When bank stocks were shaken from their lofty valuations Oct. 27, bank analysts at this quarter's analysts roundtable were already predicting the tremors. Banks appear to be ill-prepared for the inevitable downturn in the business cycle, say analysts who met on Oct. 23 for American Banker's quarterly roundtable session.
Chief concerns included on-target quarterly earnings that failed to impress, costly acquisitions, and dwindling reserves. Credit quality is still an issue despite marginal improvement.
Roundtable participants were Yun Jae Chung, Bessemer Trust Co.; Lawrence W. Cohn, Ryan, Beck & Co.; Joseph A. Stieven, Stifel, Nicolaus & Co.; and roundtable newcomer Nancy A. Bush, Brown Brothers Harriman & Co.
Let's look at the earnings reported over the past couple of weeks and discuss what surprises, if any, occurred among banks you follow.
CHUNG: The banks' fundamentals have remained pretty strong-stronger than I would have expected. For me, the only real surprise this quarter was Chase. It had an outstanding quarter with record corporate finance, trading, and venture capital profits. It was surprising and encouraging how broad-based the improvement was. I had expected the improvement in credit- card losses, but I did not expect it to be as great as it was.
COHN: We frankly are not impressed. The numbers were just fine-as expected or above, across the board. But when you start digging inside the numbers, particularly at the large money-center banks, one of the things that jumps out at you is that the market-based sources of earnings have really become a huge chunk of these companies' earnings. Whether it's trading profits or venture capital gains, or gains on the securities portfolio, those have been the largest drivers of earnings gains at most banks. But when you look at what most investors think of as the higher quality traditional banking revenues, their revenue growth has been a real problem.
BUSH: What struck me was that everybody made the consensus estimates, plus or minus a penny. That was as good or as bad as it got. The other striking thing is the loss of consumer deposits. It just goes on. You keep hearing (merger) deals rationalized as a means to gain market share, or a way to get the consumer back. It is just not happening. It is not reflected in the numbers, which leads me to believe the banks still don't know how to deal with the consumer behavior that is causing that.
What are the major issues facing banks right now?
COHN: I think the failure to make adequate investment in the business continues to be a very serious issue. An industry that basically keeps responding to its problems by cutting costs is feeding on itself. As it loses its capacity to invest in future businesses, it ensures that revenue growth is going to be slow going forward.
BUSH: I would say also that the industry is not paying the consumer for his money, nor is it paying up for people who actually know how to deal with or really care about the consumer. The cutting of personnel costs in the industry has probably been the most destructive trend that we've seen in the last few years.
We want to touch on merger activity as well. I wonder if the high multiples that have been paid in the last quarter are boosting the shares of banks and whether that trend can continue.
STIEVEN: Obviously, with the recent headlines from transactions and the prices that have been paid, a lot of people are raising their eyebrows. Some of the numbers are big. I don't think it's going to slow down because the acquirers have the currency to do these deals right now.
I think what's interesting is if you look at somebody like Fifth Third in Cincinnati, which has a currency to buy so much, doesn't do that, because they know that one of the keys to their company's success is maintaining its culture. And contrary to what people say, acquisitions will dilute your culture. The smarter companies are very concerned about that, and when they do an acquisition they take a little rest and make sure that they get everybody pulling in the same direction before they go on to the next deal.
You will see higher prices starting to filter down to even the smaller institutions, just because there are still a lot of bankers who still think big is the key to survival-even though it's not.
COHN: I guess I have a different view toward this whole acquisition business. It's really being driven by the accountants more than anything else. And one of the things that just jumps out at you and strikes you is that deals are being done for paper today. They're not being done for real money. The reasons are really obvious. If you had to pay cash for these franchises and start working through the economics of the acquisitions on a "real-honest-to God-it's-money-out-of-my-pocket basis," nobody in their right mind would pay these prices.
What about cash earnings?
COHN: Nobody's paying any attention to them. Cash earnings ignore the real cost of the transaction. Look at Wells Fargo. It was the Wells guys who really brought a lot of attention to cash earnings. The problems that they're experiencing now with that transaction drive home the idea that cash earnings aren't reflected. No one can look at the results of that merger and argue that there hasn't been a real deterioration in the value of the First Interstate franchise.
When Wells reported earnings the other day, I did what managements just absolutely hate you to do: I went back to 1995 and pulled out the handout that Wells gave us and I looked at what they said 1998 was going to be, and I looked at what 1998 is going to be now, and the gap is huge. These deals at four times book are just a disgrace, in my opinion.
BUSH: I agree. Dilution lives with you forever. Your stock price may not. The (recent) bank deals are problematic at best. Then you look at the nonbank deals-these lovely investment banks that are now being bought at hefty prices. Some of these companies are going to be regurgitated in a few years. The mistakes this time around are not credit quality mistakes. They are acquisition and operational mistakes. And I think they can be even more dangerous because they're not going to be as fixable in a short period of time as the credit quality problems were.
CHUNG: Well, I'll never forget what Wells Fargo said on that conference call: "If we can't (make) these numbers, we shouldn't even be in the acquisition business."
BUSH: Famous last words.
CHUNG: The pricing in recent deals has gotten out of hand. I think bankers should carefully evaluate acquisitions regardless of where their currencies are. And they're not doing that.
If you look at the other mergers in 1994 and 1995, and what they said they were going to do, would you see a similar kind of earnings story?
COHN: The problem with pooling-of-interests accounting is that it's really hard to know what's going on. I agree that the Chase quarter was a great quarter. But when management stands up and says we had another $130 million of incremental merger-related (cost) saves in the quarter, I've got to tell you that they could have inserted any number they wanted to. There's no way to have any clue whatsoever as to what in fact was really going on there.
STIEVEN: When Mercantile in St. Louis did the acquisition of Mark Twain, they did it under a pooling basis. They took $2.25 out of book value for "10 cents in earnings accretion." If your calculator works like mine, you start saying, "Wow, that's a lot of book dilution to take for a mere dime in earnings."
CHUNG: Still, on a relative basis, the banks look pretty attractive. I just think you have to be extremely selective. The regionals in particular are becoming overvalued, especially as the market factors a lot of consolidation activity into the stock price. The thrifts have that too, as well as from some of the goodwill lawsuits.
BUSH: There are companies out there that are getting better, such as First Union. They are learning to do things better from a technological standpoint. In fact, they're one of the best in the industry. The last quarterly report we saw from them was just about the cleanest I've seen from that company in 12 years of following it.
What about Fleet? Is that one of those companies that's improving, that's doing better as far as earnings?
COHN: Not that I can see.
BUSH: From the standpoint of integrating Natwest and Shawmut, they probably have put the worst behind them. But they still have to grapple with the issue that their franchise, by and large, is still a northeastern franchise. And what does that get you?
CHUNG: But I've noticed this quarter that the (regional) economies that have previously lagged, like New England, are starting to pick up some steam, while the economies that have done well, like the Southeast, seem like they're starting to slow down. Are you seeing that?
BUSH: Yes, we saw it in loan growth. That was one thing that was very interesting in the third quarter. Loan growth in the southeastern banks, by and large, did slow. But when people say to me that even Connecticut is picking up, I get a little worried. When the Northeast economy gets heated up, you've got to wonder if the end is near.
STIEVEN: I would sort of classify ourselves as either very nervous bulls or fully invested bears. Like Warren Buffett, who's been saying values are tough, but is always fully invested. We have one of the lowest number of "buy" ratings in a long time-actually in about nine years.
But we've got a lot of banks out in the central part of the country who grow their businesses the right way, which is to say internally. Everybody likes to do deals because it's easy to add mass. But if you really want to enhance your own shareholders' value, you have to grow internally.
Name some of your favorite companies.
STIEVEN: One is Commerce Bancshares. They are headquartered in Kansas City, but really their biggest base of business is in St. Louis. They've had record earnings for easily over the past decade. I think they were voted the safest bank in the country four of the last 10 years.
Another smaller company is Firstbank of Illinois Co. in Springfield, Ill., which is a very strong company, and Union Planters. Could they be takeover targets? Yes, maybe. Do they want to sell? Probably not. But if somebody approached them honestly and agreed to pay them big prices like other people are getting paid, they'd do the right thing.
CHUNG: Chase Manhattan has very strong momentum going into the fourth quarter, so I see good earnings from Chase in the near term.
And it's still a very cheap stock. It really hasn't gained anything in terms of relative valuation versus the (bank stock) group.
Citicorp is trying to build something very different and unique for the long term. Once they get through these periodic tests, they should get a premium valuation in the market. I don't think it's anywhere near that yet.
I continue to like BankAmerica. That's been a tremendous stock this year. I think there is some more to come in terms of restructuring their businesses.
COHN: Among the large cap stocks our "strong buys" are Bankers Trust and First Union. First Union really has a very clearly defined strategy that's working for them, and they focused on the middle market and consumer. They focused on capital markets and capital management. Fee income growth has been phenomenal for the last year with great momentum there.
Banker's Trust made a terrific strategic fit in Alex. Brown. And we think that they are just starting to scratch the surface of what that deal can do for the company.
BUSH: I would echo Larry's first comments about First Union. That's my top pick right now. One thing that gives me great comfort with that recommendation is, having watched them for a long period of time, credit quality is something that they'd never really had a problem with. Commercial credit quality has been uniformly high.
The other one I have which is rated "long-term outperform" is Banc One. And this is kind of controversial, because I put that rating on after the First USA deal. The deal was incredibly expensive-I acknowledge that. But I think they have a management that knows what it's doing, in a segment of business where increasingly it's important to know what you're doing.
I've also got a couple of get-rid-of-thems. And the biggest is CoreStates. They're sitting there waiting for Mellon to buy them. It's going to be a long wait. They told us very clearly there is a strategic assessment coming that doesn't preclude deals. But they also mentioned, by the way, to get ready for the charges that are going to come with the next restructuring. This is a company that has been restructured and consolidated into a big mess. Now, here comes round two.
I have a "long-term underperform," on NationsBank. Doing a very big deal every Friday before Labor Day is getting a little tiresome. I think that the Boatmen's deal-because it was a purchase deal-basically at least assured that the stock was going up because they had to repurchase their shares in the middle of a hot banking market. That's not the case with Barnett. With Barnett, they're going to hit the issue of dismantling a company that has been very successful and well-loved in its market. I don't think they know the downside of that yet.
Is credit quality still an issue?
BUSH: Credit quality has been mostly dismissed as an issue, not only by the industry but by those of us who watch it. There seems to be an assumption that, somehow it's all going to work out this time. Generally, credit quality has surprised me, at least, on the upside for much longer than I would have expected. I don't know when it's going to end. But it is going to end at some point.
COHN: One of the things we worry about a lot is that the banking industry has been restructuring its balance sheet. In the process of doing so, balance sheets are getting more dangerous, and I don't think that the market understands that.
BUSH: Having watched what happened in 1990, more reserves are better, more capital is better. The banks are leveraging themselves at the most dangerous part of the cycle.
STIEVEN: I agree with a lot of the points that have been made, but over 25% of the banks in our region have never had a downtick in earnings per share from 1986 to today. Granted, I firmly agree that the next turn is down. But I will bet that those 25% will come through in great shape. Unfortunately, the other 75% will get their teeth kicked in.