Zions Reaffirmed At Neutral

We are maintaining our ‘Neutral’ recommendation on Zions Bancorp. ( ZION - Analyst Report ) based on the upgraded long-term ratings of the company and its subsidiaries by Moody’s Investors Service – the credit rating arm of Moody's Corp. ( MCO - Analyst Report ) – as well as its better-than-expected third-quarter performance. However, we remain concerned about the prevailing low interest rate environment, sluggish economic growth, asset-sensitive balance sheet, losses related to collateral debt obligations (CDO) exposure and regulatory pressures.

Zions’ better-than-expected third-quarter performance was attributable to higher net interest income, declining operating expenses and lower preferred stock dividends. These were partially offset by lower non-interest income.

In December 2012, Moody’s Investors Service upgraded the long-term ratings of Zions and its subsidiaries, while reiterating the outlook at “Stable”. The rating agency is impressed with the company’s efforts toward continuously improving asset quality and reducing its risk profile. The rating revisions are likely to be valuable for Zions as these play a major role in preserving the investors’ confidence in the stock and help boost creditworthiness in the market.

In September 2012, Zions finally redeemed the remaining 50% ($700 million) of its TARP preferred equity. Earlier in March, the company had redeemed 50% of the preferred equity. The full repayment of $1.4 billion of TARP dues relieves Zions of a huge financial obligation and will enable it to enhance its capital ratios as well as stabilize its balance sheet, going forward.

Further, improving credit quality continues to be a major strength for Zions. Management expects continuous improvement in credit trends in the subsequent quarters due to the constant reduction in its non-accrual loans, which is expected to push down net charge-offs and the provision for loan losses. Also, the company anticipates credit costs to continue declining going forward, owing to reductions in loan balances in categories that have exhibited higher loss rates.

On the flip side, we anticipate continuous deposit pricing pressures, sluggish loan demand and low interest rate environment along with growth in higher-cost funding accounts to weigh on Zions’ net interest margin (NIM). Though management expects NIM to benefit from modest loan growth, the maturity and re-pricing schedule of the loans and the continued conversions of debt into preferred equity will keep it under pressure over the next several quarters.

Further, modest core deposit growth could cause a negative mix shift. Despite marginal improvements in deposits in the first half of 2012, Zions expects deposit growth to continue to lag loan growth in the near term. Moreover, a portion of its future loan growth is likely to be funded from alternative higher-cost funding sources.

Lastly, Zions’ mix of a high level of risky Commercial Real Estate assets will put the company in a tight spot, at which raising new capital and removing troubled loans may take precedence over finding new growth opportunities.

Zions currently retains a Zacks #3 Rank, which translates into a short-term Hold rating.