Banks are facing their toughest business climate in years, and at American Banker's quarterly roundtable, conducted March 12, analysts seemed certain of several things: Wall Street was overestimating bank earnings for the coming year (but perhaps underestimating profits for the thrifts), and first-quarter results would go a long way to resolving questions about the outlook for this year.
In a reversal of sentiment from recent roundtables, analysts cited out-of-favor banking companies like First Union Corp. and Bank of America Corp. as some of their favorite picks because of their low valuations, while high-priced stocks like Northern Trust Corp. were viewed more cautiously.
The participants were Denis LaPlante of Fox-Pitt, Kelton Inc.; Katrina Blecher of Sandler O'Neill & Partners; Scott Valentin of Friedman Billings Ramsey & Co.; and Steven Wharton of Loomis Sayles & Co. As we leave the first quarter there seems perhaps to be even more doubt about the outlook for 2001 than there was at the end of last year. The sharp slowdown in the economy and slumping financial markets have contributed to that sense of uncertainty. As we look ahead to first-quarter earnings, what kind of results are you expecting, and what themes are you watching for? DENIS LAPLANTE: The first quarter may be the toughest quarter this year. Capital markets revenues will be soft and credit quality will continue to show deterioration.
We anticipate that the gross inflows of problem assets will peak in the first half, although we do not anticipate that non-performing assets will peak until the fourth quarter or the first quarter of 2002. We are projecting a linked-quarter median increase in problem assets of 5% to 10%. Consumer credit will not become a real issue until later this year or in 2002.
STEVEN WHARTON: I think the first quarter is going to be mixed, but generally better than the fourth quarter of 2000.
The real wild card in the quarter is going to be management comments regarding middle-market and large-corporate commercial credit quality for the rest of the year. Last year, it was much easier to pinpoint early problems in the leveraged, syndicated loan market. This year, we are hoping that middle-market commercial credit quality does not deteriorate meaningfully, based on our belief that banks did not make the same lax underwriting decisions in the middle market that were made in the leveraged market in the mid to late 1990's.
Management guidance on credit quality, both in terms of nonperforming assets and net chargeoffs, will be a key determinate of future bank stock outperformance.
SCOTT VALENTIN: Looking at thrifts, the first quarter will be marked by upside EPS surprises. I expect the largest net interest margin increases by ARM lenders, with a smaller degree of margin expansion by fixed-rate lenders.
The one risk we're monitoring is the overextended consumer, which I think will [play] out later in the year, if the economy continues to weaken.
As far as guidance goes, I think management will be probably more positive than negative. We've already seen upward EPS revisions for this first quarter. We just raised Washington Mutual's estimate for 2001 from $4.35 to $4.50, so I think there will be continued positive news from that sector.
KATRINA BLECHER: I'm not looking for a great first quarter. I don't think there are going to be any major surprises. I think if there's going to be any one particular overriding theme it's going to be the slowdown in commercial loan growth. It will make the credit-quality numbers look a lot worse.
On the positive side, there are going to be better mortgage revenues, although I think a lot of people have taken it into their numbers.
I think the acceleration we've seen in nonperforming assets is going to be slow. I think that growth is going to continue, which is at odds with what many company managements are saying, because they're saying that everything's going to be fine in the second half.
LAPLANTE: I'm not sure of any managements who are very confident about what's going to happen in the second half of the year.
BLECHER: I think also an overriding theme in the first quarter is that there's going to be downward earnings guidance given on the first-quarter conference calls, which we didn't necessarily get at yearend.
How would you characterize the visibility of earnings right now compared to a year ago?
BLECHER: Visibility has certainly declined, and I think it's due to two factors. One, there is less guidance on the Street from management and because of Regulation Fair Disclosure.
But I think even more importantly than that, the companies, more so than a year ago, more so than five years ago, are more certain of earnings trends. They're not as sure of growth rates and where the demand is in the marketplace, and a lot of companies are less willing to go out on a limb and make a projection. Hence we have less guidance.
And the visibility in terms of the quality of the earnings that are reported has shown little improvement. Too many companies are still reporting nonrecurring items into which they're throwing in the kitchen sink. And it becomes very unclear to find out exactly what they earned.
Are you worried that the kitchen sink is becoming a habit for some companies?
BLECHER: I think that that there are some companies that clearly are perpetual nonrecurring charges, and they trade at a lower price-to-earning multiples. I'm surprised, though, at what the Street accepts as nonrecurring. I think that there should be more policing of the numbers, and analysts should scrub them a lot more.
One of the things we were hearing late last year was that the first and second quarters would be slow in terms of earnings. But there was relative optimism that it wouldn't go too far beyond the second quarter. Do you believe that was true then? Do you think that's still true now?
VALENTIN: I cover mostly thrifts and some community banks. The macro environment is near perfect. The margins are expanding. Earnings estimates are going up. Asset quality is expected to be relatively benign. There's very little capital markets exposure. The fundamentals look very good.
I think we will see continued upward EPS revisions throughout 2001, reflecting improving margins and relatively stable credit quality.
Do you feel that is priced into the stocks, though?
VALENTIN: Somewhat. The top 10 largest thrifts are up an average of 50% over the last 12 months in anticipation of an accommodative Fed, so they have had a nice move, but I believe there is still another 10%-15% upside. Given the economic slowdown, thrifts are one of the few industry groups with improving earnings over the next 12 months.
With the exception of thrifts, you all seem to agree that estimates are too high. Is this a matter of figuring out which banks are at risk or, more broadly, the degree to which everyone's estimates across the banking universe is too high?
WHARTON: I think earnings estimate analysis should be evaluated on an individual company level. One thing that is notable about banks' performance year-to-date is that companies that have seen ongoing negative EPS revisions have performed very well in some cases. For example, Fleet has had a greater-than-average negative 2001 EPS revision, and yet the multiple has expanded, and the stock is up.
I do not think this dynamic will persist. It is going to be much more important from this point forward to identify which companies are going to have negative EPS revisions and which companies are going to see earnings revisions trends level off and possibly improve. It is the latter category of banks that are likely to sustain longer-term outperformance. We think the overall group will see negative revisions trends in the first half of 2001, and then level off in the second half.
BLECHER: I agree with Steve that I think it's really company-specific. I think there are some companies out there whose estimates are way too high.
What's way too high? Is that more than 10%? 20%?
BLECHER: Way too high would be 10%, which for a bank I would think is significant. But I would also say that those are not necessarily the stocks that are going to get hit the most. For example, if a bank revises earnings downward because of a change in strategy - they're cleaning up the balance sheet or something - I think people will give them credit.
But I think overall analysts are still sitting out there with estimates that are too high.
Will the first-quarter conference calls get us there?
Late last year Alan Greenspan started saying that he was concerned that the slowdown in credit availability was starting to hurt people who deserved the credit, and that the banks were starting to play a role, perhaps, in slowing the economy down.
Do you think there's a risk that banks are being too cautious right now?
VALENTIN: Most thrifts are focused on residential and consumer lending. We saw no sign of a pullback in those areas. To the extent large banks pulled back from small to mid-market commercial lending, it created an opportunity for some thrifts to gain borrowers.
BLECHER: I do believe that in the fourth quarter there was a real pulling back by the commercial banks lending to the corporate sector, and that had the Federal Reserve concerned, in my view, that maybe they were going to overdo it and slow the economy too much and create a liquidity crisis, which is something to be avoided at all costs.
I think in the first quarter the regulators and the rest of us got very lucky, because the debt markets opened up, and so liquidity increased. You had corporations able to go and raise money in the fixed-income market where they weren't able to in the fourth quarter. That took pressure off the fact that borrowers were not getting as much credit from the banks.
WHARTON: I think Greenspan originally made that comment in early December of 2000. Shortly following that comment, Fleet chief operating officer Chad Gifford suggested at the Goldman Sachs Bank Conference that while Greenspan was trying to jawbone the banks back into lending, the banks were more interested in seeing a rate cut before they felt like taking more risk.
Also, the banks have been dealing with the reality of the regulators telling them to lend more carefully, while Greenspan tries to prevent a credit crunch.
Since the Fed has begun easing, the banks feel better about lending, and I expect this to be reflected in the upcoming senior bank loan officer lending surveys. While banks are likely to retain a more disciplined underwriting bias, we also do not expect them to shut off the lending spigot altogether, especially to quality, investment grade, large corporate and middle-market commercial customers.
Last year we saw cases where the corporate customer said, "If you don't give us the credit line, we don't give you the underwriting business." Is this something that could catch on widely or really will be limited to those select multibillion-dollar clients willing and able to apply their leverage to the relationship?
WHARTON: I think this is mainly a factor for the multibillion-dollar corporations, particularly ones that find themselves in distressed situations. The tier right below the Fortune 100 are still going to need and want the expertise of a Goldman Sachs for M&A advisory and major equity and debt underwritings. These corporations will be able to get their credit needs fulfilled, whether they give investment banking business to their bank or not.
Right now, we are in a really tough capital markets environment. Large companies that are seeing fundamentals deteriorate, yet need access to liquidity, are bullying investment banks and money-center banks in need of advisory and underwriting business into providing the liquidity that is growing more difficult to arrange.
Money-center banks are best positioned to provide that liquidity due to the nature of their large balance sheets.
What's everyone's favorite stock, and why?
LAPLANTE: Our strategy has been to buy the "dogs of 2000." Bank of America has been one of our favorite names. It is a contrarian pick, but had the lowest P/E of the 50 stocks in our universe. We think there is a chance they will beat the consensus estimate in Q1. We thought it was the perfect stock in a rate-cutting environment.
Our favorite names in the midcap area are Unionbancal and Hibernia. Each has had a checkered past on credit quality, but they are also near the bottom of the valuation range.
BLECHER: I like First Union for the same reasons. I think the stock is too inexpensive relative to the expected earnings turnaround. We believe that a couple of quarters out this company should be able to command a much higher multiple in the marketplace. We've done a line of business analysis and determined that it should really be trading by about a 7% discount to the group. It is currently trading at 10%.
On the other side of the table, I believe that there is also a place in portfolios for the high-quality companies that aren't going to get hurt and see lower earnings. Bank of New York and Wells Fargo are not going to come out in the second quarter and say numbers are too high.
Lastly, I'd just say that SunTrust is a company that we continue to love. We think its credit quality is exceptional, and as those concerns linger this year, we think investors will gravitate towards the strong-credit-quality institutions again.
VALENTIN: I like Washington Mutual, for its lack of credit risk and expanding margins. Dime Bank has a good metro-New York franchise and is well positioned to take advantage of the increased mortgage origination activity. Additionally, in September they announced a securities portfolio restructuring initiative, which will benefit net interest margin, and a cost reduction initiative.
Banknorth Group has good credit quality, an attractive franchise in New England, and low valuation.
WHARTON: My favorite stock currently is U.S. Bancorp. It is a contrarian pick in that the company does not have a lot of credibility right now. Earnings estimates for 2001 and 2002 are below management guidance from the [Firstar-U.S. Bancorp] merger presentation, yet the company has a strong track record in delivering on expectations. The forward P/E multiple on the stock has gone from a high of over 30X to 12X currently.
We think the first quarter will show improving core revenue momentum, excluding some capital markets weakness. The net interest margin of the new USB should expand as rates fall and management improves the efficiency of the old USB balance sheet. We expect the company to deliver on original merger earnings expectations and would eventually like to see upward EPS revisions.
What situations would you avoid buying into?
BLECHER: I would say that a lot of people are focusing on credit quality, and I think that that is going to be an issue for this year.
But I think an equally important issue is revenue growth, and a lot of people are not yet focusing on that. I think that while there might be some margins expansion, I think it's going to be more moderate. I think it's going to be able to offset the slowdown in loan growth. That's why I'm not expecting much growth in net interest income next year.
WHARTON: I think that Bank One is fully valued. While I believe Jamie Dimon's efforts to fix the bank are admirable, he has inherited a very broken franchise. It is going to take more time than the Street is discounting to turn the bank around. Earnings expectations for 2001 have been revised significantly downward, despite Dimon's moves to take $5 billion in random "charges." While the stock has not gone up much recently, it also has not fallen as much.
We think both BAC and USB have much better near-term fundamentals, yet these stocks trade at a discount to ONE.
VALENTIN: Sovereign Bancorp, given the execution risk involved in the acquisition of the FleetBoston divestiture, high level of leverage, and deteriorating credit quality. In general we are more concerned about those companies which have recently increased exposure to commercial credits and consumers. Given the high level of consumer debt, continued economic weakness could pose problems for lenders with large consumer portfolios.
LAPLANTE: Northern Trust is a great company, but at just above $65 a share, it still trades at a hefty 28 times projected 2001 earnings. They will weather the credit cycle better than most and will produce a better-than-average gain compared to the rest of the industry. But I think we still could see maybe a little more P/E contraction ahead.