Umpqua Holdings: No Dividend Cut In Sight; 40% Share Price Upside

Umpqua Holdings: No Dividend Cut In Sight; 40% Share Price Upside

Besides having one of the most unique names in community banking, Portland, Oregon based Umpqua Holdings Corporation (UMPQ) reported operating results that were rather lackluster for both the first and second quarters this year. After throwing into the mix a global pandemic and an incredibly volatile economic backdrop, UMPQ’s 1H20 results actually look quite good relative to bank peers.

At the beginning of the year, UMPQ generated a net loss of $8.41 per share, largely having to do with the goodwill impairment write-down. First quarter results were followed up with a solid $0.24 per share in the second quarter.

While second quarter results were only slightly better than what is paid out through the dividend (which is still $0.21), the two biggest drivers of investor consternation post-second quarter were from the size of potential future credit loss and the delayed timing of the significantly larger than average dividend.

Since UMPQ has a very risk-averse portfolio, carries one of the best relative reserve levels, and has seen significant growth in fee income, my modeling indicates that not only is the dividend sustainable, but shares should grind higher over the medium term as investors get more comfortable with the credit landscape.

Being that Umpqua Holdings has one of the best balance sheets for a recession, I believe the shares are more likely to return to pre-COVID valuation levels much faster than the average bank peer.

During a recession, bank valuations typically switch from forward P/E multiples, which look at future earnings, to Price to Tangible Book Value, which looks at overall balance sheet health. Putting that into more salient terms, I think the price to tangible book value will increase to 1.5x (from its current 1.1x level) as positive economic data is announced.

Should it happen, this valuation upside would produce a 40% price return (or a $16 price target). After adding in the 7%+ dividend yield, investors could see a 45%+ upside over the next twelve to twenty four months.

ChartData by YCharts

Credit Profile

When reviewing the balance sheet, one can see that at the end of 2Q20, the balance sheet’s reserve level was $356 million, which equates to 1.57% of loans outstanding. Putting this into perspective, management has actively added to the reserve throughout 2020, as it was 1.37% in 1Q20, and up from 0.74% in 4Q19. While these levels might seem a little lower than average, I would consider them more than appropriate for the current loan portfolio.

As I have talked about in previous articles, like when analyzing Huntington (HBAN), when in an early stage of a recession, I find the best area to review is the criticized loans and how they have changed over time.

Remember, the FDIC’s definition of a criticized loan:

… one that is rated “special mention,” “substandard,” “doubtful,” or “loss,” and is now considered to have a higher risk of default.

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Source: SEC filing

As you can see from the chart above, criticized loans haven’t really moved too much since the middle of 2018. This muted change gives me a good deal of solace in the overall credit quality. Also, when one juxtaposes criticized loans to the overall reserve level (black line in chart), one can see that the management team is prudently adding to the reserve in order to mitigate any future potential problems. The bank is actually getting safer than where it was pre-COVID, at least on a credit perspective.

Since the reserve is properly funded, I don’t think there should be any major issues in terms of overall profitability in the future. The outsized provisions taken in the first and second quarter were significant and did a tremendous job in making the bank’s credit quality “safe.”

However, I did think it would be prudent to dig a little deeper into some potential areas of interest, mainly those that could be potential COVID-19 impacted loans.

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Source: SEC Filings

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Source: SEC Filings

Within the portfolio: Hotels & Motels make up 2.4% of the portfolio, Air Transportation is 0.6%, Oil & Gas is $30 thousand (which is a rounding error), Restaurants are 0.6% of the portfolio, and Gaming makes up 1.8%. When adding those all together, the portfolio holds a rather minimal 5.4% in COVID-impacted industries, notably less than the industry average of 6% to 9%.

Dividend Looks Safe Too

Besides the now known level of loans associated with COVID-impacted areas, some investors were skeptical about the sustainability of the high dividend. During recessionary times, the order of priority should always be to fund the reserve before anything else. Once that is in a healthy position, it’s up to management to either pay out excess capital in terms of a dividend or to repurchase shares at discounted prices.

Since UMPQ has a strong reserve level compared to its fairly risk-averse lending portfolio, I am not expecting much in terms of future reserve additions through the dividend. See modeling at the bottom of the article.

While previous dividends have historically been announced before the quarterly earnings announcement, management recently changed both the timing of the 3Q20 dividend announcement, and all future dividend announcements, from intraquarter to after quarterly results are released.

The timing change derived from the sizable negative retained earnings achieved in 1Q20 and the current need to receive approval from the Board of Governors of the Federal Reserve System.

On August 10th, the 3Q20 dividend was formally announced at $0.21 per share, indicating that there would be no change to the dividend. My modeling also indicates that future earnings are also likely to be stronger, which should silence critics of the current payout ratio.

Future Profitability

While the first half of the year did reflect some recessionary-driven net income compression, I believe UMPQ is past the point of distressed profitability. While this rounding of the curve is very unlikely to see rebounding back to recent highs, I believe that it should be seen as an improvement off of the current base and future profitability will improve.

From my modeling, I suspect the net interest margin has basically reached a cycle floor. The uptick I am modeling in late 2020/early 2021 has to do with Paycheck Protection Program loans being forgiven, and not a sign of renewed strength. However, based on the liquidity and overall loan yields, I think investors should view the 2Q20 results as setting the stage to be the new cycle floor (+/- a basis point or two).

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Source: SEC filing and Author’s Estimates

On the second quarter earnings call, management indicated that mortgage-related fee income should continue to be strong. In fact, when reviewing second quarter results as a whole, mortgage really drove the bus in terms of positive news.

Between the margin being sustained at current levels and some pretty strong fee income assumptions by management for the second half of 2020, even if there is a continued elevated provision, I doubt it would be enough to warrant a dividend cut.

Concluding Thoughts

At first glance, it makes sense that the overall banking sector took a hit at the beginning of the year. I often times think of banks as being call options on the local economy they serve. That said, I think prudent investors will be rewarded if they take the time to dig a little deeper into the loan portfolios at each bank. Since we all know every bank is different, it doesn’t make sense to treat them all equally.

When thinking about Umpqua specifically, I think the stock valuation should not only retain its premium to peer banks, but because it has a very clean credit profile, it should expand from here. I think valuation should return to ~1.5x tangible book value (or roughly $16.00 per share) by the end of 2021, as seen in late 2019. In the meantime, the very healthy and sustainable dividend should reward investors for doing their own credit due diligence.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Credit: SeekingAlpha

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