The fundamental outlook for banks has rarely been better, according to a panel of Wall Street analysts recently gathered by American Banker.
Nevertheless, banks face daunting revenue challenges that are dividing them into haves and have-nots. The analysts say they believe that investors should select stocks primarily based on the ability of banks to meet such challenges.
The summer wave of bank mergers drew differing responses, including some sharp criticism. However, all agreed that the consolidations would continue.
The panelists, who gathered on Aug. 28 in New York, were Robert B. Albertson of Goldman, Sachs & Co., Thomas K. Brown of Donaldson, Lufkin & Jenrette Securities Corp., Dennis Shea of Morgan Stanley & Co., and Felice M. Gelman of Keefe Managers Inc.
AMERICAN BANKER: First I would like to ask each of you for your view of the market, the important factors you see, and your top picks.
ALBERTSON: To the extent it's an industry group of stocks at all, I think the most important thing to recognize is that profitability is up dramatically while the relative price/earnings and price/book valuations are not. Banks are also generating a lot of capital that is earmarked, I hope, to repurchase stock.
That's the good news. The bad news, I think, is that the revenue cycle is coming to an end, so investors need to be careful. The average bank that was a good investment even two months ago may not be now.
Our three leading recommendations are Citicorp, Banc One Corp. and Norwest Corp. They have a revenue edge. They are run by retailers, which gives me comfort. They understand the consumer banking business at the relationship management level, which you don't see in retail banking.
Right behind our top picks are BankAmerica Corp., Nationsbank Corp. Chase Manhattan Corp., Chemical Banking Corp. - all have been on our recommended list for some time.
Finally, I want to point out that the group is not over-owned by investors. So, overall, I think we are in a good period, provided increased selectivity is applied.
BROWN: As you say, Robert, it's not an industry anymore, as such, and I think there is too much focus on the "industry averages." To me, the big issue is the wide range of performance by the banks. In fact, the ranges get wider each quarter, and that is not being reflected in the P/E multiples of individual companies.
Some companies, in my opinion, are making a serious mistake in dealing with the "revenue wall" they are up against. We see that in the wave of mergers and acquisitions right now. Some of these companies are running big risks by having to focus on merger integration when what they should be doing is concentrating on their customers and becoming marketing-driven firms.
We are concentrating on owning companies that have four traits: first, they are marketing driven; second, they are in the midst of a radical change in their distribution system, not just closing one or two branches; third, they have a passion for improving their productivity; lastly, they manage their capital well - many acquirers certainly don't fall into the category of managing their capital well.
Our top six, in order of preference, are Capital One, First Tennessee, Wells Fargo, BankAmerica, First Bank System and Signet.
SHEA: I agree that there are questions about the merger wave, but I am also encouraged to see what I consider greater rationality in the consolidation of the industry and reduction of overcapacity.
We are recommending two very different institutions as our top picks. First is Bank of New York Co. It has done a great job of focusing itself in areas were it has strength and has a disciplined cost culture. I also like First Virginia, which is a tremendous consumer lender.
Just below those two would be Mellon Bank Corp., where there is a huge amount of value locked up. I also like BayBanks, which is one of the best retail marketers in banking. Then there a couple of warm and fuzzy names. SunTrust, which tends to bore a lot of people but is a very profitable and well-run company. and Norwest. Those are my top six.
GELMAN: This is a broad range of recommendations without much overlap. When you have everyone recommending different stocks it's a pretty good environment for banks, and we're also very positive on the banking industry in general.
I start off with the idea that we are in a sustainably low inflation environment, for the first time in a very long time. We have been through a period with inflation coming down but not in a true low-inflation period since the 1960s. Banks sold at 20 times earnings then. I'm not ready to prognosticate a 20 multiple, but for the first time in my career in this business I've begun thinking it may be possible for banks to sustain a higher multiple if we're in that kind of environment.
Second, I think the banks are very rapidly separating themselves into haves and have-nots. The haves are the banks that have found ways to grow revenues or made strategically intelligent acquisitions or found some other way to position themselves exceptionally well with efficient use of their capital through some strategy that returns greater value to shareholders.
As to recommendations, we've liked Chemical for a while, on the basis that they were finally reaping the rewards of their merger with Manufacturers Hanover Corp. and were undervalued relative to their core profitability.
Now they have a great deal with Chase. A lot of analysts thought Chemical could pay $70 for Chase. They didn't, so they are already up one. They now have opportunities for enormous cost savings and for tremendous balance-sheet efficiencies. I think the balance sheet of these two banks can be downsized significantly and that there is going to be plenty of excess capital. They have already said they are going to return that to the shareholders. So I think that one is a home run.
I line up with Robert on Citicorp. Its a company that has changed itself completely. It has a tremendous earnings stream and it's really a unique franchise. It deserves a premium valuation. And I line up with Tom on Signet, It has redefined itself as a marketing-driven company. We're just beginning to see what these guys can do.
Finally, among nonbank financial companies, we like United Companies Financial Corp., a subprime first-mortgage lender that is benefiting from demographic and wage trends. More importantly, it is benefiting from the fact that finance companies have recently been able to access the capital markets, so the efficiency of their use of capital has increased almost exponentially. With securitization opportunities, their ability to grow is not constrained by funding, and margins have widened considerably. This company is really No. 1 in this area. They have done a great job and still are not valued as some of the other finance companies.
I would also say that there are still lots of opportunities in bank mergers and acquisitions. It's true that many larger-capitalization companies have been priced up by the market, so you have to be a little bit careful there, but go down the food chain and you can find lots of companies selling for less than one and a half times book with decent earnings and nice franchises. Those companies should be worth 1.8 to 1.9 times book in consolidation, and the kind of merger wave we have seen is going to spark secondary deals like that.
ALBERTSON: I hope it doesn't spark another 1987-88, in terms of over- bidding.
GELMAN: I don't think so.
BROWN: I'm not quite as optimistic. I think we will look back on this period and say that those who paid twice-book, to use a terrible valuation methodology, overpaid for the income stream they bought.
SHEA: There is more seriousness behind the merger boom going on right now than in either 1991 or in 1986-88. We haven't seen the sort of blow-out deals we saw in that earlier period, like Bank of New England paying 3.1 times book for Conifer. That kind of over-optimism hasn't appeared, although it may yet.
BROWN: The projected 40% increase in non-interest income in First Fidelity Bancorp - being bought by First Union Corp. - qualifies for me as a wildly optimistic forecast.
ALBERTSON: Tom, I think you're correct in saying we may look back at some of these acquisitions as pretty expensive, but we will also look back with the help of a sharply lower cost structure. We must not forget that banks have had this giant amount of cost sitting in back offices that will be blown away almost immediately after deal consummation.
GELMAN: On revenues, the toughest deals to make work are the acquisitions of plain-vanilla banks.
A merger I think would be easy to live with would involve Bank of Boston. I know there's been controversy, but it's a great company. They've been able to grow revenues when other banks have not. They are going to earn $5 next year and the stock still sells at around nine times earnings.
Also, in the acquisition of Integra Financial Corp. by National City Corp., Integra has a finance company that is really just a tiny baby. National City has the ability to grow that finance company as Integra couldn't possibly do.
BROWN: Why do you think National City can grow that franchise any faster than Integra could?
GELMAN: Because National City already has the distribution network to leverage it with.
BROWN: You are not going to leverage the finance business through bank branches.
GELMAN: No, you leverage it through markets that you know.
BROWN: They could have taken their franchise and leveraged it without having to have the physical distribution capability of bank branches. That's the whole fallacy here, to imagine that National City could only get into another state through a physical presence.
GELMAN: It's not a question of branches. It's knowledge of the market, customer relationships, and presence.
BROWN: But National City is not at the cutting edge. By their own admission their business will be growing at only a 6% to 8% annual rate. Should a company like this acquire somebody out of market or fix what they currently have? To me, its much better to fix what you have, and while you are doing that take the excess capital and buy back stock.
ALBERTSON: I think you can do both and that it's critical to take a cost advantage where you can.
BROWN: Well, as we discussed last time, the banks that are going to be acquired in four years are the ones making these foolish acquisitions now. Four years from now, U.S. Bancorp and National City could well be gone because they will have underperformed for their shareholders and had to look for a way out.
SHEA: There will be a lot of mergers launched. Some are going to be successful where we can't imagine success. Others are going to fail in spite of optimism about them right now.
ALBERTSON: We think conceptually that what the acquiring bank buys isn't necessarily a bank with branches and all the physical pieces, but rather customers. Broadly stated, you have two channels through which you can deliver products and services to your customers and grow. These acquisitions are over-analyzed on the physical side, on the branches, which are still an important channel, by the way. But it's a wider game. A bank can now grow purely by electronic means.
GELMAN: I agree with Tom on marketing as the long-term focus. But we are talking here about niche marketing, targeting a few specific products to a specific and select market, which is what Signet and also Wells Fargo have done so well.
If you want to expand full-service banking, you have to buy branches. How many of us bank with Fidelity Investments, or Charles Schwab or with Merrill Lynch? I bank with a bank that has branches, even though I use my computer for home banking and even though I would probably call them if I needed a loan rather than go to the branch.
BROWN: I think we have a lot of confusion between the means and the end. The end is a superior total return for shareholders.
BROWN: If the means to that end is to buy branches, that's great. But in a lot of the deals this year there is no way you can convince me that this is the justified means to that end.
SHEA: In a perfect world, Tom, we would have exactly what you're talking about, but not all banks are there yet.
ALBERTSON: And before we dump all the branches, we do need to remember that the average bank customer still goes into the average bank - not the ATM - 70 times a year, which is a jaw-dropping statistic.
AB: Do we think the deals momentum will be sustained? If so, why? And what are the possible combinations?
GELMAN: I would say there is no question it will be sustained as long as the acquiring banks have sufficient stock-price currency.
BROWN: Yes, it will be sustained as long as we have the lemming-like tendency in the industry and we have currency values where they are. And we all love it. Frankly, our firms are making a lot more money this year because of the irrationality of some of our clients.
SHEA: Oh, certainly mergers are going to continue as long as the currency is there, because this is still an industry with far too many players. What will take the currency away is dumb deals.
ALBERTSON: No one is saying all these deals are perfect, but the bulk of them so far have impressed me for their discipline. I think the key in any merger is to achieve a commanding market-share position in a region. Integra had one of the few Pennsylvania franchises left with which you could do that.
Don't forget the biggest advantage intrinsic to banks - the opportunity, more so than anyone other financial-service provider, to sell multiple products through a relationship. They're finally waking up to that, and it's very powerful.
SHEA: I agree banks should look at costs and revenues in terms of customers. I was down at Barnett last week and they talked about the customer profit system they are putting in. But many banks are just starting to approach things this way.
BROWN: So how can those banks do any real merger analysis? They don't know how they can leverage their own customer base. I want to own companies who know what they can do with their own customers, so they can justify the premiums they are paying.
AB: What should investors be doing in this environment and whose shares should they think of buying?
ALBERTSON: History suggests that we should shift gears, viewing the acquirers as more attractive than the acquirees. Particularly, the disciplined acquirers.
Despite their frequent citation as the most logical buyer in almost every deal announced, you have to give very high regard to Banc One, Norwest, BankAmerica, and NationsBank. I think they all stand tall for their dilution intolerance and slavish devotion to accretion.
BROWN: I agree with Robert's list and would add Wells Fargo, First Bank and SunTrust to that list. But the other approach is just to avoid companies with a high risk of making a dilutive transaction.
Look at the list of poor performers this year. First Union, National City, PNC, U.S. Bancorp, and Fleet are all in the bottom dozen. I think there is a common trait there. Better to focus on those who are either value-added acquirers or who are not going to make a dumb transaction.
SHEA: Some of the companies on that list of disciplined acquirers are actually wanna-be acquirers who don't quite have the stock price they used to. If you gave Banc One the valuation that Norwest has you would see them doing a lot of deals.
ALBERTSON: But never dilutive in either case.
SHEA: Norwest seems to have such a religious belief that their stock is undervalued that they just don't want to give it to anybody. SunTrust is another. They would rather buy their own stock than somebody else's.
ALBERTSON: Of course, there is a dual discipline. The investor shoots an acquirer who overpays, and doesn't bother asking questions first. Second, the sellers want to know what the value of the stock they are getting is likely to be. As a result, and this may come as a surprise, acquisition price/earnings and price/book ratios have actually been dead flat for over six years, despite an explosion in volume.
SHEA: Bank of New York has also been a disciplined acquirer.
GELMAN: I think there is a yellow flag on some of the mid-cap-sized banks. Some of these banks that have hit the revenue wall are looked at as takeover candidates and are trading at multiples far above the rest of the industry.
Either these banks will be taken over or they won't sell. The second alternative is worse, of course, but either way the risk-reward equation is dramatically bad. Fourth Financial, for example, could have gotten a better price 12 months ago.
BROWN: What I see are companies like Midlantic, Integra, and First Fidelity, who had hit the earnings wall but found companies to buy them at premiums that don't reflect this. These buyers were willing to pay up, as if they still had strong earnings momentum.
AB: Let's talk for a few moments about industry fundamentals.
SHEA: Well, I think loan growth may continue to be fairly strong for some time. There is still good demand out there. We'll see in the next credit cycle who has done the best in taking advantage of this without creating problems for themselves in terms of losses.
ALBERTSON: I think we are between the two humps of the camel in the revenue cycle. The consumer side is decelerating. The corporate side will not peak for another year or two.
The good news is that loan pricing seems to be staying favorable, particularly auto loans. That is as good now as it was bad six months ago. Enough banks got shaken up enough about underwriting standards to do something, which encourages me about discipline.
The loan-loss cycle is still way off in the distance. The consumer-loss cycle is going up, but banks understand that consumers are debt maximizers and very conscious of their debt service. They don't get killed by consumers. It's corporate debt that blows them away.
BROWN: Sounding like a broken record, I think individual companies are all that matter. The averages don't. It's building asset value, not building volume, that matters. The smart marketers know how to build value. Some right now, like Signet, are building both volume and value.
ALBERTSON: Stock selection does supersede the averages, but the average investor still has an average view of the industry. And that view is still a negative one. The first questions I get now are about loan losses and lack of revenue growth. Before I can give them my favorite smart marketer they have to be converted to the idea that maybe somebody in this industry can make it through the business cycle.
GELMAN: We have worried for 18 months that things "can't get any better" with bank stocks. But the interest-rate environment seems benign and the economy is chugging along. This says to me that any problems on the credit side will be problems of management and not problems of the environment.
The issue really is what shape the cycle takes. Is it the 1990 cycle again, or a 1960s cycle? I think we are more in a cycle where the ups and downs are smaller than they were.
AB: How about the next 90 days?
BROWN: Once again, I think investors should focus on individual companies that are radically changing they way they do business, such as Wells Fargo and BankAmerica. They are going to be surprised how rapidly these kinds of companies can grow their earnings and at the improvement in P/E multiples that will occur over the next few years.
SHEA: I mostly agree. I wouldn't go out and try to pick the next takeover target. I would pick from among the industry standouts. That is the avenue to making serious money over the longer run.
ALBERTSON: I think the takeover game for investors is mostly over for the moment at these prices. The volume of deals can still be large, which I expect, but the premiums won't be as attractive to investors.
The big differential over the next 12 months will be banks that have deep customer-information files and have very sophisticated marketing programs. They will have to prove themselves with results. This is going to be a small handful of companies.
GELMAN: I'm going to disagree. I don't think the takeover game is over at all. Investment bankers have been busy all summer. They have lots of deals queued up and the higher valuation of the acquirers lets those deals take place. Also, deals in banking tend to be more of a second-half phenomenon.
There remains a lot of pressure for consolidation in this industry. It will slow down eventually, followed by a period of rationalization. It's like eating Thanksgiving dinner. Afterward, you take a break and don't really eat again until Christmas. But right now I think we haven't finished Thanksgiving dinner yet.