It's arguable that no industry took a harder hit during and following the financial crisis than the banking sector. But, after six long years, the banking business once again sits on sound footing and is producing massive profits. The industry as a whole appears on the cusp of a sustained bull run.
For investors looking for a specific bank stock with lots of upside, now is the time to take a long hard look at Zions Bancorporation (NASDAQ:ZION).
The industry is back, and in a big way
Every quarter, the FDIC publishes industrywide data breaking down the current state of the banking business. The numbers in the "Ratios By Asset Size Group" are looking increasingly impressive.
For banks with assets over $10 billion, the industry returned an average of just under 10% return on equity. Compare that with the 0%-6% the industry saw in 2008-2010, and it's clear that profitability is back on track. If the trend continues, banks will soon be producing the 15% returns investors have been historically accustomed to.
The second quarter of 2014 marked the second consecutive quarter that no bank with more than $10 billion in total assets failed to generate a quarterly profit. Every single one of these 109 banks reported a profit. Every single one.
For banks of all sizes, just 6.8% posted a quarterly loss -- the lowest level since the second quarter of 2006.
The more you dig into the data, the more the industry seems poised for a boom. Problem loans are down, profits are growing at the majority of banks, capital levels are exceptionally strong, and banks have maintained strong margins and efficiency despite an overwhelming increase in regulation and operating challenges.
Banks have accomplished all of this in a period of generationally low interest rates; when those rates rise in the next few years, banks will immediately see a boost to profits as they immediately charge higher prices for loans. The result will be supercharged revenues, higher profits, and an industry-wide bull market.
Zions Bancorporation is cheap because of past problems, not future potential
Zions has trailed its peers in the stock market over the past few years, primarily because the bank has not been able to reduce its level of problem loans as quickly as others. This problem with credit quality was the headwind that held Zions stock down, while competitor's stock prices rebounded healthily.
Over the past three years, though, that trend has effectively reversed.
As of Sept. 30, 2011, Zions reported $1.2 billion in non-performing assets. Non-performing assets are loans that are severely past due plus property in foreclosure. That number represented 2.4% of the bank's total assets; that level was about 30% higher on average the the rest of the nation's largest banks.
Fast forward to today and Zions reports non-performing assets of just 0.69% of total assets, a figure 28% below the national average of large U.S. banks.
In other words, Zions problem loans are decreasing at a considerably faster rate than the rest of the industry. Where the bank struggled in 2010 and 2011, it excels today.
It won't be long until investors recognize that Zion's primary problems are in the rear-view mirror. When that happens, it's my view that the bank's valuation will no longer trail its peers, as it has for the past five years.
Typically, investors look to a bank's price to tangible book value to assess its relative valuation. A price to tangible book value less than one typically represents a very cheap price, while a price over three tends to be expensive.
As this chart shows, Zions is much cheaper than its peers as measured by price to tangible book value.
The bank's other question marks are poised to reverse as well
Zions Bancorporation does have other issues to deal with, starting with its 8.2% return on equity as reported on its second-quarter call report. This figure trails the peer set average by about 1.5%.
There are two primary reasons I expect this number to catch up to and then exceed the peer group over the coming quarters. First, there are the macro economic considerations discussed above -- when interest rates rise, bank's across the board will see a major boost to revenues. Zions is no exception.
Second, as a result of the bank's previous issues with problem loans, Zions has built up an excessively strong reserve that will be redeployed to earnings over the coming quarters. I think of it as dry powder waiting to boost earnings.
When banks identify possible problem loans, they are required to set aside cash -- cash that is accounted for as an expense on the income statement. As problem loans decrease, the need to add to that reserve also decreases, meaning net income will rise simply because credit quality is improved.
Even better for the short term, any excess reserves can be released and added back as income. This boost to profits is admittedly short term, but when used effectively, it can create a healthy boost to profits for several quarters, and also signal to the markets that the bank's health is stronger than ever.
Zions currently has a reserve of about 1.7% of total loans, which could mean a boost to profits upwards of $500 million in the short term.
Another issues is that the bank is expected to raise an additional $400 million of capital after failing this year's stress testing of the nation's largest banks by the Federal Reserve. While this is an unfortunate event that absolutely raises questions about bank management's ability to cooperate with regulators and prepare for the worst-case scenario, this event is a mere hiccup on an otherwise clear road to recovery.
In fact, this short-term hiccup could be exactly the moment for a long-term value investor to scoop up the stock and hold it for the long term. Because at present, Zions looks like a steal of a value.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.