Bank stock rally faces earnings test

Shares of big banks are gaining as investors anticipate falling credit costs. Now the companies must deliver the goods.

By TheStreet Staff Apr 9, 2010 10:40AM

TheStreetBy Lauren Tara LaCapra, TheStreet


The performance of big banks in the first quarter will depend on whether they boosted profits in booming areas or stitched up wounds in still-troubled ones.


Capital markets continued to improve last quarter. Wealth management, stock and bond issuance, advisory services and proprietary trading businesses are likely to have grown during the first quarter. Net interest margins probably expanded as credit costs eased.


On the downside, lending is weak and new regulation has curtailed fee revenue from sources such as overdrafts, credit cards and deposits. It's unclear how mortgage modification programs are faring with charge-off and foreclosure rates still high. It's also difficult to tell whether fees from strong refinancing volume and new home purchases will be enough to counter those losses. Banks that took advantage of shifting interest rates early with smart hedging strategies may have offset housing losses entirely.

Collins Stewart analyst Todd Hagerman issued a report on Monday that cited the positive trends for the group. He upgraded Wells Fargo's (WFC) stock to “buy” and reiterated the same rating for JPMorgan Chase (JPM) and Bank of America (BAC). He rates Citigroup (C) stock “hold.”


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"Bank stocks have soared this quarter as cheap valuations, combined with the likelihood that credit has finally reached an inflection point, have provided the necessary fuel to propel the group higher," Hagerman said in his report.


Deutsche Bank (DB) analyst Matt O'Connor says negative factors are "known issues" and identified several areas that have room for "potential positive surprises." He says margins could expand because of low funding costs and revenue could increase from mortgages, nonperforming loan sales and trading in bonds, currencies and commodities.


"We think more banks will talk about becoming profitable at some point this year," O'Connor says.


Performance hinges on expectations too, and the positive Wall Street sentiment on banks may end up leading to a rally that falls flat when the companies report. The KBW Bank Index ($KBX) soared 22% during the first quarter, with JPMorgan gaining 7%, Wells Fargo adding 15%, Bank of America climbing 15% and Citigroup soaring 22%.


During the first week of the second quarter, they have continued to surge. Bank of America shares have risen every day this week, topping $18 five days in a row, something the stock hasn't done since November 2008.


Bank of America is expected to earn 8 cents per share on revenue of $27.6 billion, the average estimates of analysts surveyed by Thomson Reuters. Analysts predict JPMorgan will report a profit of 65 cents on $26.6 billion in revenue. Wells Fargo is projected to earn 40 cents on $21.6 billion in revenue. Citigroup is forecast to report a slight loss but break even on a per share basis on $20.9 billion in revenue.


With the bulls charging in ahead of the earnings reports, any minor disappointment could set the stocks back. O'Connor lowered his "normalized" annual profit estimate for Bank of America to $2.09 per share from $2.82 after doing a "deep dive" into the firm's profit fundamentals.


O'Connor says the elimination of certain fee sources, along with reductions to Bank of America's home equity, auto and credit-card portfolios will impact the company more than Wall Street expects. The firm is also rebalancing its assets to keep pace with changing interest rates, which may limit profits in the near term. Most analysts expected normalized estimates of $3 per share or more, according to O'Connor, something that's not realistic given the headwinds, he says.


O’Connor says Wells Fargo is a "top pick" because of its asset exposure to a steep yield curve and strong mortgage business. He also expects Wells Fargo to pick up business as Bank of America and JPMorgan get rid of some assets and customers.


"With the stock trading at about eight times our normal earnings per share estimate (versus 9 times for the overall group), we think the valuation is very attractive," says O'Connor.


Citigroup's results stand to be muddled as ever, as the company keeps works through bad mortgage bets and business divestitures. Its core business lines appear to have improved and its stock has gained. The Treasury Department plans to sell its 30% equity stake over the course of the year.


In a note to clients last week, Rochdale Securities analyst Richard Bove joined a growing number of analysts and investors arguing that Citigroup's book value is understated. He said its recent Primerica spin-off showed there's more value in Citi Holdings assets than many assumed, and proved there’s a market for other assets the firm is trying to sell.


"Buyers for the stock that the government is about to sell are likely to line up,” Bove wrote. “The issue will be sold sooner rather than later."


If credit costs improve, investors will question when these banks will be able to consistently increase revenue again. Bank of America, for instance, is expected to post sequential sales growth for the first time in year.


Ladenburg Thalmann (LTS) said in a research note this week that banks will have to focus on reinvestment this year to set the stage for future growth. Questions about credit will shift to questions about revenue.


"We think normalized earnings means more than just lower credit and operating costs," the firm wrote. "To us, it means a return to growth levels that modestly exceed nominal US gross domestic product growth (recent economic forecasts are 3.5% to 4.5%)."


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