A note of caution about share buyback programs surfaced at the quarterly American Banker analysts roundtable.
Panelists generally agreed that the programs would continue to be a popular way for banks to return value to shareholders. But Judah Kraushaar of Merrill Lynch noted a risk that the programs' impact on return on assets would be lessened.
Analysts also were optimistic that banks' share prices would continue to appreciate, though many already trade at record highs.
Analysts disagreed over whether NationsBank Corp. paid too much for Boatmen's Bancshares or how the deal might affect NationsBank stock in the short term.
Participants in the quarterly discussion at American Banker's New York office included Mr. Kraushaar, Thomas Brown of Donaldson, Lufkin & Jenrette, Stephen Berman of Stein Roe & Farnham, and roundtable newcomer Catherine Murray of J.P. Morgan Securities.
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What economic trends have interested you the most in assessing banks this past quarter?
BROWN: The last time we spoke we said the biggest surprise to all of us would be if interest rates went up. And I would say, we just narrowly escaped that. I still think the next move in rates is going to be down rather than up. I also think we were surprised how strong the economy was during the third quarter.
I also made the statement the last time (that) the biggest surprise in the second half of '96 would be the stabilization in credit card delinquency rates. I think when we see third-quarter numbers we'll see increasing numbers of banks talking about stabilization in credit card delinquency rates and some easing of concerns about consumer credit quality overall.
KRAUSHAAR: I'm picking up the same signals on credit card delinquencies. But I'd be quick to point out that there's typically a summer lull or seasonal factor both in delinquency rates and lawyers taking off in August, so bankruptcy filings sometimes are not as high then as they are at other points in the year.
With many bank stocks posting record highs recently, do you see prices leveling off in the coming quarter, and what factors do you see having the greatest effect on prices?
MURRAY: I think that we will cap some of the upside in the bank stocks in the near term, although I'm still optimistic about continued outperformance by the sector. In the next few months I think there's still uncertainty (about possible changes in interest rates). Therefore the banks could give up a little of the ground that they've gained recently before going into what should be a more prolonged period of outperformance.
KRAUSHAAR: My feeling is that the risks are growing and banks will more reflect the market at large. Bank stocks have three challenges: They are structurally moving into overvalued territory. The economy is an increasingly important variable in how well they will do, and the confidence investors have in the economic outlook is great. And third, in terms of the basic fundamental patterns, we think there has been a peaking in the relationship for the average bank between return on equity and cost capital.
These three factors combined may make investing in bank stocks more haphazard over the coming year. It reinforces our view that you have to really focus on companies that have deep, continuing restructuring or refocusing stories. I do think we may be in for a little bit more optimism in the near term, assuming that interest rates don't change wildly.
BROWN: As long as we stay in this economic environment of moderate growth, low inflation, and relatively low interest rates, we're going to continue to see the relative multiples of banks creep back up.
MURRAY: I agree with you because I think that even though we're at the end, or near the end, of the economic cycle I don't think the economy is going to contract that rapidly. That should be good for banks and help make their earnings more predictable. You shouldn't see the contractions in valuations that people often expect near the end of the economic cycle.
Did you say you thought the banks were moving into an overvalued category?
KRAUSHAAR: I think if you looked at relative measures of valuation you could almost always make the argument that banks are cheap. But if you look at kind of a long-term dividend discount model, and assume constant interest rates, I'd say we're probably about 10% overvalued today. That doesn't mean necessarily that the stocks always peak when they go into overvalued territory. Covering bank stocks for as long as we have, we all know that these stocks oscillate between valuation extremes.
MURRAY: Two things should support the continued appreciation of the sector relative to the market - high capital levels and continued consolidation. Both factors I think are very positive in the medium term and definitely support relative appreciation.
What are the trends in consolidation? Do you think the high price NationsBank paid for Boatmen's Bank will set a precedent?
BROWN: If you start with the Boatmen's-NationsBank deal, I certainly don't think that's going to be a trend. My feeling is that NationsBank set some pretty high expectations for their earnings in 1997. And it's going to be very difficult for them to meet those expectations.
MURRAY: I have a different view. I had NationsBank rated "buy" before the transaction, and I maintained the "buy" on the stock afterward. I'm confident that they'll be able to deliver the earnings we have in our model, which are probably slightly above consensus in both '97 and '98. One of the reasons I'm still recommending the stock is because '98 earnings look very attractive.
You don't have any problems with the assumptions they used in the transaction?
MURRAY: No. I think there was a lot of momentum in the core earnings generation at NationsBank, and I think the numbers that they suggested for the Boatmen's transaction are very achievable.
KRAUSHAAR: There's probably a little bit more risk in the earnings outlook than the company projected. But I also think the market's reaction confused the economics of the deal, which I think are adequate. It may be that NationsBank stock was somewhat overvalued before the announcement. But I think that cash-on-cash returns on this transaction, even shaving off some of the management's assumptions, you could rationalize something like a 17% return.
BROWN: Wait a minute now. Based on what they said, they get to a 15% internal rate of return. If you're going to haircut their assumptions, there's no way you can get to a higher return on investment than what they got to.
KRAUSHAAR: I'm not sure where your 15% return comes from.
BROWN: That's exactly what they said in the meeting is that this gives us a 15% cash-on-cash return on investment with ...
KRAUSHAAR: I don't think that's correct. They were talking about in excess of a 20% leverage return. What was 100% unique about Boatmen's was they were sitting on a mountain of excess capital and - wake up, Wall Street - leveraged buyouts have come to the banking industry. And as long as you don't have a terrible credit cycle, a lot of that capital can probably be reasonably returned to the shareholders. Instead of viewing it as an $8.5 billion purchase price up-front investment, I think you've got to be thinking about $3 billion less. That makes a tremendous difference in terms of the base investment that you're basing rate of return on.
BROWN: When the market cap at NationsBank went down $2.5 billion, I think the market was saying not only did NationsBank overpay for Boatmen's but this is an indication of what this company is going to do going forward. What was Ken Lewis' comment? "I would hate to wake up the next day explaining why we didn't get this deal rather than why we paid the price that we paid?" That has got to be scary. That says that, in any future bidding contest, who is going to win?
KRAUSHAAR: We could have a debate on this.
BROWN: Do you want to own that company?
KRAUSHAAR: I think many people have misread the economics of this deal. NationsBank hadn't done such a large deal in a long time. But I think there are other explanations to the stock's performance other than they did a terrible deal.
MURRAY: Keep in mind that the stock had appreciated about 60% in the 12 months preceding that announcement and more than 15% in the six weeks leading to it. The stock's decline of 10-12% over a few days may have reflected the fact that it had run up so fast, so quickly. And then there was some confusion regarding the deal as well. But I think the stock's reaction was a natural pullback that might have occurred anyway.
BROWN: I will bet you that NationsBank's goodwill assumption will be 25% higher by the time they close this deal than what they announced. They will have significantly underestimated the cost of consolidating 50-some banks that Boatmen's brings to the party. I'm going to be shocked if they're not off the mark.
What does this transaction tell us about the future?
BROWN: It says that NationsBank will continue to pursue a geographic strategy. In the year 2015 when the banking industry's consolidation is over, and NationsBank is a $600 billion organization, then may be the time that you want to own it. I think between now and then its shareholder returns are going to be less than adequate. I don't think the risk of this transaction justifies its low upside.
KRAUSHAAR: I think the message here is if a bank's management is sitting on a mountain of excess capital and if it doesn't manage it to the market's satisfaction, there's a greater risk today that another bank is going take it out of your hands for you. I think it's a message for smaller companies because smaller companies in the industry tend to sit on more excess capital than bigger companies, but there are some fairly large, multistate franchises that are out there that are underleveraged and some might say undermanaged.
The small-bank stocks have been really smoking lately. Why is this?
BERMAN: I'm sure some of it has to with NationsBank and the anticipation of more (takeover) activity. And to some extent the small banks were laggards, too.
So it's portfolio managers filling in the gaps?
BERMAN: I think last time I spoke about a rubber band effect. You get the leaders up there, they appreciate, their multiples improve, and they sit awhile, and the others catch up. And I think that's a pattern that you do see, both up and down, in the stocks.
BROWN: I'd say too that it's a lot easier for midsize banks to adjust to what I would call the new environment than it is for the bigger banks. I'm finding more banks in a $5-20 billion category that are really doing well. And that is by no means a generalization that they're all doing well. But I think there are some companies, like First Tennessee, that are doing a great job of managing the business.
KeyCorp said it would reevaluate its buyback if it reached a certain level. With bank stocks going so high, do you think other banks may slow their buybacks?
MURRAY: In general I think banks will continue to buy back stock, even at these levels, because I think you're going to continue to see more capital generated than is needed in the business. In addition, I think you'll see banks will increasingly be originators and not holders of assets. And as long as that's the case, you're not going to need as much capital.
BERMAN: I think buybacks are going to continue. And the companies are managing their capital well and also managing their businesses generally well. They're an important part of delivering the consistency and the growth rate that can improve valuations further.
KRAUSHAAR: I am getting a little more concerned that along the way the incremental power of buybacks begins to level off or go in the other direction. I still think there are going to be some companies that can benefit from reinvigorated new buyback programs, but the risk is that some programs will slow or have a less positive impact on future ROEs.
BERMAN: It does get tiring after a while. It's not new now. It has been new in the last couple of years. But these programs can still create enthusiasm. There's a very positive correlation, I believe, between buybacks and what's happened to stock prices. But like all of these things, they can wear out after awhile.
BROWN: I don't like what these people are saying. I disagree that the buybacks are going to end. I think what others are saying is the impact on share prices is going to be reduced. And there's a difference. I'm expecting continued share buybacks because there is no more attractive use of capital than repurchasing your stock.
MURRAY: I agree with Tom's comment, but I'd also say that the slowing rate of earnings growth is the principle challenge facing the industry now. It's the factor that I worry most about as I look at '97. I worry more about slowing growth - revenues in general - than I do about credit quality.
KRAUSHAAR: In the very short term, I sense that we're getting in the third quarter a broader array of banks that we cover have slower revenue comparisons compared to the first half of the year. Money-centers will probably grow 3% or 4% year on year. First and second quarters of the year, you were talking 8-10% growth rates, and the slowdown is broad-based - in trading, equity gains, loan demand, you name it.
