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We continue to maintain our long-term Neutral recommendation on Zions Bancorp. (ZION - Analyst Report) based on its continuously improving quarterly results. Though we are impressed with Zions’ significant turnaround and believe that its cost control efforts will drive future growth, the company’s near-term outlook remains cautious as the loan demand is likely to remain weak, with persistent legal and regulatory challenges.

Zions’ second quarter 2011 earnings beat the Zacks Consensus Estimate on the basis of year-over-year growth in net interest income and non-interest income, continuous progress in credit quality and decline in non-interest expenses. However, a continued weakness in loan demand and modest deposits growth were the negatives.

Over the last several years, Zions have acquired many small banks and financial institutions. In the current market conditions, there are many small banks and financial institutions in the company’s footprints that are struggling to cope with the ever-increasing regulatory expenses and the slow economic recovery. Therefore, we believe that Zions will have a good opportunity to pursue its inorganic growth strategy once its near term concerns are eliminated.

Zions is located in some of the high-growth areas in the country, where population growth is faster than the national average and the major areas have higher per capita income. Moreover, Zions’ community banking model will enable it to continue increasing market share in the foreseeable future.

Additionally, Zions’ credit quality continues to improve and remains a major tailwind for the company at present. The company anticipates credit costs to remain low for the next few quarters due to reduced loan balances in categories that have exhibited higher loss rates, such as construction and land development loans.

However, due to continuous deposit pricing pressures and growth in higher-cost funding accounts, Zions will face downward pressure on net interest margin. Further, as a result of various regulatory changes, the company’s top-line will experience added pressure over the next few quarters.

Also, Zions has still not received regulatory approval for the repayment of the TARP money, which the company believes is unlikely until it is able to comply with the Basel III capital requirements. However, the company will have to move fast on this front as the TARP preferred dividend will increase to 9% from the fourth quarter of 2013, making the cost funding expensive.

Further, the company has been proactive in issuing stock in order to maintain its capital ratios, which has led to a continued risk of equity dilution going forward.

Zions currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Similarly, one of the company’s close competitors, First Republic Bank (FRC - Analyst Report) also retains a Zacks #3 Rank (short-term Hold rating).

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