for loans of more than $350,000 and less than $2,000,000; and 1% for loans of at least $2,000,000. Keeping it simple, for the 12,806 loans under $150,000 mentioned in the slide, the “yield” is either 3.50% for two-year loans or 2.00% for five-year loans.

The $1.9 billion of lower-yielding, interest-bearing cash and temporary investments on UMPQ’s balance sheet as of the end of 2Q 2020 could be invested in higher-yielding assets, but during the 2Q 2020 conference call, CEO O’Haver explained that the bank was maintaining $1.0 billion to $2.0 billion in cash due to uncertainty about the stickiness of PPP-related deposits and to provide optionality in funding forecast loan production.

Interest expense fell an amazing 31.1% sequentially, but due to the impact of relative volumes – average interest-bearing deposits were $15.8 billion during 2Q 2020 – this was equal to a dollar decline of “only” $15.5 million; hence the $6.0 million decline in net interest income. The primary component of the decline in interest expense was a $14.1 million or 34.9% decrease in deposit expense as average deposit rates ratcheted down 36 bps from 1.03% 1Q 2020 to 0.67% 2Q 2020. How soon will management be “pushing on a string” in trying to force deposit rates lower?

The bottom line is that UMPQ’s margin squeeze continues with no end in sight. The earning asset yield plummeted a full 60 bps from 4.19% 1Q 2020 to 3.59% 2Q 2020 compared to a 37 bps decline in the cost of interest-bearing liabilities over the same period. Exacerbated by the volume differences, the net interest margin fell 32 bps from 3.41% 1Q 2020 to 3.09% 2Q 2020 – and the net interest spread broke well below 3.00% to a remarkably low 2.81%.

Provision for Credit Losses and Credit Quality: Where’s the Bad Assets?

Management is prudently reserving for bad assets that have yet to appear on the balance sheet. After the provision for credit losses, net interest income was up $24.9 million over 1Q 2020, but it was all in the provision. The provision decreased from the giant $118.1 million in 1Q 2020 to the merely huge $87.1 million in 2Q 2020. For some perspective, the largest provision in the last five full years was $72.5 million in 2019. UMPQ has already provided almost three times that amount in the first half of 2020.

Here’s where things get interesting. Management appears to be far ahead of any developing credit quality problems as the tsunami hitting other banks is not yet in evidence at UMPQ. Instead, UMPQ’s provision for credit losses is being driven by the bank’s new CECL model which relies on Moody’s economic forecast of a short, sharp recession with high unemployment. Consider that as of 2Q 2020, the allowance for credit losses was about 495.9% of nonperforming assets. Rather than re-inventing the wheel, here’s Slide 21 from the 2Q 2020 Earnings Presentation.

Source: 2Q 2020 UMPQ Earnings Presentation

Nonperforming assets were 0.28% of total assets 2Q 2019 and they’re 0.26% of total assets 2Q 2020. Classified assets – the source of potential trouble as they migrate to nonperforming – were 0.68% 2Q 2019 and they’re 0.68% 2Q 2020. Other credit quality statistics follow suit.

Can we find any signs of developing stress in the portfolio?

Well, loans on deferral of payments in connection with COVID-19 were 5.7% of loans according to Chief Credit Officer Frank Namdar during the 2Q 2020 Conference Call, but that was down from a mid-June peak of about 9.0%. Management did outline some loan portfolios where there is concern of COVID-19 and/or potential recession impact:

Until the 2Q 10-Q comes out, we can’t dig much deeper. Looking ahead, the expectation set by larger banks with wide exposure to multiple asset classes and geographical areas is that credit quality at UMPQ will decline, but we’re just not seeing it as of 2Q 2020. During the 2Q 2020 Conference Call, CEO O’Haver made the following general statement (edited for clarity) on credit quality:

And I would be the first to tell you that I think a lot of the stimulus deferrals and other things that were necessary, have probably potentially kicked the can on issues at all banks, not just Umpqua, we will see relative to credit performance.

So I can tell you on a near-term basis, to answer your question [as] clearly as I can, with as much as I know today, that we feel comfortable. But until we get beyond deferrals and enhanced unemployment benefits and other things that do trickle into our credit portfolio, it is hard for me to give you [more] guidance…but hopefully you can appreciate my position. So we feel comfortable today with what we see but there is a lot unknown.

Many analysts are focusing on specific portfolios, like those “of interest” above, but I am convinced the second-order impact of the lockdowns, business interruptions and unemployment from the efforts to fight COVID-19 will inevitably result in credit quality deterioration across all loan portfolio asset classes. I applaud UMPQ’s management for quality underwriting and diligently applying the new CECL methodology, but I expect loss reserves set aside now will be needed later.

Noninterest Income: 2Q 2020 Not Sustainable

Noninterest income, up a huge $74.8 million over 1Q 2020, saved UMPQ from a 2Q 2020 earnings embarrassment. It was primarily due to the mammoth $66.4 million increase in mortgage banking income over 1Q 2020. In fairness, 1Q 2020 suffered from a very large $25.4 write-down of the MSR asset, however, completely zeroing out the 1Q 2020 valuation hit would still leave a very large $41.8 million sequential quarter increase in mortgage banking income. For mortgage banking all the stars were aligned during 2Q 2020: income spiked due to $2.1 billion in originations, up 50.0% from 1Q 2020, an increase in the gain on sale margin to 4.75%, and a much lower $6.4 million MSR valuation write-down. In the table below, I’ve marked mortgage banking in very, very light green because of the very high degree of variability associated with this activity.

During the 2Q 2020 Conference Call, CFO Ron Farnsworth characterized mortgage banking as “an absolute home run this year.” He went on to explain that management expected “mortgage activity to remain robust in the second half of 2020” although he expected the gain on sale margin to moderate. Continued strong mortgage banking income would certainly help UMPQ muddle through what promises to be a very choppy second half of 2020, but will mortgage demand remain strong if high unemployment persists?

The impact of waiving fees in connection with COVID-19 customer distress can be seen in the $3.8 million or 24.3% sequential quarterly decline in service charges on deposit accounts. This will probably begin to reverse 3Q 2020.

Finally, the $12.7 million 2Q 2020 increase in other income is actually a return to a more normal level for this category of income compared to 1Q 2020. This category consists of a grab-bag of income items, one of which was an unusual 1Q 2020 loss of $14.3 million on swap derivatives.

$115.5 million of noninterest income rescued UMPQ’s 2Q 2020, but the reliance on mortgage banking income makes the sustainability of that level questionable.

Noninterest Expense: Wrong Time For An Increase

I concede that expense control is difficult in the middle of a pandemic, but management kicked off an expense reduction program called NextGen in 2017 that was designed to wean customers from the branches and allow the bank to permanently reduce staff – although that part was not stressed – through online customer interaction and access. Almost three years later, the efficiency ratio was 55.4% for 2Q 2020 compared to 54.93% for the bank’s peer group in the latest (1Q) FDIC Quarterly Banking Profile. Unfortunately, there are really only two places to cut: compensation and occupancy. UMPQ is selling three eastern Oregon branches to First Community Credit Union which will address both expense categories, but the bank is still a little porky.

Case in point, noninterest expense, excluding the 1Q 2020 goodwill write-down, increased $4.2 million or 2.4% over 1Q 2020. If ever there was a time for a reduction in run-rate noninterest expense…

Management’s only comment in the 2Q 2020 press release was that expenses increased $10.4 million in in the Home Lending Division over 1Q 2020. FDIC assessments have increased due to the 1Q 2020 net loss, a real cash cost to the non-cash write-down of goodwill.

Shareholder Pain Will Increase: Dividend Cut on the Way!

UMPQ is in a new situation regarding dividends. Discussion of dividends disappeared from UMPQ’s 2Q 2020 Press Release since, as the bank’s 1Q 2020 net loss drove retained earnings negative, regulatory approval is required to declare a dividend. Here’s what CEO O’Haver said about the dividend during the 2Q 2020 Conference Call:

We covered our historical dividend over the last eight quarters are so. And feel highly confident about our ability to continue to cover that over the near-term.

I am not buying it. Here is my take on 2020 worst-case earnings and the associated payout ratio.

Notice that I am not attempting to “normalize” mortgage banking income, and I am giving a ballpark credit for PPP fee income.

I think we’re looking at 2020 EPS of $0.71 per share. With dividends at $0.84 per share, I see at least a 60% cut on the way. With the stock closing at $11.36 per share on July 24, 2020, the implied 7.28% yield would be cut to roughly 3.00% and a 47% payout ratio.


Conclusion: Avoid For Now

If you don’t own UMPQ, this is a stock to avoid. Management is doing the best it can with a bad situation. During the remainder of 2020, I expect the margin squeeze to be exacerbated by deteriorating credit quality. The stock might appear relatively cheap at a slight discount to tangible book of $11.44, but that’s a PE of about 15.97 on my worst-case adjusted earnings.

There is no point in chasing UMPQ as there may be a retail investor reaction to the dividend cut – although it’s already trading like one is priced in – and earnings can be expected to be weak for the remainder of the year. At some point, the bank will make a nice speculative purchase, maybe on a sharp drop to 75% or so of tangible book, but there’s no hurry. Take it quarter by quarter and see what 3Q 2020 brings.

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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