Thomas Hanley, a prominent bull on bank stocks, has turned even more bullish after looking over bank's second-quarter earnings reports.
The First Boston analyst sees strong earnings growth from dramatic reductions in loan-loss provisions and from loan growth. And he thinks bank earnings are more stable now, because of new attitudes among bankers, productivity gains, and the use of derivatives to lock in margins.
Mr. Hanley has been a bank analyst for 27 years, the last two at First Boston. His experience tells him that mergers and acquisitions activity combined with low-rate environments are a powerful stimulus to bank stock prices.
That's part of the reason he is convinced that bank shares will trade at a higher multiple relative to the broad market.
He's had some luck in picking takeover targets, which he publishes. Recently, two of his picks have accepted takeover offers: First United Bank Group and Constellation Bancorp. Who's next? He is betting on Integra Financial Corp. in Pittsburgh.
Q.: You've been bullish for a while. Did second-quarter earnings make you more or less optimistic?
HANLEY: I came out more bullish. I feel better about the industry's fundamentals.
We changed earnings estimates on 24 banks in our 35-bank universe. The percentage change in 1993 earnings was 9.95%. The percentage change for 1994 is 6.68%.
I think the first half of the 1990s could be the best of all worlds for bank stocks.
Q.: What in the earnings reports convinced you?
HANLEY: Loan volume is just a little bit better than what we thought, especially on the consumer side.
Net interest margins weakened a touch more than what we would have thought. But there wasn't a bank that showed a decline in margins that didn't have an increase in net-interest income.
The improvement in credit quality is still running six months ahead of where we thought it would be. So are the productivity ratios.
Q.: Is the loan growth significant?
HANLEY: According to the Federal Reserve numbers I saw on June 2, it was the first time the industry broke into positive loan growth, at 0.5% if you excluded two of the districts. New York and San Francisco, the other 10 districts were up 5.8%.
Ideally, loan growth more or less parallels nominal growth in the economy, which is about 6%.
Even on the West Coast, you are seeing lending commitments picking up.
If you look at the past 30 years, after the economy bottomed, it took five quarters before total loan growth ran at an annualized 7% rate. We think it will be 10 quarters in this case, which puts normal loan growth around the first quarter of 1994.
Q.: You've been talking about falling loan-loss provisions as a source of earnings. Did this happen last quarter?
HANLEY: Several banks have shown a negative loan-loss provision, including Deposit Guaranty and First American.
In conference calls, managements have been dancing around this issue. They've indicated they will recapture part of this reserve in 1994 and 1995.
NationsBank said its has $700 million in unallocated reserves. NationsBank viewed a lot of that $700 million as excess reserves that would be brought back into the income statement over the next year or so. Wells said an $800 million in unallocated loan-loss reserves.
In our forecasts, we assumed reserve coverage in 1995 would be 126%. It now looks like that number will be 80%, which we've had confirmed by several banks.
For the 35 banks we cover, that works out to be worth $9.9 billion dollars in pre-tax income. About $6 billion after-tax. That's equal to about 37% of what we thought the banks would earn in 1995.
This will prove to be a real cushion to banks when many outside observers are apprehensive about loan volume or margins.
Q.: Are you talking about guaranteed earnings? Don't the bears argue that those earnings won't last?
HANLEY: I recall last year, after bank stocks had been going up for a year and a half, people said the party is over. The argument was, look at the investment gains these banks are booking.
People ignored the fact that the banks set themselves up according to classic bank economics: When you think there is going to be a recession, you move aggressively to buy bonds and when the rates come down, you shorten the maturity and you book the profits.
Then for the last couple of quarters, people said margins had peaked, that they would come down very sharply. Now they are questioning loan volumes. They always question foreign-exchange trading and bond trading.
Ironically, when robust loan growth returns, it is the time to underweight commercial banks. Because you only see strong loan growth when you see a healthy American enconomy.
And when you see that, there are other industries that will come through with substantial earnings leverage. So that even though the banks stocks may continue to rise absolutely, it is ironic that they will underperform the market.
Q.: Won't there always be ways to criticize bank earnings?
HANLEY: Banks' earnings are different now. They will be more predictable for several reasons. Banks can use derivatives to lock in spreads. We have loan-loss reserves up front now. This is the first time I recall banks zeroing on in productivity. Mergers will let banks buy loan volume, which will smooth out earnings.
Q.: Who do most like now?
HANLEY: We just put First Chicago on our recommended list. The other money center we like is Chemical. Both can generate earnings internally. Among the regionals, we like NationsBank, which is cheap, and Keycorp, for its earnings and the possibility that it will be taken over in 1995 or 1996. We also like First Union Corp and Wells Fargo. We raised Wells' 12-month target from $125 to $146.
Q.: Do you stick with your forecast that the trading multiples will be higher for bank stocks?
HANLEY: If I've noticed one thing during my career in bank stocks, it's the corollary between bank stock moves and the macroeconomic environment, which we've seen in the early 1960s and now: modest but improving growth in the GNP, controlled inflation, and relative stable short rates. In the 1960s, the merger and acquisition activity heated up and the stocks went wild. We saw the same thing in the early 1970s and mid-1980s.
Those two are very powerful factors. When you add them together, these multiples do well.
Bank stocks trade at a 40% discount against the market. Excluding an overall downturn, I think those multiples will expand to 70% to 75%.
Q.: You publish a list of takeover candidates. Who is likely to go next?
HANLEY: We think Integra and Union Planters are next. Then there's Liberty Bancorp., the largest independent in Oklahoma. In Texas, there are a few, and we've chosen to play Cullen/Frost.
Remember, there were 40 bidders for First City Bancorp. in Houston, and 38 came away with nothing. And Cullen/Frost is the largest independent left in the state.
