Even though it was the only bank to fail the most recent round of Federal Reserve stress tests (though four others had their capital plans rejected), Zions Bancorporation (NASDAQ:ZION)’s stock price hasn’t really been punished, it’s just been volatile for the last month. Now we know that Gator Financial Partners has been long on Zion for more than a year, and that it was advancing its thesis that Zions is undervalued because of its hidden earnings power just before news about the stress test broke.

Zions prefers cash to bonds ahead of likely interest rate rise

“The fund has owned warrants in Zions Bancorporation for a little over a year. While the price of the warrants is very volatile, we believe they present an interesting asymmetrical risk/reward situation that could produce high returns,” wrote Derek S. Pilecki, managing member of Gator Capital Management LLC in a March 12 letter to investors, explaining that the hedge fund has been using new inflows to increase its position in Zions Z warrants (NYSE:ZIONZ); the bank also has ZIONW warrants outstanding.

At the time he was writing, Zions Bancorporation (NASDAQ:ZION) had a price to tangible book of 1.3x and a PE of 17.2x, but Pilecki explains that he prefers to look at the former number in this case, because Zions is holding on to so much cash that its earnings are muted ($8.5 billion or 16% of its balance sheet versus the average 1% that its peers are holding). Zions was trading around 3.0x before the financial crisis, so expecting it to at least cross 2.0x isn’t that optimistic. (n.b. The grey line in the graph is relative to its regional peers.)

Zions PTB 0414

Zions’ NII could grow 17% as rates go up

Zions Bancorporation (NASDAQ:ZION) management prefers cash because they don’t want to invest in bonds just before rates start to go up, which may be a good long-term decision but decreases earnings right now. Zions is also leveraged to higher interest rates because it has more floating rate loans on its book than most of its peers, and the bank has estimated that a 2% rise in interest rates would push net interest income up 17%.

If that interest rate increase materializes in the next year or two and Zions Bancorporation (NASDAQ:ZION) decides to put most of its excess cash into 15-year mortgage backed securities, Pilecki estimates that the bank could have $1.35 per share in additional earnings. If the cash is used in faster-than-expected loan growth, even better.

zions cash v banks 0414

The question is when, not if, interest rates will go back up, and Zions Bancorporation (NASDAQ:ZION) is positioning itself to take advantage of the change when it comes. Selling off CDOs to increase its tier 1 capital ratio and appease the Fed doesn’t change Pilecki’s underlying thesis.