Zions Bancorporation (ZION)

ZION Bancorporation (ZION) is a diversified financial service provider operating across 506 branches and about 625 ATMs as of June 30, 2008, in 10 western and southwestern states (Utah, Idaho, California, Nevada, Arizona, Colorado, Texas, New Mexico, Washington, and Oregon). ZION operates under a community banking model, offering its services through local banking identities using local management teams. ZION offers a full range of traditional banking services, as well as small business administration lending, public finance advisory, and electronic bond trading. Tax-equivalent net interest income represented 82.2% of net revenue in 2007, with the balance coming primarily from service charges, loan sales and servicing, and other commissions and fees. In 2Q08, Tax-equivalent net interest income represented 87.1% of net revenue.

The company manages its operations with a primary focus on geographical area. As of December 31, 2007, ZION operated eight community/regional banks in distinct geographical areas.

ZION's strategy centers on three key factors: (1) focusing on high-growth markets (2) keeping decisions about customer's local and (3) centralizing technology and operations to achieve economies of scale. In December 2005, ZION completed the purchase of Amegy Bancorporation (formerly Southwest Bancorp of Texas) for roughly $1.7 billion in stock and cash. This was a rather large bite to take (nearly a 25% increase in assets at the announcement date), but ZION wanted to get into Texas for some time, and there was a clear strategic fit. In January 2007, ZION completed the acquisition of Arizona-based Stockmen's Bancorp, Inc. in a $206.1 million all-stock deal, adding $700 million in net loans, $1.1 billion in deposits, and 43 branches, including some in smaller and more rural markets in Arizona and California. Out of those 43 branches, the company sold the 11 California branches in November 2007. In September 2007, ZION completed the acquisition of Inter Continental Bank Shares Corporation located in San Antonio, Texas, which added $58 million in loans and $105 million in deposits, including $98 million in core deposits, to the company's balance sheet.

As of June 30, 2008, ZION's relatively diversified loan portfolio comprised roughly 47.6% commercial loans (including owner-occupied), 33.8% commercial real estate (CRE), and 18.2% consumer loans (primarily residential real estate). The securities portfolio showed a downward trend yet again on a relative basis, and was a manageable 10.3% of average earning assets in 2Q08. Non-interest-bearing and other low-cost deposits funded 56.5% of average earning assets in the quarter, while time/ foreign deposits and borrowing funded 21.4% and 22.5%, respectively. As of June 30, 2008, ZION had $54.6 billion in total assets, $41.9 billion in loans and leases, and $37.6 billion in deposits.

To a large extent, the ZION story remains one of location. ZION is located in some of the highest-growth markets in the U.S., where the population is growing much faster than the rest of U.S. as a whole. During the period 2000 through 2030, the population growth in these states is forecasted at about 51% compared to the national average of 29% over this time. We favor the community banking model in general, and therefore expect ZION to continue stealing market share from its larger out-of-state competitors for the foreseeable future. The Amegy acquisition certainly fits in well with ZION's strategic plans, as Texas is another large, fast-growing market, and ZION had no presence there. Organic loan growth has been solid, consistent with the economic activity across ZION's diverse footprints.

As we have noted previously, ZION seems much more focused now than it was for a number of years. After restructuring the operations of Vectra Bank, closing its supermarket branches in Utah, and disposing off its e-commerce subsidiary, ZION is now consolidating the systems of its various community banks. ZION is also looking at innovative technological solutions to drive operational efficiencies in branch operations. Using GMT Corp.'s workforce optimization solution, ZION has been able to reduce staffing costs by almost 4.0%. The company completed its acquisition of Stockmen's Bancorp in January 2007 and the Intercontinental Bank Shares Corporation in September 2007. In November 2007, ZION sold 11 branches in California that were originally part of Stockmen's Bancorp acquisition. Though small, the deals will enable ZION to gain additional foothold in some smaller and more rural markets of Arizona and Texas.

Competitive pressures are high throughout the banking industry and we expect competition, continuous deposit pricing pressures, and growth in higher cost funding accounts to continue to reduce ZION's NIM, creating headwind on the revenue front. Net Interest Margin (NIM) declined by 5 bps sequentially during 2Q08 to 4.18%. The Management anticipates modest downward pressure on NIM in the near-to-medium term. Loan growth has remained solid, but slowing growth in core deposits could cause a more negative mix shift than we have modeled, another negative for the NIM. Further the management also expects that deposit growth may continue to lag behind loan growth, and that a portion of future loan growth may be funded from alternative higher cost funding sources.

Though the Amegy acquisition facilitated Zion to expand its foothold in Texas, we were a bit disappointed with the transaction, though only time will tell how it all plays out. The deal looked expensive to us on nearly every metric, representing roughly a 40% premium to the pre-speculation market value of Amegy. Though we did not follow Amegy specifically, it appeared to have been struggling relative to the several Texas banks we did cover at the time, which may have prompted the sale. All in all, these were not the transaction economics we would expect from ZION. Though the Stockmen transaction was smaller and the details fewer this acquisition also appeared to be on the expensive side.

We are concerned about ZION's CRE exposure. CRE represents over one third of ZION's overall loan portfolio. Continued weakness in the residential development and construction activity in the southwest has resulted in further deterioration of credit metrics in the present quarter. The provision for loan losses for 2Q08 was $114.2 million compared to $17.8 million in 2Q07. On an annualized basis, the provision was 1.13% of average loans for 2Q08 compared to 0.20% of average loans in 2Q07. The non-performing assets increased to 1.66% of related assets and net charge-offs to 0.67% of average loans in 2Q08. Given the sluggish economic conditions, we do expect credit to further deteriorate industry-wide in the coming quarters.

Moody's Investors Service recently placed the investment-grade ratings of ZION on a review for a possible downgrade, mainly due to concerns over the bank's large residential and construction development portfolio. Currently the company's senior debt rating of "A3", financial strength rating of "C+ , and long-term bank deposits rating of "A2" of its main operating subsidiary, are on review. The rating agency is also concerned over the bank's collateralized debt obligation portfolio, which contains potentially more volatile tranches of CDO securities. Any downgrade in the ratings will further affect the results in the coming quarters.

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