'Quality' bank stocks gain in favor
Wells Fargo and U.S. Bancorp may be better bets than companies recovering from deep losses.
It may finally be time for bank-stock investors to favor quality names.
Until now, the big money has been made on shares of banks recovering from losses and a slowdown in lending.
The KBW Bank Index (BKX) is up 7% this year through Friday's close, following a 30% return in 2012. Last year's gain was heavily influenced by two major recovery plays: Bank of America (BAC), which was up 110% after plummeting 58% in 2011, and Citigroup (C), which rose 51%, following a 44% drop in 2011.
With the bank-stock rally continuing, this is a good time for investors to consider quality over recovery potential, as major players with strong earnings performance are trading for relatively low premiums to earnings estimates.
Stifel Nicolaus analyst Christopher Mutascio said in a report Monday that "the market is allowing investors to purchase low-risk franchises with strong management teams that are generating profitability ratios well in excess of the industry's average at 'no extra charge.'"
Bank stocks are charging ahead, in part, because of the rapid rise in the yield on 10-year U.S. Treasuries. The Federal Reserve is planning to keep short-term rates at a record low until the U.S. unemployment rate improves to 6.5%. Some banks, reports TheStreet, are poised for significant earnings improvement if this widening of the yield curve holds.
But some investors see the advancing yield on the 10-year benchmark bond as a sign that the central bank will move faster on raising short-term rates, which would cause a "parallel" increase in long-term rates and improve profitability for nearly all banks.
"The recent rally in bank stocks on the erroneous view that an increase in the 10-year U.S. Treasury yield is a significant driver of improved earnings or on the false notion that the Fed will raise short-term interest rates in the near-term has resulted in very little differentiation in the valuations between highly profitable banks and those that aren't as profitable," Mutascio wrote.
Bank of America and Citigroup, unlike the regional banks, are still trading at significant discounts to book value. Bank of America's shares closed at $11.76 Friday, trading for a relatively low 9.1 times the consensus 2014 earnings estimate of $1.29, among analysts polled by Thomson Reuters. Citigroup is at 8.1 times the consensus 2014 EPS estimate of $5.18, based on Friday's closing price of $42.68.
But the relatively low valuations for Bank of America and Citigroup reflect the high level of price volatility over the years, along with weak earnings. Bank of America's 2012 return on average assets (ROA) was 0.19% during 2012, according to Thomson Reuters Bank Insight. The ROA has ranged from a negative 0.09% to 0.22% over the past five years. (Also see TheStreet's Community bank stocks are overvalued.)
Citigroup's 2012 ROA was 0.41%, and the company's ROA has ranged from a negative 1.28% to 0.57% over the past five years.
Mutascio's point about the market's failure to place a premium on quality is supported by a look at forward price-to-earnings ratios for the nation's largest regional banks, while also considering earnings strength and consistency.
Shares of Wells Fargo (WFC) closed at $34.88 Friday, trading for 9 times the consensus 2014 EPS estimate of $3.88. The amazing thing about the stock is that it trades at a slightly lower P/E than Bank of America, despite being a much less risky play for investors. The company's 2012 ROA was 1.41%, and the ROA has steadily risen over the past five years, from a low of 0.44% in 2008. In fact, 2008 was really the only "bad year" for the company in recent memory. Aside from a relatively low ROA of 0.97% in 2009, the ROA has been well above 1% over the past 10 years.
Shares of U.S. Bancorp (USB) of Minneapolis closed at $33.65 Friday and traded for 10.2 times the consensus 2014 EPS estimate of $3.30. While that's a bit of a premium above the market's forward P/E for Bank of America, USB has been an even stronger earnings performer than Wells Fargo. The company's 2012 ROA was a solid 1.62%. Over the past 10 years, U.S. Bancorp's ROA only slipped below 1% in 2009, when it was 0.82%, and the ROA was above 1.5% each year except for 2009 and 2010, when it was 1.16%.
Mutascio on Monday upgraded Wells Fargo and U.S. Bancorp to "buy" from "hold" ratings.
The analyst's price target for Wells Fargo is $42, and he said the stock's discount to lesser-performing peers "is based on fears that the company is over-earning in the current mortgage banking environment." Mutascio disagrees with that notion, and said "the company has several material offsets to lower origination activity and gain on sale margins."
According to Mutascio, the offsets to lower mortgage volume and lower gains on mortgage loan sales include increased income from loan servicing, the "eventual reduction in mortgage repurchase requests from investors, declining expenses following the recent industry foreclosure settlement with federal regulators, and the elimination of forgone revenue from the retention of mortgage originations." (See also TheStreet here and here.)
Stifel Nicolaus estimates that Wells Fargo will earn $3.59 a share this year, with EPS increasing to $3.83 in 2014.
When discussing his upgrade of U.S. Bancorp, Mutascio wrote that "investors have the potential to earn significantly higher profitability and invest in one of the strongest management teams in the industry at a discount."
Mutascio's price target for U.S. Bancorp is $39, and he estimates the company will earn $3.08 a share this year, increasing to $3.25 a share in 2014. The analyst wrote that U.S. Bancorp's shares trade "at a lower P/E multiple than both [Comerica (CMA) and KeyCorp (KEY)] despite a projected ROA of 1.62% (versus just 0.75% for CMA and 0.94% for KEY)."
Mutascio downgraded these regional banks to "sell" from "hold" ratings, with no price targets:
- KeyCorp of Cleveland. Mutascio estimates the company's ROA for 2014 will be 0.94% on EPS of $0.91. "Our analysis indicates the company has no material EPS upside in an environment where both the net interest margin and the loan loss provision expense normalize," he wrote. Net interest margins would "normalize" in a higher-rate environment. The loan loss provision is the quarterly addition to loan loss reserves. With credit quality improving, many banks, including Comerica, have seen a benefit to earnings as loan loss reserves are "released." Mutascio also said "the shares trade at the second-highest P/E multiple within our large-cap bank universe."
- Comerica of Dallas. "The shares are trading at a 25% premium to the rest of our large-cap bank coverage universe despite having one of the lowest projected ROAs," Mutascio wrote. The analyst added that "with approximately 72% of the company's earning assets tied to the short-end of the yield curve (not the long end), we believe the market is way ahead of itself in assuming just how much the company benefits from the recent rise in long-term interest rates." Stifel Nicolaus estimates that Comerica's 2014 ROA will be 0.75%, with EPS of $2/85.
Mutascio downgraded Fifth Third Bancorp (FITB) of Cincinnati to "hold" from "buy," calling the move "purely a valuation call as the shares are now within 2% of our $17 target price." The analyst added also said "we still like it over other Midwest banks like CMA and KEY."
Stifel Nicolaus estimates that Fifth Third will earn $1.73 a share in 2014, with an ROA of 1.21%. Fifth Third's shares closed at $16.61 Friday, trading for 9.8 times the consensus 2014 EPS estimate of $1.69.
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