At American Banker's quarterly roundtable, analysts said bank stocks could recover later this year - once investors lose interest in dot-com stocks. Participants were Frank Barkocy of Keefe Managers, Michael Plodwick of Lehman Brothers Inc., Carla D'Arista of Friedman Billings Ramsey & Co., and Andrew Collins of ING Barings.
Rising rates have hurt banks' margins and their stocks. Will this continue?
MICHAEL PLODWICK: The margin issue really got most of the investors' attention this quarter. What's amazing to me is it's really not a new phenomenon. Margin pressure has been with us for quite some time now. Margins for Lehman's 50-bank universe peaked out in the fourth quarter of 1996 at about 4.22% and are now down to about 3.93%. We saw about 6 basis points on average of margin pressure between the third quarter of 1999 and the fourth quarter, but this is something that has been going on for quite some time. It's just that we had a few very visible, isolated examples, such as National City Corp. and U.S. Bancorp.
FRANK BARKOCY: The market's concern about margin compression was a bit overdone. Banks are much better hedged today to deal with swings in interest rates than ever before. What's important to note, too, is that in the quarter you still had good loan demand coming in, both on the commercial and consumer side, so net interest income in most instances was still higher, despite the pressure on margins.
Banks are also in a transitional phase where a growing proportion of their earnings now is the result of fee-generated income, so their dependency on net interest income has lessened.
PLODWICK: A lot of value-based portfolio managers got taken out on their backs last year, so the guy who owns the growth stock fund is saying, "I have to own technology, because technology can grow through anything." Banks, on the other hand, are going to have a hard time, because interest rates are going up. Everybody's chasing the growth funds, and until that cycle breaks, it's going to be difficult to sustain a rally in the financial sector.
CARLA D'ARISTA: Some high profile portfolio managers are suggesting that subsets of the technology sector are still undervalued relative to accelerating revenue growth. Estimates put expenditures on business-to-business e-commerce at over a trillion dollars in the next several years. Spending on software and other Internet systems support and development is expected to double from here. In addition to the diversion to the technology sector and concerns about rising interest rates, the rotation out of the financial sector has been exacerbated by deterioration in margins and sluggish revenue growth. At this late juncture in the business cycle, investors are not comfortable with decisions to ratchet down loan loss reserve coverage ratios. In addition, six banks (Bank of America Bank One, First Union National City, KeyCorp and U.S. Bancorp) collectively have generated an earnings shortfall in excess of $5 billion for the 1999-2000 period, compared with profit expectations signaled during merger presentations and other analyst meetings.
ANDREW COLLINS: Most of the compression in the margin over the last six or seven years has to do with the yield curve, the difference between the three-month and the 30-year. The spread has narrowed, from 468 basis points in 1992 to under 100 basis points today.
I think that has a lot to do with why there's been so much margin compression over the last six or seven years. It's also been a function of the banks selling their higher-yielding bond portfolios, as well as more active loan securitization, so there's a fundamental change in the way banks are operating nowadays.
I would agree that fee-based revenues have increased significantly among the larger banks. And although we will continue to see margin compression, much of that will be offset by higher levels of fee-income growth.
I would say, though, that some of the smaller players that have not made the transition to the new banking paradigm will continue to see margin potentially impacting earnings.
PLODWICK: The real impact of rising rates is misunderstood by most investors. They automatically say, "Oh my God, margin pressure's coming." To be sure, when the Fed is in tightening mode, there is always the risk that they will tighten too much and push us into a credit cycle, which will increase loan losses and loan loss provisions, and cause a real hit to earnings. We've shaved nickels and dimes out of earnings, but we have not seen the kind of hits we're going to see if we have a credit cycle.
BARKOCY: The last time the group rallied, which was in October 1999, you had three specific considerations that came into play. One, many banks were reporting very attractive earnings; two, you had some benign economic numbers being reported; and finally, the passage of the financial reform legislation.
Over the last month or so bank earnings came in pretty much in-line to better-than-expected after the pre-announced shortfalls of Bank One and U.S. Bancorp. You had an event, which was the Charles Schwab Corp.-U.S. Trust acquisition announcement. What you did not have this time around were the benign economic numbers, and that resulted in the group getting beaten down again, as fears of rising interest rates have been raised.
To come out of this cycle, we will need the continuation of generally solid fundamentals, a reversal in the rate cycle, and perhaps another event, such as a major consolidation announcement, to spark a sustained bank rally.
Are credit problems a worry?PLODWICK: As long as the economy stays relatively good, we don't think credit quality will become a major issue.
But rates keep going higher, and sooner or later credit will become an issue. Right now, the problems we've seen in credit have been relatively isolated, although there's been enough of them to cause concern.
What about mergers and acquisitions?PLODWICK: The macroeconomic factors driving consolidation, such as the lack of top-line revenue growth, the need to invest in technology, the lack of fee revenue at a lot of banks, have not really gone away. But bank stock prices fluctuate, and it's very difficult to strike a deal when your stock price is down 30% in a one-month period.
There will probably be a lowering of expectations on the sellers' part as we go forward. We saw an example of that recently with BB&T Corp. and One Valley Bancorp, which got a 30% premium to market. But it took them nowhere close to their previous 52-week high.
We believe there will be deals, but they are probably going to be at the lower end of the food chain on a market cap basis. There will probably be more mergers of equals, where banks merge to cut costs to grow earnings.
COLLINS: It has become a buyer's market. The reason for that is that in 1997-1998 there were a number of deals announced in which none of them really met their expectations in terms of originally estimated earnings-per-share figures. Amongst the notable ones would be Bank One, First Union, Bank of America Corp. and U.S. Bancorp.
They all fell well short of what they originally put out there in front of the investment community when these deals were announced. A lot of this had to do with prices that really got out of control, and trying to justify them with extremely high expense savings.
Going forward, we could start to see more cost-saving type deals, perhaps towards the latter part of this year, but they'll be driven by in-market synergies, where perhaps the headquarters are right across the street from each other.
D'ARISTA: There has been a dramatic level of takeover activity in Europe, notably in Spain, Italy, France, Switzerland and the U.K. We believe that the bulk up in market capitalizations and the attractions of a $17 trillion U.S. capital market suggests that it is just a question of time before other foreign financials join HSBC and Deutsche Bank in the their recent acquisition forays in the United States. Asset management and private banking are a top priority for these financial groups.
COLLINS: I don't think there is going to be a lot of cross-border type of transactions where we see big banks from Europe coming into the United States. What the big banks are interested in more is probably the small insurance companies where they get some asset management capabilities, or there may be a few combinations between similar-sized banks and brokers.
BARKOCY: There were great expectations when financial reform legislation was passed, in that you'd see a number of combinations between banks and insurance companies. Wells Fargo, BB&T, and First Union had been mentioned as candidates. But those institutions have looked hard at the insurance industry and have come away at this point at least feeling that there is very little to justify an acquisition, given the low rate of returns generated by the insurance underwriters.
PLODWICK: Everybody's looking to Citigroup again, and they've obviously been the most successful stock with far and away the largest market cap, which provides them with tremendous capacity to do a large deal.
They appear to be in a "never say never" mode. This may be one company which could get people excited about bank merger and acquisitions again, because Citigroup probably has more credibility right now than any other company out there. It's not inconceivable they could wind up investing in Bank One or First Union.
BARKOCY: Wells Fargo is active on the acquisitions front, but rather than doing one big blockbuster deal, they're content at doing fill-in acquisitions or modest extensions of their marketplace.
COLLINS: I would agree Wells Fargo is being very opportunistic in the acquisitions it's doing out there. The company is in a sweet spot. Their acquisitions are more rural in nature, where the margins, the capital, and deposit market share are high. Their pending acquisition of National Bancorp of Alaska is an example of that.
What are your favorite bank stocks?PLODWICK: It was a lousy year for banks, but there were a few stocks you could have made a lot of money in.
Our favorite at this point in time is Firstar. We think they have been grossly, unfairly tarnished with the same brush that has been applied to many other banks that have done large deals. This company has not missed a number.
They have delivered on everything they promised since they were Star Bank back in 1992 and 1993, so they've got a tremendous record.
We think that in this environment in 2000, where many banks are feeling that interest margin pressure, you're going to see exactly the opposite at Firstar. Their margin is going to widen based on some of the things they're doing in the securities portfolio, plus the switching of the loan mix of the companies they acquire. As a result you're going to see fairly robust net interest income growth into the double digits. If you couple that with double-digit fee income growth, you're going to have low 20% earnings-per-share growth and upper teens per-share growth over the next several years.
Another favorite of ours, and this is hard for a lot of people to stomach in this environment, is Fifth Third Bank. No other company has their track record. They've got something like 27 consecutive years now of 10% or better earnings-per-share growth.
Only two other companies in the entire S&P 500 can make that claim, so you get what you pay for.
BARKOCY: When the turn in bank stocks comes, we believe that it will be in the higher-quality, more liquid, well-managed, large-capitalization issues. Our top picks include Chase Manhattan in the money-center sector, and currently depressed priced superregionals, such as FleetBoston Financial, Wells Fargo, Comerica, Wachovia Corp. and SunTrust Banks Inc.
COLLINS: Chase is our top pick. The stock is significantly undervalued at this point, given its break-up value when you assign multiples to its business components.
I think the Street is underestimating the earnings capabilities of the organization. If the company does suffer some weakness in terms of market-sensitives, we think that it has now the both the expense and capital management to more than offset it.
We also like Wells Fargo. The company has an accelerating revenue growth outlook, as well as healthy earnings-per-share prospects. We're looking at 15% earnings-per-share growth over the next two years there. That significantly exceeds its current cash price/earnings ratio of roughly 12.1 times the 2000 estimate.
And finally, we like Bank of New York, given the transparency and consistency of earnings growth over the next three years. In fact, we recently established a 2002 estimate for this company, the only 2002 estimate we expect to establish for some time.
D'ARISTA: We are also big fans of Chase Manhattan, based on its market share within the capital markets sector and a business strategy that fully incorporates the ways in which the so-called new economy will continue to transform the financial services sector.
Citigroup reported a 38% increase in global consumer income last year, posted an impressive turnaround in its global corporate and investment bank and is a major beneficiary of the recovery in emerging markets overall. I suspect that the cost saves epitomized by the $2 billion in efficiencies achieve in 1999 will persist for some time.
While not a bank stock, Fannie Mae is trading at just 13 times our 2000 earnings estimates notwithstanding the fact that the group is very much on target to maintain an earnings growth rate of 15% over the next four years.
Loan losses are de minimus and the loan loss reserve exceeds $800 million.