With the turnaround stocks running out of steam, banks that can show strong revenue gains will become the next investment theme in the sector, said Mark Alpert and John Heffern, analysts at Alex, Brown & Co.
The analysts' top three picks among major banks: First Interstate Bancorp, NationsBank Corp., and Keycorp. Each will show double-digit earnings growth next year, Alex. Brown predicts.
Baltimore-based Alex. Brown also follows community banks, which it defines as those with less than $10 billion of assets. Its top three picks in this category: First Commercial, BB&T Financial, and Citizens Bancorp. Q.: You see several reasons to be concerned about the industry, don't you? ALPERT: There are two important macro themes that we are closely looking at. The first is whether the wide net interest margin that the banks are enjoying today is sustainable.
The second theme is that there is a transition that is inevitable between bank earnings' being driven by lower credit costs to one of bank earnings' being driven by revenue growth. The market will assign different multiples to the stocks depending on where the banks receive their earnings growth. Q.: If spreads are destined to fall, won't loan growth make up for it? ALPERT: The spread between fed funds and the prime rate is about 300 basis points. That isn't sustainable. Historically, it is about 150 basis points. To some extent, it's been a benevolent operating environment for these banks as opposed to any brilliant management strategy.
Even if rates remain stable, there will be a general repricing down of asset yields as investment portfolios mature or loans mature and reprice.
We expect that, over time, that spread would contract. Even if it is not as low as 150 basis points, it will be 200 or 225. Q.: What about the margin contraction's being offset by loan growth? ALPERT: In some pockets of the country where there is loan growth, banks will be able roll out of maturing assets into loans with higher spreads. But that won't happen everywhere. HEFFERN: The economy has some capacity to grow without using bank debt, and there seems to be less interest among corporations to borrow in the 1990s than they did in the 1980s. You have to be skeptical about whether there'll be sufficient loan growth to offset the natural margin compression. Q.: Do you see signs of a shift among investors away from turnaround stories and toward revenue-growth stories? ALPERT: Yes. We looked at all the regional banks over $10 billion in assets, and we broke them down into quintiles based on the degree to which they are provisioning.
The banks in the lowest quintile, where provisions are less than chargeoffs, were trading at an average of 1.39-times book value and 9.3-times estimated 1994 earnings. This group includes the turnaround stories - Shawmut National, Bank of Boston, and Midlantic.
Those in the top quintile, which provision the most, were trading at 1.93-times book and 10.4-times earnings. Banks on the top of the list include Fifth Third, SunTrust, and Wachovia.
The room for future earnings growth from lower credit costs is diminishing. Banks that are showing earnings growth because they have growing franchises or revenue growth will experience an expansion in their trading multiple, to closer to a market multiple. Wachovia is already selling at 13 times earnings. These banks have been out of favor in the last year or so. We think they may come back and will get higher multiples than the average bank. Q.: Keycorp was a top pick before the Society merger, and you are sticking with it, right? HEFFERN: Despite the controversy that now surrounds Keycorp, it remains one of our top picks.
We recognize that investors are disappointed that Keycorp didn't sell outright but took the merger route. On the other hand, the shares are down, which presents an opportunity. It will be hard for investors to ignore the merged bank, if it is generating the pace of earnings growth and the returns that we believe are possible, even in the absence of synergies.
So once investors' tempers calm, we think a target P/E multiple of 10.5 to 11 times 1994 estimates is certainly possible. That means $46 to $48 on Keycorp's shares. That's more than 20% appreciation. [The shares traded at $36.625, unchanged, Tuesday afternoon.] Q.: Your other two top picks - First Interstate and NationsBank - seem just as controversial. Let's start with First Interstate. ALPERT: They started out a couple of years ago as a recovery story. The degree of their recovery is not fully appreciated because they are tainted with the concerns investors have about California, when, in fact, 70% of their revenue comes from other states, including Texas, Arizona, Oregon, and Washington.
The stock is selling at a discounted P/E multiple. We are looking for them to earn $7.50 in 1994, so shares are 8.8 times that estimate, which is a full multiple discount to the average regional. We think it could be an $80 stock in 12 months. [The shares traded at $67.25, up 12.5 cents, Tuesday afternoon.] Q.: What about NationsBank?" ALPERT: If you were to ask yourself a simple question - what bank has built [its] franchise through the 1980s in the most valued-added way to shareholders, the answer is going to be NationsBank.
The most compelling reason to own the stock now is that it is so cheap. It is cheaper than any other bank in the Southeast. It is cheaper than the regional average. It is cheaper than Citicorp. We think in 12 months the stock should be selling in the low $60's, 10.5-to 11-times our 1994 estimate. [Its shares traded at $51.625, down 12.5 cents, Tuesday afternoon.] Q.: Let's end with your top picks in the community banks. ALPERT: We like some banks that aren't takeover candidates. First Commercial of Arkansas is in that category. It has a 1.3% return on assets, a reserve coverage that's a multiple of nonperforming assets and 10% to 12% growth in earnings. It sells at 10 times our 1994 estimate.
BB&T Financial has disproved the notion that a community bank can't thrive in a market dominated by superpowers like First Union, Nations-Bank and Wachovia.
On the other hand, Citizens Bancorp in Laurel, Md., has a strong franchise that will attract acquirers' attention. It has $3 billion in assets and is one of the top three banks in market share in Prince Georges and Montgomery counties.