CLEVELAND -- When you track earning machines like Norwest Corp. and Fifth Third Bancorp as Fred Cummings does, it's easy to become fixated on performance.
The McDonald & Co. analyst is convinced that banks and thrifts that cannot deliver earnings growth and higher performance than peers may soon be takeover targets.
His case in point: Michiganbased First of America, the supercommunity bank whose stock has fallen on hard times. Enen more likely to become targets, in his view, are traditional thrifts that are feeling the earnings pinch because of the slowdown in mortgages.
But his investment strategy centers on the stocks of companies that have the earnings growth to remain independent.
Mr. Cummings, 27, has spent his five-year career at Cleveland-based McDonald where he focuses on 42 banking companies. During a recent interview, he and assistant Michael Durante outlined their view of banks in the upper Midwest.
Q.: What is your near-term outlook for bank stocks?
CUMMINGS: For the short-term, we continue to believe that the group should outperform the broader market based on the solid earnings growth prospects. We are looking for 11% growth on average in the next two years.
We believe the low valuations of banks at 61% of the S&P also supports that.
Finally, because median [dividend] yield for our group is 3.7%, we expect banks to continue to aggressively increase their dividends. That supports our belief that the group will outperform over the next six to 12 months.
Q.: You follow a select group of Midwestern banks that has historically beaten the market and the sector. That hasn't been the case in the last year, why?
CUMMINGS: Longer term, [the midwestern banks] have been more consistent than their peers across the country, primarily given their disciplined underwriting standards. Over the last year, this group has actually underperformed other peers because we didn't have as many turnaround stories in our universe.
Q.: Who are you recommending?
CUMMINGS: We have a couple of recommendations. One is an earnings momentum play, Huntington Bancshares in Columbus. The company's earnings are expected to grow 15% this year and % next. Huntington is seeing strong double-digit loan growth.
The bank has had fairly broad-based [potential] from the commercial and consumer side, including a fairly large indirect auto business. The company is continuing to have some credit quality leverage.
They are in a position to lower their [loan loss] provision at least through the remainder of 1994. In 1995, we think the provision is going to be flat to up slightly.
The company has very strong cost control and we are looking for less than two to three percent expense growth year-over-year. Finally, Huntington is doing disciplined acquisitions, primarily to fill in, and utilizing excess capital by doing purchase transactions.
Q.: Who else are you recommending?
DURANTE: Probably our other top pick right now is Norwest Corp. out of Minneapolis. About 40% of its net earnings come from nonbank subsidiaries, primarily a consumer finance company that is growing 20% to 25% a year. We think Norwest is going to sustain 15% to 20% growth over the next several years. The growth rate will be closer to 20% in 1994 and 1995, which is roughly double what we expect the rest of the universe.
The stock is trading at about 9.8 times 1995 earnings. That is in line with our universe, yet it has a growth rate that will be double the group. We have a six-month target price of $34 and that's looking for a modest multiple expansion.
Q.: How do Norwest's acquisitions factor into your recommendation?
DURANTE: Norwest has had a torrid acquisition pace over the last several years and added about $12 billion in assets [focusing] primarily on underpeforming and troubled companies. The bank has now assumed these companies and we are starting to see improvement. That is driving up profitability. We think Norwest is certainly capable of reducing its efficiency to the mid-60% range by 1995.
Q.: Anyone else?
DURANTE: We also like First Bank System which is also in Minneapolis. We kind of characterize this company as the McDonald's of banking. It has high tech automation and uniform products throughout their system. First Bank essentially has consolidated 95% of its back office into one customer service and loan center.
View From Cleveland McDonald & Co.'s picks and pans
First Bank System
First of America Bank
Marshall & Ilsley
This is probably the industry's most glaring example of a centralized regional bank. It has driven down its cost base dramatically. We are looking for % to 15% growth over the next couple of years.
Q.: Who are you telling people to avoid?
CUMMINGS: First of America is one company we have a "hold" on. We don't see a lot of downside risks, but at the same time, we think the upside is very much limited, primarily due to relatively sluggish earnings growth prospects. We are looking for flat earnings in 1994 and were looking for a rebound in 1995.
I think the market is going to continue to be concerned about the company's acquisition strategy, and that is going to limit the upside potential in this stock.
DURANTE: One of mine would be Marshall & Ilsley Corp. We are neutral at this point. [M&I] just consumated a very large inmarket acquisition of Valley Bancorp. in Wisconsin. We think they paid a very healthy price for Valley and we think there is potential dilution higher than management originally forecasted last year. Second thing, this particular stock has traded, at least in recent history, at a premium to the rest of the banks because of M&I Data Services, their very lucrative data processing business.
The problem with the Valley acquisition is that it dilutes the relative significance of the revenues from [data services] and perhaps eliminates the rationale for the premium in their stock going forward. They are certainly a well-managed company and we feel that there is a still a chance they can pull this deal off.
Q.: What is your view on acquisitions and how the upper Midwest will be affected?
CUMMINGS: Our view is that what is going to determine the winners and losers will indeed be the ability to sustain above average earnings growth. We think near term the companies that are most likely to merge will be those experiencing some earnings pressure.
It's more likely that we'll see acquisitions in the thrift industry, particularly for fill-in opportunities, given that many companies are beginning to see some earnings pressure due to the rapid slowdown in [mortgage] originations.
Q.: But hasn't earnings pressure most often come from credit quality problems, something the industry isn't facing right now?
CUMMINGS: As opposed to earnings being driven by deteriorating credit problems, it will be driven by erosion of the earnings stream that is related to higher interest rates in some cases. That is especially true with thrifts since they generally have a more limited business mix. We think you are going to see banks acquire thrifts that are having earnings difficulties.
Q.: What companies make sense to you as targets in Ohio?
CUMMINGS: One is Citfed Bancorp. a $1.8 billion institution, and the third largest in Dayton. It's got significant market share, so you've got scarcity value. And you've got management that's done a very good job of turning the institution around and improving the profitability. The question is how far can Citfed push the envelope. There a number of larger banks in that market that could take Citfed out. You are looking at companies like banks like Fifth Third, Star Banc, PNC Bank and possibly Keycorp.
Q.: Who else?
CUMMINGS: I would say MidAm Inc. [$1.9 billion in assets, Bowling Green, Ohio]. This is a company that is more thrift-like in its balance sheet. It's a good company, but earnings this year are expected to be down slightly due to significant decline in mortgage banking revenues. The growth prospects aren't that promising. Right now the company is targeting a substantial expense reduction program.
DURANTE: I have one on my takeout list. It's a mortgage bank called Republic Bancorp. It's a Michigan-based holding company and about 80% of its earnings are derived from a mortgage banking subsidiary. This is clearly a story of earnings pressure. We expect Republic's earnings to decline by about 12% this year. It's an attractive takeout.
This company has about a $4 billion to $5 billion origination capacity. It does not have a large servicing portfolio, but we think commercial banks are going to be focusing more on origination capacity as an opportunity to sell their other products.
Q.: Could earnings pressure make First of America a takeout candidate?
CUMMINGS: Longer term they very well could be, but I know it's management's intent to remain independent. If this stock price stagnates and their multiple continues to lag the group, someone may very well come in and put an attractive bid on the table.
Q.: Who else is being looked at in your universe?
CUMMINGS: You've heard about [Cincinnati-based] Star Banc. I don't think it is a likely candidate in the near term. This company has a lot of internal momentum. Management is doing a good job of cutting costs as well as increasing revenues.
Q.: What is the likelihood of a megadeal in the Midwest where you have sizable banks like Banc One, National City Corp. and others?
CUMMINGS: As far as inmarket opportunities, where you can reach the largest degree of synergies are very much limited in the Midwest because of anti-trust concerns. What's more likely to happen in the Midwest is for a Southeastern or a Mid-Atlantic bank to come into this market.
I think PNC would like to strengthen its presence here. Mellon may have an interest in coming in.