CFA Institute Research Challenge Sterling Financial Corporation (STSA) research report Gonzaga University

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1

Banking

Ticker: ●STSA Recommendation: ●Hold

Price: ●$18.49 Price Target: ●$19.46

Split-Adjusted

Earnings/Share

Mar. Jun. Sept. Dec. Year P/E Ratio

P/B Ratio

2009A ($0.40) ($0.55) ($7.48) ($5.37) ($13.80) NA 1.51x

2010A -1.43 -0.94 0.54 -10.37 -12.2 NA 1.53x

2011A 0.09 0.12 0.18 0.24 0.63 26.51x 1.18x

2012E 0.26 0.46 0.35 0.42 1.49 13.06x 1.26x

Highlights

Price Target: Our analysis indicates a one year price target of $19.46, which is a 5.25% increase

over the current price of $18.49.

Market Comparison: Sterling has performed better than the SPDR S&P Regional Banking index

(KRE) over the past 6 months with a 9.19% return compared to 5.35% for the index. Sterling’s

volatility (beta 2.21) is higher than the index, however, which has a beta of 1.02.

Growth Strategies: A primary organic growth strategy for Sterling is to increase loan originations.

The company originated $926 million in portfolio loans in 2011, which represents a 195% increase

over the previous year. We estimate that this trend will continue (although at a slower rate)

throughout 2012 due to improving loan demand and low interest rates. In addition to the growth of

the loan portfolio, the bank is actively pursuing a strategy of growth by acquisition. In the first

quarter of 2012, they should complete a Purchase and Assumption agreement with First

Independent Bank in Vancouver WA. Along with market penetration and asset growth benefits,

this transaction will allow Sterling to begin offering trust and wealth management services to its

existing clients.

Improving Trends: Net interest margin has improved since the recapitalization in August 2010,

where Sterling was at 3.03%, to 3.29% as of December 31, 2011. The loan loss allowances have

also decreased steadily from $335M in December, 2009 to $177M in September of 2011, giving

them an average quarterly decrease of $21M over those seven quarters. Other Real Estate Owned

(OREO) has also fallen from its peak of $161M at the end of 2010 to $81.9M by the end of 2011.

Valuation Risks: Continued economic uncertainty and a generally cautious market may have a

negative impact on the volatility and price of Sterling in the coming year. Slow growth in the

economy could also keep interest rates low, which would put continued pressure on Sterling’s

interest rate margins. This could slow down loan growth rates putting pressure on earnings. This

earnings pressure, however, would be partially offset by improved interest income from the existing

commercial loan portfolio.

Conclusion: Sterling is a fundamentally sound company that should perform well in its business

operations. At current market prices, Sterling is a hold, but they could become a buy in the event of

market correction.

Sterling Financial Corporation

[Banking]

Date 01/26/2012

Market Profile

52 Week Price Range 11.61-19.71

Average Daily Volume 107,553

Beta 2.21

Dividend Yield (estimated) NA

Common Shares Outstanding 62,057,645

Market Capitalization 1.15B

Institutional Holdings (shares) 45.42M

Insider Holdings (shares) 6.49M

Earnings per share 0.63

Book Value per Share 14.16

Tier 1 Capital 11.40%

*SPDR S&P Regional Banking ETF (KRE) Source:Yahoo Finance

Business Description Sterling Financial Corporation is the bank holding company for Sterling Savings Bank, which began in 1983

in Spokane, Washington. Sterling Savings bank also operates a subsidiary commercial bank, Intervest

Mortgage Investment Co., founded in 1987, which focuses on institutional lending. Sterling expanded

rapidly, largely through aggressive acquisitions, and now has over $9.1 billion in assets, with 178 branches in

five states including Washington, Oregon, Montana, Idaho and California.

As a regional commercial bank Sterling offers a typical array of financial products including consumer loans,

real estate mortgages, retirement and wealth management services, commercial loans, and a full range of

deposit products. While they offer a broad product mix, they have a strong focus on business relationships.

Moving forward, the bank seeks to strengthen this focus.

During the height of the market, Sterling was heavily involved in construction lending, especially speculative

development projects, with as much as 33% of their total loan portfolio concentrated in this one segment.

When the real estate market collapsed, many of these loans defaulted. Many banks, including Sterling, are

still liquidating OREO properties, much of which was land and speculative housing developments. OREO

increased dramatically as management took foreclosure actions on non performing assets, and since their

peak at the end of 2010, Sterling has been liquidating these problem loans systematically. As a necessary

reaction to the current market conditions, only 4% of their loan portfolio is now concentrated in construction

and development (C&D). This has helped to improve their portfolio quality, since C&D loans typically carry

the highest level of default risk. Analysis of their current portfolio concentration indicates that they are much

more reasonably diversified, so OREO should continue to decline.

Sterling’s subsidiary, Intervest, is a small portion of the overall company, but because this company

specializes in brokering loans to the secondary market (primarily insurance companies), they are able to offer

terms to borrowers that most community banks or credit unions cannot offer. This allows Sterling to capture

borrowers that would be forced to work with larger national banks that also offer institutional lending

solutions. The loans that are sold to insurance companies are typically of high quality, but the terms would

not be favorable to Sterling because they often have longer fixed-rate terms associated with them. By

brokering these loans, Sterling is able to earn fee income while reserving capital for higher yielding loan

products.

Management has targeted their portfolio concentrations at 1/3 in consumer loans (including mortgages), 1/3

in commercial loans and 1/3 in non-owner occupied commercial real estate. With much of their loan

portfolio in commercial loans, they are at the high end of the spectrum compared to their peer group. This is

not necessarily a concern, but it does indicate the strategic approach that they are taking. This strategy has a

unique set of benefits and risks, which we discuss throughout this analysis.

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Community Involvement

One of Sterling’s strengths is their Community Involvement, which has been a focus for Sterling since its

inception. They show commitment to customer relationships and their communities through multiple

channels, as they hope to make a positive impact on the communities in which they operate. In 2010,

Sterling employees donated more than 25,000 hours to over 400 organizations, demonstrating their dedication

to the mission of being a community-focused entity. This community investment is not only good for

society, but it creates name recognition and a positive image of the bank.

Recapitalization

Due to its heavy loan losses from 2008-2010, Sterling’s capitalization plunged until they came under heavy

regulatory pressure that culminated in a Cease and Desist order in 2010. The Cease and Desist order required

Sterling to improve its Tier 1 capital to 10% or better, reduce its level of classified and non-performing loans,

and to restructure the management team. Sterling restructured in August 2010, receiving a net capital

infusion of $730 million from two private equity funds and 30 other individual investors. Both of the private

equity firms are registered as bank holding companies, with significant banking experience. Each received

one non-voting board seat. Subsequent to the restructuring, Sterling’s capitalization exceeded their 10% Tier

1 capital requirements. As part of this recapitalization, the cease and desist order was lifted.

A large part of Sterling’s strategy has been to reduce its levels of non-performing assets by selling or

otherwise divesting themselves of distressed properties. They have been able to reduce OREO properties by

$68.9 million year over year, which is a 46% decrease. Loan loss allowance has fallen by $69.6 million over

the past year, which is a 28% decrease.

Management

Much of the success of the recapitalization of Sterling can be attributed to the current management of Sterling

Financial Corporation and Sterling Savings Bank. Despite a challenging environment for the banking

industry, managers were able to orchestrate the investment of two large private equity firms, who provided

the large capital investment necessary for recapitalization. This success, along with consistent improvement

of the financial performance of the institution, indicates the strong capabilities of management. Brad

Williamson, director of the state DFI Banking Division, who headed the team that was in charge of closing

banks in Washington, stated succinctly that, “Sterling survived because management did a good job getting a

handle on its problems.”

J. Gregory Seibly serves as the President and CEO of Sterling Financial Corporation, and has been a major

part of the restructuring of Sterling. Mr. Seibly also sits on the Board of Directors, which boasts impressive

resumes within the banking industry, as well as in other business endeavors. Included in the Board are former

management from Wells Fargo & Company, Bank of America, U.S. Bank, Citicorp, and JPMorgan Chase, as

well as presidents of Ivar’s Inc., Norwest Corporation, and Starbucks Coffee. This extensive understanding

of business and banking allows Sterling to view their current situation from knowledgable positions and

diverse prior experiences. Executive experience is critical to determining the direction of the organization, so

it is important that Sterling’s leadership comes from diverse financial backgrounds. The presence of these

0

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Loan Loss Allowance

diverse backgrounds and experiences suggests that they will have the knowledge necessary to grow Sterling

into the future.

One notable management change in 2011 was that Sterling’s former CFO was replaced with Patrick J.

Rusnak. Before moving to Sterling, Mr. Rusnak was the CEO of AmericanWest Bank. He was promoted

from CFO to CEO and tasked with the responsibility of recapitalizing to avoid bankruptcy. He was successful

in recapitalizing the bank by negotiating investments from private equity investors. This experience in

working through the turnaround of a troubled bank and the facilitation of a recapitalization exhibits valuable

skills which will help Mr. Rusnak to facilitate Sterling’s full recovery.

The private equity (PE) firms that injected capital into Sterling were Warburg Pincus and Thomas H. Lee

Partners. According to Private Equity International, an industry trade publication, Warburg Pincus is the 13th

largest private equity firm in the world and Thomas H. Lee Partners is the 27th largest (based on total

fundraising over the preceding 5 years). Although banking regulations restrict the PE firms from exercising

direct control over the management of banks, the management expertise and network of industry contacts

they provide is a tremendous asset for a relatively small bank such as Sterling. Sterling also benefits from the

expertise of Scott L. Jaeckel, the managing director of Thomas H Lee Partners, and David A. Coulter, the

managing director and senior advisor at Warburg Pincus, who joined the Board of Directors in 2010. As a

result of the bargaining power of these large investors, Sterling may be able to engage in service contracts

with vendors on more favorable terms. The PE firms provide a wealth of knowledge that will be useful in

benchmarking and determining best practices. Prior to the financial crisis, Sterling outgrew the expertise of

their management, which led to many of the subsequent problems. Overall, our analysis of the new

management at Sterling indicates that they are well equipped to direct the company towards greater

profitability, in the future.

Growth Strategy

Sterling has strived to increase loan originations year over year. The company originated $926M million in

portfolio loans in 2011, which represents a 195% increase over the previous year. We estimate that this trend

will continue throughout 2012 due to improved loan demand and low interest rates. Downward pressure on

interest rates is a concern, however, due to the increase in demand and increase in competition as many banks

more aggressively pursue loan growth. This trend is evidenced by the decrease in loan yields of 0.13% since

3rd qtr of 2011.

Sterling has recently been increasing their percentage of assets concentrated in multi-family housing loans.

This is beneficial as this is one of the strongest sectors in the commercial real estate spectrum. Management

has an internal target for this sector of 22% of total loans. The average loan to value (LTV) of these loans is

66% and the debt service coverage ratio (DSCR) (net operating income divided by debt payments) is 1.30:1.

Both of these ratios are better than the standard underwriting qualifications of 75% LTV and 1.20:1 DSCR at

most competing commercial banks. This should help them to avoid significant defaults.

At projected growth rates for multi-family loans, the company will need to start selling these notes in order to

maintain their target loan portfolio composition. This could be done effectively through their subsidiary,

Intervest. They could also attempt to grow their other loan segments at a similar rate.

In addition to loan portfolio growth, the bank is actively pursuing a strategy of growth by acquisition. In the

first quarter of 2012, they should complete a Purchase and Assumption agreement with First Independent

Bank in Vancouver, WA. Along with market penetration and asset growth benefits, this transaction will

allow Sterling to begin offering trust and wealth management services to its existing clients. With Tier 1

capital exceeding 11%, Sterling is well-positioned for further acquisitions.

First Independent Purchase and Assumption

As previously noted, Sterling has historically grown their business primarily through acquisitions. Now that

they have returned to profitability, they appear to be returning to that model. Sterling is in the process of

finalizing a P&A Agreement with First Independent Bank. The P&A structure was chosen over an acquisition

in order to allow Sterling to exclude approximately $79 million worth of undesirable assets. The transaction

will add approximately $691 million in deposits, $450 million of trust and wealth management assets, and 16

additional branch and office locations.

First Independent operated with a similar focus on community banking, so this acquisition should allow

Sterling to expand their reach in the Vancouver/Portland market, while maintaining their community focus

and feel. One of the most beneficial aspects of this transaction is that it will allow Sterling to add wealth

management and trust services to its product offerings throughout the company. Our analysis indicates that

there will not be significant overlap of the geographical footprint of the combined entities. Sterling’s

management has stated that they expect modest operational efficiencies from the P&A as a result of the

consolidation of back office personnel.

7%

13%10%

2%

25%

13%4%

18%

7%

Loan Portfolio Concentrations

Sterling

Residential real estate Investor CRE

Multifamily Construction

Total commercial real estate Owner occupied CRE

C&I Total commercial

Consumer

12%16%

47%6%

6%

13%

Loan Portfolio Concentration

First Independent

Consumer and Other C&I

CRE Multi-Family

1-4 Family C&D

The acquired assets and deposits have a product mix favorable to Sterling, and merited a $25 million

premium, of which $17 million is contingent upon the quality of the loan portfolio and retention of at least

90% of pre P&A deposit levels. The conditions of the closing are reasonable and the banks are working

closely with regulators throughout the process, so the transaction is likely to be completed in the first quarter

of 2012.

Customer Retention

The McKinsey Banking Report suggests that banks will need to transition to a Customer Relationship focus

in order to succeed in today’s economy. Sterling paid above industry average for time deposits in an effort to

attract customers and maintain adequate liquidity prior to the restructuring. This resulted in interest expense

being well above industry average. Sterling seeks to retain their core customers, but allow “floating”

customers (those that change banks often in search of the best rates) to drift away. To retain their core

customers, Sterling is focusing on customer service and relationship banking, positioning itself to become the

premier one-stop commercial bank in their region. This builds customer loyalty, while also shifting their

deposit mix more toward business checking accounts and demand deposits, instead of savings accounts and

CD’s.

Industry Overview and Competitive Positioning Financial markets have remained volatile as investors are still trying to determine the impact of the housing

crisis going into the future, as well as determine the impact of the European debt crisis on the economy.

Although loan demand is currently rising, there is still the threat that lagging loan demand due to poor

economic conditions and uncertain economic outlook could slow the financial sector recovery. Although it

does not directly impact regional banks, the spillover effects of the European debt crisis could adversely

impact the market for financial stocks as a whole.

In today’s banking environment, where interest rate risk is a significant concern, commercial lending

typically offers the benefit of variable loan rates, which can reduce this risk. In general, banks prefer to have

variable loan products in a rising rate environment. Following the recent Federal Reserve pronouncements,

we believe that interest rates will remain fairly flat through 2013. Loan demand has increased over the past

two quarters, especially for business loans. This trend is helpful for commercial banks such as Sterling.

Despite concerns about commercial real estate following the pattern of extremely high foreclosures, as seen

in the housing sector, commercial real estate foreclosures have not been as high as projected. In the Pacific

Northwest (Sterling’s primary market), the foreclosure rate and rate of distressed properties has been

manageable.

Regulatory Risk

On October 1, 2011 the Durbin Amendment of the Dodd-Frank Act took affect. This regulation significantly

reduces the fee income generated by the use of debit cards for institutions with more than $10 billion in

assets. It is anticipated that Sterling will not reach the $10 billion threshold in 2012, but likely would in

2013. At that point, the projected revenue losses per year will be approximately $7 million. These

transaction fee changes do not affect credit card fees. Sterling has very low levels of credit card assets as a

percentage of total loans, and could increase their marketing of credit cards in order to offset this loss of

income.

The Troubled Asset Relief Program (TARP) was signed into law in October 2008, as an attempt by the U.S.

Government to increase liquidity and capitalization by purchasing assets and equity from financial

institutions, thereby strengthening the financial sector as a whole. Sterling received funds from TARP in

December of 2008. As a concession to Sterling, the preferred stock shares issued to the government were

converted to common stock during their recapitalization, so they have no further special obligations as a

consequence of TARP. The government’s consequential minority ownership of Sterling has no impact on its

valuation.

The Federal Reserve’s recent endorsement of higher capital requirements could limit the profitability

potential of large institutional banks. Although these changes could impact smaller banks, it could function as

an opportunity for Sterling, as these regulations are likely to affect larger banks more heavily. Further,

Sterling’s Tier 1 capital is already 11.4%, and they are maintaining an 11% target rate. Any regulatory

change in this area could benefit Sterling, as Sterling would likely exceed the new standard, and it would put

further pressure on Sterling’s competitors.

13%

3%

7%

35%

26%

16%

Deposit MixFirst Independent

CDsIRASavingsMoney MarketNon-interest Checking

Competitor Analysis

Banking has become a commoditized industry. In order to compete effectively, some banks try to specialize

in key areas and some use a diversification strategy (all things to all people). The competitive landscape for

Sterling includes a wide range of financial institutions. Large banks such as BofA, Chase and Wells Fargo,

and small community banks all compete with Sterling for customers. (See Marketshare tables in Appendix 3)

Within Washington, Oregon, Idaho, Montana and California, Sterling has the ability to serve the specific

needs of the customer, but their lack of presence outside those states makes Sterling less appealing to

depositors who need access to their funds across the country or internationally. For example, Sterling cannot

compete with larger banks such as JPMorgan Chase or Bank of America in their geographical reach, because

those banks each offer over 5,000 branch offices nationwide where Sterling is currently limited to 193

branches and only the Northwest region.

Credit unions, which have been growing rapidly, were given an additional surge of membership and exposure

as a result of Occupy Wall Street and National Bank Transfer Day initiatives which urged bank customers to

move to these non-profit financial institutions. Regulations for credit unions have become less stringent over

time, allowing them to have less restrictive membership requirements and to offer additional business

products. They are increasingly becoming a threat to banks as they expand into commercial lending.

Net Interest Margin The shape of the treasury yield curve has flattened significantly over the past 6 months. Flattening of the

curve is caused by a number of factors, including the Fed’s quantitative easing, but usually is indicative of

bond investors’ lack of confidence in the market. Net interest margin has been impacted by this shrinking

margin between short and long term interest rates. As long term interest rates decline, competition forces

banks to lower the rates that they charge for loans. Savings rates are not able to fall at the same rate, so their

margins shrink. This is a significant risk for Sterling as they have a higher than average cost of capital.

In addition to the capital that Sterling raised through private equity firms, they needed to quickly raise capital

by attracting traditional deposits. To accomplish this, they were required to offer significantly higher rates

than market for deposits (primarily time deposits). This strategy was successful, but it reduced the net

interest margin of the bank. With maturities between 1 and 5 years, these CDs are starting to mature and this

should help reduce the average cost of capital. As of December 31st, 2011, the average cost of these deposits

was 0.80%, which matched the peer average. This cost of funds for Sterling is down from 0.86% in the third

quarter of 2011. The P&A will also help to reduce the cost of deposits because First Independent has an

average cost of interest bearing deposits significantly below the market, at 0.41%.

As with most financial institutions, a vast majority of Sterling’s fixed mortgages are immediately sold to

Fannie Mae or Freddie Mac after origination. This asset management strategy reduces Sterling’s exposure to

interest rate risk in the current interest rate environment since real estate loans have long term rates that are

still historically low.

Regulation Q, originally part of the Glass-Steagall Act of 1933, was recently repealed by the Dodd-Frank

Act. As a result of the repeal of Reg Q, banks are no longer prohibited from paying interest on demand

deposits (checking accounts). The impact of this change will likely be minimal in this low rate environment,

but once interest rates start to climb, this will be another competitive tool that banks will use to attract

deposits, and could negatively impact net interest margins.

Duration Gap Analysis

One tool commonly used to calculate interest rate risk is an analysis of the Duration Gap between assets and

liabilities. Sterling manangment has calculated their duration of assets at 1.65 years and duration of liabilities

at 2.42 years. This yields a duration gap of -1.088 years. Because of a negative duration gap, Sterling’s

financial performance will actually improve as interest rates rise (all else being equal). It should be noted that

in calculating durations of assets and liabilities, managers must make certain assumptions when determining

the cash flow streams. If these assumptions are incorrect, then the validity of the duration gap analysis will

also be incorrect. Based on Sterling’s duration numbers, the change in net worth as a percentage of assets

would increase 50% if interest rates increase by 3%. This indicates that Sterling could significantly benefit

from an environment of rising interest rates.

Investment Summary Our analysis indicates a one year price target of $19.46, which is a 5% increase over the current price.

Sterling has performed better than the SPDR S&P Regional Banking index over the past 6 months with a

9.19% return vs. 5.35% for the index. Sterling’s volatility (beta of 2.21) is higher than the index, which has a

beta of 1.02.

8%19%

32%41%

Deposit Mix-Sterling

Interest-bearing transaction

Noninterest-bearing transaction

Savings and MMDA

Time deposits

Currently, Sterling does not pay dividends. Competitors such as Umpqua Holdings Corporation (UMPQ) and

Glacier Bancorp, Inc. (GBCI) have paid regular dividends to investors, making them appear stronger to

investors who have a focus on dividend returns. Sterling stopped paying dividends during the financial crisis

(after the third quarter of 2008). Very recently, one of the obstacles to paying dividends, the Memorandum of

Understanding (MOU), was recinded. According to Sterling management, the Department of Financial

Institutions (DFI) is reviewing Sterling’s financial condition relating to the final restrictions on dividend

payments. This would indicate that Sterling may be able to start paying dividends once it has paid all of the

accrued interest on its subordinated debt. Management has indicated that they do not currently have plans to

issue dividends.

Positive EPS Surprises:

Sterling has a good track record of positive EPS surprises over the past four quarters, indicating that they

have been successful in managing the firm. This recent track record of positive surprise also suggests that

Sterling has been effective at managing market expectations by being very transparent in their actions. The

positive track record continues in performance against the Financial sector as a whole, in which Sterling has

outperformed by 3.7% in the last month and 18.9% over six months.

The market has reacted well to Sterling’s performance outlook and the news of the P&A agreement with First

Independent. The share price has risen over 18.5% since the purchase announcement. This also may be an

indicator that the market supports management’s decision to seek out these types of acquisitions.

Figure 1: Sterling Stock Price and News Last 12 Months

Source: Schwab

Valuation We derived the price target of Sterling using a weighted average of the Forward P/E ratio (20% weight) and

the P/BV ratio (80%). Historically, the PE ratio has been a commonly used ratio for determining the current

valuation of a company’s stock. One problem with this ratio in a poor economic climate is that when there

are very low or negative earnings, then this valuation tool becomes less effective. As banks have started to

recover from the recession, this ratio is again a relevant instrument for assessing the value of a company. The

Forward PE ratio looks further into the recovery, creating more realistic valuation expectations. Because it

relies on third-party estimates of future earnings for the comparable banks, it still merits a lower weighting

than the P/BV ratio.

The price to book value ratio (P/BV) is arguably the best metric for evaluating a capital intensive company

such as a bank. Unlike many industries, this is a good metric because the book value of assets for banks is

presumably very close to the actual market value. This assumes that problem loans have been identified and

marked to market. During the real estate bubble banks had inflated asset values, but we believe that the

necessary corrections have been made and book values closely match the market. Any P/BV ratio of more

than 1.00 would mean either that the market thinks the company has undervalued the assets or investors

believe that the current (or projected) ROA is positive. Many banks are still trading at levels which result in

P/BVs which are less than 1, but our comparables yielded a weighted average that was 1.24. Because this is

the stronger of the two metrics, we gave the P/BV an 80% weighting in our analysis. (See Appendix 11)

As we used a comparables approach for the valuation of Sterling, our analysis depended on finding the most

highly comparable companies. The FDIC identifies Sterling’s peer group as all banks above $3 billion in

assets. Sterling is a pure-play bank, and most larger banks are not pure play firms. Furthermore, banks with

fewer than $3 billion in assets face a different regulatory environment. For these reasons, we determined that

only banks within $6 billion in assets were truly comparable. We excluded banks above $16 billion in asset

size, subsidiaries of larger banks, non-commercial banks, industrial banks and non-public banks.

The remaining banks were ranked by their similarity to Sterling in a number of financial categories, including

interest income and expense, net interest margin, loan loss provisions, non-interest income and expenses, and

loan portfolio. Commercial banks operate in a different manner than retail banks, so the remaining banks

were ranked based on the level of commercial assets comparative to Sterling. Those banks not highly similar

in their asset mix were excluded. The financial information we used for this analysis came from the FDIC.

(See Appendix 8)

A banks’ performance is strongly influenced by the economic conditions in which they operate, so we

calculated an economic strength coefficient for the remaining banks in our sample. We used two variables to

determine the economic strength of States in which the banks operate: GDP growth and unemployment rates.

For banks that operate in multiple States, we weighted these calculations based on the percentage of branches

that they have in each state. (See Appendix 9)

The banks in the sample are similar in size, have strong concentrations in commercial loans, and operate in

markets that are equivalent economically to those of Sterling. In addition, their financial performance metrics

and ROA are similar to Sterling’s.

The nine banks we determined to be the closest peers to Sterling are First Midwest Bank (FMBI), Umpqua

Bank (UMPQ), MB Financial Bank (MBFI), The Privatebank and Trust Company (PVTB), National Penn

Bank (NPBC), Citizen Bank (CRBC), United Bank (UBSI), Banner Bank (BANR), and Columbia State

Bank (COLB). Interestingly, three of the nine banks which we identified as the closest peers to Sterling are

also direct competitors (Umpqua Bank, Banner Bank, and Columbia State Bank).

The composite price to book value and P/E ratios were then calculated using weights assigned by their

relative rankings. This gave a slightly higher weighting for those banks that were the most similar to

Sterling. The resulting weighted average Forward P/E ratio target was 28.97 and the weighted average P/BV

was calculated at 1.05. (See Appendix 11)

We calculated the projected balance sheet and income statement data for Sterling and used the statistical

forecasting method of two factor exponential smoothing to create baseline growth projections. Income

forecasts were based on financial performance for Sterling and their comparables group, and balance sheet

forecasts were based on Sterling’s own balance sheet, both using data from the last ten quarters. (See

Appendix 4, 5, 6)

We then modified these projections where necessary, following management guidance and taking into

account competitive risks, economic outlook, and regulatory environment. Using this technique, we

calculated the 12/31/12 book value per share to be $15.42 and the earnings per share to be $1.49. The EPS of

$1.49 was multiplied by the weighted average Forward P/E ratio of the comparables (13.99) to arrive at a

Target price of $20.85. The book value per share was multiplied by the P/BV of the comparables to give a

price of $19.12. Using the 20/80 weighting noted above, the final calculated YE 2012 target price for

Sterling is $19.46. (See Appendix 4, 7, 11)

Financial Analysis Sensitivity analysis

To determine the sensitivity of the market price to variability in earnings per share, we determined a range of

possible earnings per share estimates. These estimates range from no earnings to $3 per share for 2012. For

each earnings estimate, we calculated book value and used our target forward PE ratio and price to book

value ratio to determine a target price. For our low estimate of no earnings, forward PE ratio would be not

applicable, so the price target has a 100% weighting on the price to book value ratio. This sensitivity analysis

provided a range of possible stock prices, from a no earnings $17.27 per share target to a high earnings

$26.67 price target.

Capital Structure Sterling benefits from a capital structure with little or no debt, making it less financially risky when compared

to the industry aggregate. Competitors such as Glacier Bancorp, Inc. (GBCI) operate with greater long-term

liabilities and therefore greater financial risk. Sterling does, however, have over $1 billion in junior

subordinated notes (forward repurchase agreements) for which they pay an average interest rate of 3.9%.

These interest payments have been accruing, and are required to be paid current before dividends can be paid.

The high interest rate on these notes has an adverse impact on the net interest margin of the bank. (See

Appendix 5)

Earnings

We took Sterling’s performance ratios and forecasted earnings based on projected changes. Interest income is

expected to decline somewhat over the next year, but this is partially offset by a decrease in interest expense.

Net interest margin improves to 3.38%, which is only a partial improvement over the 3.30% at close of 2011.

Management’s target for net interest margin is 4.00, but we do not expect Sterling to reach this target until the

Federal Reserve relaxes interest rate controls. (See Appendix 6, 7)

Balance Sheet

An understanding of the trends in asset growth is critical to an understanding of the financial performance of

the company. Our analysis of Sterling’s asset growth assumes that loan portfolio would decrease somewhat

in the first quarter and then begin gradual growth as Sterling manages the portfolio to remain below the $10

billion asset level. This has a net positive effect on Sterling’s net income for 2012. We expect the securities

portfolio to be managed in a similar fashion, with tapered growth and then some decline in the fourth quarter,

to keep Sterling from exceeding the $10 billion asset level. (See Appendix 5)

Sterling maintains a direct purchase plan for individuals to buy newly issued shares directly through their

transfer agent, American Stock Transfer & Transfer Services, LLC. Increase in common shares outstanding

through this program is very small, and we projected very modest increases throughout the year.

Investment Risks

Insufficient Capital Levels

If Sterling’s current capital levels are found to be insufficient because of changing regulations, they may need

to raise additional capital that may be subject to additional regulatory restrictions. For example, if the

economic conditions worsen leading to additional provision for loan losses then it could force Sterling to seek

additional capital.

Issuing New Securities

Sterling may decide to raise capital through public or private debt or equity finacing, so if the decision is

made to raise funds through the issuance of securities that could dilute ownership interests of existing

shareholders.

Acquisition Risks

Acquisitions make up a large part of Sterling’s growth strategy, leaving them susceptible to the risks

associated with acquisitions. These risks include overpaying for assets as well as improper implimentation or

integration of newly aquired assets. Unfavorable accounting consequences as well as increases in taxes may

cause acquisitions that appeared to be beneficial to ultimately hurt Sterling overall because of unforeseen

factors.

Regulator Restrictions

There remains some uncertainty as to when regulator restrictions will be lifted or additionally imposed.

Under the terms of the Reserve Bank Agreement, Sterling cannot currently pay dividends, and there is no

certainty that the restriction on dividends will be lifted in the near future. The Reserve Bank Agreement also

Sensitivity Analysis EPS BVPS Price

3 18.42 26.67

2.25 16.18 22.35

1.49 15.42 19.47

0.99 14.92 17.57

0 13.93 17.27

prevents Sterling from appointing new board members or senior executive officers, which could prevent

Sterling from making personel changes that could benefit the bank.

THL and Warburg Pincus

Because of the significant holdings of these investors they each have a representative on the Board of

Directors. Although these board members are non-voting, they will have influence over corporate

governance. This becomes a risk if the goals of THL and Warburg Pincus become substantially different

Sterling, leading to a conflict of interests on the Board.

Stock Volatility

Sterling’s stock price has been very volatile, which may cause investors to lack confidence in the investment

quality of this stock. This volitility may be a result of factors completely outside of the control of Sterling, as

well as larger trends within the Financial Sector, which includes Sterling. Public perception has a significant

impact on stock price so if the public continues to lack confidence in the banking industry it could negatively

impact the stock price.

Appendix 1 (Source: Sterling 10-Q 2011 3rd

Quarter)

Appendix 2 (Source: Sterling 10-Q 2011 3rd

Quarter)

Largest Institutional Holders of STSA

Holder Shares % Outstanding Value* Reported

KING STREET CAPITAL MANAGEMENT, L.L.C. 2,973,487 4.8 36,811,769 30-Sep-11

Capital World Investors 2,888,260 4.66 35,756,658 30-Sep-11

Cyrus Capital Partners, L.P. 2,390,405 3.86 29,593,213 30-Sep-11

THORNBURG INVESTMENT MANAGEMENT INC. 2,272,729 3.67 28,136,385 30-Sep-11

Anchorage Capital Group, LLC 2,272,727 3.67 28,136,360 30-Sep-11

LEE PARTNERS (THOMAS H.) 12,948,112 20.89 160,297,626 30-Sep-11

WARBURG PINCUS LLC 12,948,107 20.89 160,297,564 30-Sep-11

VANGUARD GROUP, INC. (THE) 1,359,791 2.19 16,834,212 30-Sep-11

WELLINGTON MANAGEMENT COMPANY, LLP 907,191 1.46 11,231,024 30-Sep-11

BlackRock Institutional Trust Company, N.A. 603,540 0.97 7,471,825 30-Sep-11

Largest Mutual Fund Holders of STSA

Holder Shares % Outstanding Value* Reported

SMALLCAP WORLD FUND 1,666,668 2.69 20,633,349 30-Sep-11

AMERICAN FDS INSURANCE SER-GROWTH FD 1,221,592 1.97 15,123,308 30-Sep-11

VANGUARD SMALL-CAP INDEX FUND 467,860 0.75 5,792,106 30-Sep-11

ISHARES RUSSELL 2000 INDEX FD 391,569 0.63 5,877,450 31-Oct-11

VANGUARD TOTAL STOCK MARKET INDEX FUND 268,327 0.43 3,321,888 30-Sep-11

VANGUARD SMALL CAP VALUE INDEX FUND 259,273 0.42 3,209,799 30-Sep-11

VANGUARD EXTENDED MARKET INDEX FUND 251,775 0.41 3,116,974 30-Sep-11

FBR SMALL CAP FINANCIAL FUND 244,185 0.39 3,023,010 30-Sep-11

Fidelity Strategic Advisors Small-Mid Cap Fund 186,800 0.3 2,624,540 31-Aug-11

ISHARES RUSSELL 2000 VALUE INDEX FD 175,413 0.28 2,632,949 31-Oct-11

Appendix 3 (Source: Sterling Investor Relations presentation)

Appendix 4

Balance Sheet Assumptions 30-Dec-11 30-Mar-12 30-Jun-12 30-Sep-12 30-Dec-12

Assets and Liabilities Total assets Cash and due from depository institutions 1.97% 0.99% 0.49% 0.25% 0.12%

Securities 4.14% 2.39% 0.80% 0.00% -2.39%

Net loans & leases -1.54% -0.70% 0.00% 0.62% 0.94%

Bank premises and fixed assets -0.43% -0.43% -0.54% -0.76% -0.97%

Other real estate owned -26.58% -26.58% -26.58% -26.58% -26.58%

Goodwill and other intangibles -9.12% 0.00% 0.00% 0.00% 0.00%

All other assets 7.72% 0.75% 0.00% -1.25% -2.30%

Total liabilities and capital Total liabilities Deposits held in domestic offices 0.10% 0.10% 0.10% 0.10% 0.10%

Other borrowed funds -5.27% -5.27% -5.27% -5.27% -5.27%

All other liabilities 13.84% -13.84% -13.84% -13.84% -13.84%

Common stock 0.02% 0.02% 0.02% 0.02% 0.02%

Appendix 5

Balance Sheet Projections (*Dollar figures in 000's) 30-Mar-12 30-Jun-12 30-Sep-12 30-Dec-12

Assets and Liabilities Total assets 9200202 9921707 9942706 9913329

Cash and due from depository institutions 488077 540899 539400 537232

Interest-bearing balances 381956 430271 435610 441016

Securities 2608770 2836582 2836582 2768788

Federal funds sold & reverse repurchase agreements 0 0 0 0

Net loans & leases 5577565 5978715 6015872 6072121

Trading account assets 0 0 0 0

Bank premises and fixed assets 83652 115082 114210 113099

Other real estate owned 60137 44537 32698 24006

Goodwill and other intangibles 20078 23151 25985 28818

All other assets 361923 382742 377958 369265

Total liabilities and capital 9168755 9164964 9118811 9018315

Total liabilities 8282996 8254784 8179661 8057291

Total deposits 6492403 6498994 6505592 6512197

Deposits held in domestic offices 6492403 6498994 6505592 6512197

% insured 0.9008 0.9008 0.9008 0.9008

Federal funds purchased & repurchase agreements 1055763 1055763 1005763 905763

Trading liabilities 0 0 0 0

Other borrowed funds 384253 364021 344855 326698

Subordinated debt 245290 245290 245290 245290

All other liabilities 105288 90716 78161 67343

Total equity capital 885759 910180 939150 961024

Total bank equity capital 893759 910180 939150 961024

Perpetual preferred stock 0 0 0 0

Common stock 1964627 1965020 1965413 1965806

Surplus 61115 61115 61115 61115

Undivided profits -1131983 -1115955 -1087378 -1065897

Noncontrolling interests in consolidated subsidiaries 0 0 0 0

Book Value Per Share 14.26 14.64 15.09 15.42

Tier 1 Capital 11.48474823 10.94319971 11.26765992 11.56426801

Shares Outstanding 62119703 62181822 62244004 62306248

Average Total Assets 9,196,719.7 9,560,954.9 9,932,206.7 9,928,017.7

Appendix 6

Earnings and Profitability Summary Ratios Q1 2012 Q2 2012 Q3 2012 Q4 2012

Percent of Average Assets:

Post-merger

Interest Income (TE) 4.43 4.56 4.53 4.51

- Interest Expense 1.15 1.14 1.13 1.12

Net Interest Income (TE) 3.28 3.42 3.40 3.38

+ Noninterest Income 1.14 1.32 1.38 1.44

- Noninterest Expense 3.67 3.89 3.86 3.83

- Provision: Loan & Lease Losses 0.33 0.13 0.12 0.12

Pretax Operating Income (TE) 0.43 0.71 0.79 0.87

+ Realized Gains/Losses Sec 0.16 0.00 0.00 0.00

Pretax Net Operating Income (TE) 0.58 0.71 0.79 0.87

Net Operating Income 0.58 0.71 0.79 0.87

Net Income Adjusted Sub S 0.58 0.71 0.79 0.87

Net Income 0.58 0.71 0.79 0.87

Appendix 7

Income Projections 30-Mar-12 30-Jun-12 30-Sep-12 30-Dec-12

*Dollar figures in thousands (Quarterly) (Quarterly) (Quarterly) (Quarterly)

Total interest income 101862 135042 112622 111671 Total interest expense 24848 29137 28238 24959 Net interest income 77013 105906 84384 86712 Provision for loan and lease losses

2909.839077 -

100.776549 1168.098043 1109.703384 Total noninterest income 26225.39294 38121.5478 34269.9941 35644.5951 Total noninterest expense 84300.47997 115551.213 96005.24991 94925.94041 Pre-tax net operating income 16028 28577 21481 26321 Securities gains (losses) 0 0 0 0 Applicable income taxes 0 0 0 0 Income before extraordinary items 16028 28577 21481 26321 Extraordinary gains - net 0 0 0 0 Net income attributable to bank 16028 28577 21481 26321 Net income attributable to noncontrolling interests 0 0 0 0 Net income attributable to bank and noncontrolling interests 16028 28577 21481 26321 Cash dividends 0 0 0 0 Sale, conversion, retirement of capital stock, net

Net operating income 16028 28577 21481 26321

Earnings per share 0.26 0.46 0.35 0.42

Appendix 8

Peer Group Analysis Composite Capital Portfolio Financials Commercial Size Regional

FIRST MIDWEST BANK 3.81 4.83 3.54 2.55 4.52 4.29 4.60

UMPQUA BANK 3.72 4.33 2.75 2.77 4.93 4.04 4.75

MB FINANCIAL BANK, NA 3.70 4.59 2.73 3.03 3.79 4.74 4.62

PRIVATEBANK AND TRUST CO. 3.60 4.50 3.04 2.58 4.3 3.80 4.81

NATIONAL PENN BANK 3.58 4.81 2.55 3.23 3.43 4.58 3.74

CITIZENS BANK 3.52 3.70 2.45 3.14 3.48 4.97 4.44

BANNER BANK 3.50 4.74 3.44 2.75 4.15 2.17 4.64

COLUMBIA STATE BANK 3.36 4.91 2.9 2.55 4.26 2.34 4.14

UNITED BANKSHARES, INC 3.48 4.55 3.01 2.99 3.43 3.84 3.91

Peer Group Analysis Weight P/E B/V Ticker State Avg. Assets Net Income

FIRST MIDWEST BANK 11.81% 10.23 0.9 FMBI IL 8,033,595 50,245

UMPQUA BANK 11.53% 13.01 1.5 UMPQ OR 11,597,279 58,125

MB FINANCIAL BANK, NA 11.46% 12.51 1.1 MBFI IL 9,884,447 20,483

PRIVATEBANK AND TRUST CO. 11.17% 13.64 0.9 PVTB IL 12,329,198 51,821

NATIONAL PENN BANK 11.08% 14.2 1.5 NPBC PA 8,575,566 71,045

CITIZENS BANK 10.90% 9.21 0.8 CRBC MI 9,429,809 -3,053

BANNER BANK 10.84% 36.04 0.6 BANR WA 4,069,828 2,173

COLUMBIA STATE BANK 10.41% 17.66 1.4 COLB WA 4,385,387 34,361

UNITED BANKSHARES, INC 10.78% 15.55 2.5 UBSI VA 7,192,199 53,274

Appendix 9

Regional Outlook GDP Growth Unemployment Ranking

Sterling 2.06% 9.47%

Banner 2.04% 8.78% 4.64

Citizens Bank 2.76% 9.90% 4.44

Columbia 2.78% 8.47% 4.14

First Midwest 1.90% 10.10% 4.60

Santa Barbara 1.80% 11.30% 3.95

Umpqua 2.48% 9.55% 4.75

Susquehanna 2.92% 7.81% 3.74

Iberia 2.23% 8.10% 4.23

MB Financial 1.91% 10.08% 4.62

National Penn 3.00% 7.89% 3.74

Private Bank 1.94% 9.73% 4.81

United Bank 3.34% 8.57% 3.91

Appendix 10

Financial Comparison Ratings Sterling/FIB Wght United Score Banner Score Columbia Score

Earnings and Profitability Percent of Average Assets: Interest Income (TE) 4.51 10% 4.11 0.91 4.65 0.97 5.53 0.82

- Interest Expense 1.07 10% 0.66 0.62 0.73 0.69 0.36 0.34

Net Interest Income (TE) 3.44 10% 3.46 1.00 3.93 0.88 5.18 0.66

+ Noninterest Income 0.89 10% 0.85 0.96 0.32 0.36 1.21 0.73

- Noninterest Expense 3.61 10% 2.32 0.64 3.23 0.90 4.70 0.77

- Provision: Loan & Lease Losses 0.31 10% 0.23 0.75 0.95 0.33 0.15 0.49

Margin Analysis: Avg Earning Assets to Avg Assets 97.29 10% 90.34 0.93 93.66 0.96 86.14 0.89

Avg Int-Bearing Funds to Avg Assets 77.07

79.88 0.96 72.05 0.93 78.16 0.99

Loan & Lease Analysis: -Total 4.74 10% 1.36 0.29 2.51 0.53 6.00 0.79

Liquidity Net Non Core Fund Dep New

$250M 21.60 10% 5.64 0.26 6.27 0.29 0.31 0.01

Net Loans & Leases to Assets 61.42 10% 70.03 0.88 72.54 0.85 58.43 0.95

Capitalization Tier One Leverage Capital 11

10.01 0.91 11.60 0.95 11.21 0.98

Comparison Score

2.99

2.75

2.55

Capital Score

4.55

4.74

4.91

Financial Comparison Ratings Sterling/FIB Wght PVTB Score Umpqua Score MBFI Score









89.00 0.87 82.01 0.94 80.37 0.96



$250M 21.60 10% 13.06 0.60 9.46 0.44 13.05 0.60



9.89 0.90 9.53 0.87 10.09 0.92

Comparison Score

2.58

2.77

3.03

Capital Score

4.50

4.33

4.59

Financial Comparison Ratings Sterling/FIB Wght Citizens Score NPBC Score FMBI Score









86.57 0.89 82.37 0.94 81.37 0.95



$250M 21.60 10% 10.87 0.50 13.80 0.64 -5.88 -0.27



8.14 0.74 10.59 0.96 10.63 0.97

Comparison Score

3.14

3.23

2.55

Capital Score

3.70

4.81

4.83

Appendix 11

Projected EPS 1.49 Projected Book 15.42

Target PE Ratio 13.99 Target PBV Ratio 1.24

PE Weight 20% Price BV Weight 80%

PE Target Price $ 20.85 BV Target Price $ 19.12

Total Target Price $ 19.46

Disclosures:

Ownership and material conflicts of interest:

The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or

publication of this report.

Receipt of compensation:

Compensation of the author(s) of this report is not based on investment banking revenue.

Position as a officer or director:

The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company.

Market making:

The author(s) does not act as a market maker in the subject company’s securities.

Ratings guide:

Banks rate companies as either a BUY, HOLD or SELL. A BUY rating is given when the security is expected to deliver absolute returns of 15% or greater

over the next twelve month period, and recommends that investors take a position above the security’s weight in the S&P 500, or any other relevant index. A SELL rating is given when the security is expected to deliver negative returns over the next twelve months, while a HOLD rating implies flat returns over

the next twelve months.

Disclaimer:

The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but

the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used

as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of

an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with [Society Name], CFA

Institute or the CFA Institute Research Challenge with regard to this company’s stock.

CFA Institute Research Challenge Sterling Financial Corporation (STSA) research report Gonzaga University

Economy & Finance

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sterling savings bank

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