Fee revenue and expense control could make all the difference to the fourth-quarter results the nation's largest banking companies report as they search for counterweights to normalizing credit costs and continued margin pressure.
Several bank executives have been emphasizing disciplined cost containment as a key weapon to combat a yield curve that is more inverted now than in previous quarters, and creeping evidence of problematic loans after an extended period of superior credit quality.
Executives have also been preparing investors for a rebound of trading and investment banking revenues after a third-quarter lull. Last month's solid results from investment banking companies that operate on a fiscal calendar have added to analysts' expectations for good news on fees.
Analysts at KBW Inc.'s Keefe, Bruyette & Woods Inc. said that it may prove to have been increasingly difficult for banking companies to increase earnings in the fourth quarter. "Operating revenue growth should remain muted," the boutique investment firm's analysts wrote in a Dec. 18 note to clients. "Clearly, the operating environment remains very challenging, given the pressures of a sustained inverted yield curve and intense competition for loans and deposits."
Nevertheless Wall Street expects the five largest banking companies - New York's Citigroup Inc. and JPMorgan Chase & Co., Charlotte's Bank of America Corp. and Wachovia Corp., and Wells Fargo & Co. in San Francisco - to generally outperform smaller competitors, which rely more on spread income and are thus more at the mercy of the yield curve.
Analysts expect average earnings at the five largest banking companies to be flat from the third quarter but 16% better than a year earlier, at about $1 a share, according to Thomson Financial. Earnings per share at those banks fell 1% in the third quarter compared to the second. For 2006, these banks are expected on average to earn $3.97 a share, up 12% from a year earlier.
Kevin Fitzsimmons, an analyst at Sandler O'Neill & Partners LP, said investors would be combing through the numbers and analyzing executive commentary to better understand the year ahead. "They'll watch what's happening to loan growth while also looking for an inflection in credit and whether companies are boosting their reserves," he said in a recent interview. "The tone will also be important, and I think executives will be more cautious while ratcheting down expectations for 2007."
Lori Appelbaum, an analyst at Goldman Sachs Group Inc., wrote in a Dec. 19 note to clients that she favors large-cap banks in the fourth quarter because of their more diversified models. Expenses should "remain well contained as banks deploy cost controls to cushion the tough revenue environment," she wrote.
Last month Kenneth D. Lewis, the chairman, president, and CEO at the $1.45 trillion-asset Bank of America, discussed the importance of cost control as it becomes more difficult to make money in the face of intensifying headwinds. "You'd better be good at controlling expenses," he said at the Goldman Sachs Financial Services CEO conference in New York on Dec. 13, calling such discipline the "one lever" remaining to banking companies.
Speaking at the same conference, G. Kennedy Thompson, the chairman, president, and CEO of the $698 billion-asset Wachovia, said that, even though it was nearing the end of an initiative to cut up to $1 billion in annual expenses, efforts to contain costs would "simply be re-upped" heading into 2007.
Several bankers have also voiced confidence about the prognosis for investment banking and capital markets operations, citing improved volumes and pipelines during the fourth quarter.
Thomas Maheras, the CEO of global capital markets and corporate and investment banking at the $1.7 trillion-asset Citigroup, said during Citi's Nov. 14 investor day that its trading business "feels great" compared to a "lackluster" third quarter. "As far as momentum … we're doing much better than we expected," he said.
Meanwhile, Goldman Sachs' Ms. Appelbaum wrote that she expects 12% loan growth compared with a year earlier, an improvement from the 8% increase that larger banking companies posted in the third quarter. Though she noted that real estate loan growth - including an 11% rise in home equity loans - is behind the improvement, "commercial loan growth … remains strong but has been decelerating," she wrote.
Keefe Bruyette wrote in its note that large-cap banks would probably see a 7.9% rise in average loans in the fourth quarter compared with a year earlier. Though this would be a smaller gain than the 12% increase expected for smaller banking companies, the analysts expect margins to hold up better at large-cap banks.
Margins are still expected to narrow, though not as much as they did a quarter earlier, because deposit pricing in several large cities has relaxed, helping to offset somewhat the impact of the inverted yield curve. Keefe Bruyette said it expects average margin compression of 3 basis points from the third quarter level and 13 basis points from a year earlier. (Compression was 7 basis points in the third quarter, from the second-quarter level.)
Analysts will also examine items such as loan-loss reserves to interpret credit quality trends, and items such as overdraft fees to gauge consumers' health.
Analysts also say they will be watching out for the potential impact of Financial Accounting Standard 158, a recent rule from the Financial Accounting Standards Board that requires companies to move certain pension liabilities onto their balance sheets. Analysts said that several large companies could see a reduction in total common equity in the fourth quarter but the companies have said they do not anticipate any impact to earnings.
Kevin St. Pierre, an analyst at AllianceBernstein LP's Sanford C. Bernstein & Co. LLC, highlighted weaker credit quality in a Dec. 20 note to clients, writing that he expects more nonperforming assets and chargeoffs, particularly for construction loans. Banks are tightening standards for commercial and industrial loans, "which historically precedes higher chargeoffs," he wrote.
Charles O. Prince, the chairman, president, and CEO at Citigroup, said at last month's investor day that the "state of the union on credit is good." In particular, credit quality in the company's corporate book has "never been better, and that tells you it's more likely to get a little worse than it is to get better from where we are today. And so we are being very tight on credit quality, and we are budgeting or planning next year for modest deterioration in the external environment as it relates to credit.
Richard Kovacevich, the chairman and CEO of the $483 billion-asset Wells, sounded a similar note during his presentation at the Goldman conference acknowledging that "the environment has indeed changed." Though he said recoveries would begin to decline, he also said that loss rates "will still be below historical averages and still below, at least in our case, our profit model."
