Earnings Setup -- JPM, WFC, C, BAC
“The benefits of reduced expenses for loan losses outweighed the drag from declining net interest margins, as insured institutions posted a 12th consecutive year-over-year increase in quarterly net income. Banks earned $34.5 billion in the quarter, a $5.9 billion (20.7 percent) increase compared with second quarter 2011.”
FDIC Quarterly Banking Profile
Second Quarter 2012
Time once again for US bank earnings, now for Q3 2012. Just to review, income among financials has been recovering for the past three years, but mostly as a function of declining credit costs. There is very little organic growth in the banking sector with larger banks such as Wells Fargo (WFC) and US Bancorp (USB) generating positive revenue and earnings by taking share from other institutions. More than half of all banks in the US are running off in terms of redemptions vs. new lending. Net interest margin is about 3.3% and shrinking, but is still above 2007 lows near 3%.
Reports that the housing sector is recovering has generated more than a little irrational exuberance among investors regarding financials. Another thread in the bull narrative for banks coming from select Sell Side firms involves a rebound in investment banking revenue. This nirvana is right around the corner or so goes the story. Given the flat economy and the dearth of activity in the equity and M&A markets, it is hard to put clothes on Rosy Scenario, at least for investment banking volumes. Would that it were so.
The big question facing the commercial banking sector is regulation, both in terms of higher capital requirements under the proposed Basel III standard and also greatly increased regulation of the housing sector, is revenue. In terms of the former, more capital and regulatory constraints means less leverage, lower credit growth and employment, thus lower revenue growth. If you don’t have credit growth, then you don’t have job creation, etc.
The second factor of new regulation in home lending sector is a biggie. Mortgage origination and sale has been the key driver in bank revenue, especially for WFC and USB, both who boast up revenue estimates in 2012. If you follow financials and have not read the comment in this week’s Institutional Risk Analyst, “Tail Risk: Kamala Harris Declares War on Lenders, Loan Servicers in CA,” you need to do so. But remember that almost all of the production of WFC, USB and every other bank in the US is ultimately guaranteed by Washington via the FHA.
Since most of Wall Street investors only ever look at the top 8-10 bank names by assets, there is no point talking about the rest of the industry. So let’s run down the four larger universal banks with earnings out this week and next.
Wells Fargo (WFC)
With a dividend yield of 2.5% and a beta just over 1, WFC is the darling of the large bank peer group and also the most fully valued at 1.5 x book. The street has WFC up single digits on revenue and earnings for Q3 2012. You have to wonder if that is not already priced into the stock.
The lawsuit filed against WFC with respect to loans guaranteed by the FHA is small beer, IMHO. The far larger question is how WFC will continue to generate current levels of revenue and earnings in the Basel III, Dodd Frank nightmare world. Answer: They won’t. I will be writing more on WFC and non-bank originators separately.
The House of Morgan is looking a lot less like a fortress in the wake of the London Whale CIO office trading scandal. As discussed in my previous post, the litigation involving Bear Stearns likely is going to be far more significant to JPM than the civil claim filed against WFC. Think orders of magnitude difference. That said, if JPM is forced to repurchase fraudulent securities issued by Bear Stearns that event will certainly be material. But Bear will not be fatal to the bank.
One exception to that judgment might be Jamie Dimon himself, who has used up a number of his nine lives over the past decade. Imagine yourself sitting on the board of JPM and hearing Dimon and his cohorts (who brought you the CIO trading fiasco) repeating the mantra that they will litigate the plaintiffs in the Bear Stearns litigation “into annihilation.” And recall that JPM has yet to reserve for a settlement of the Bear Stearns litigation.
Like the board members of Bank of New York Mellon (BK) who reportedly ejected former CEO Robert Kelly for saying similar things about his own legal problems, the JPM directors have to weigh giving Dimon yet another chance to make good vs. a clean break and a settlement. At the very least, look for JPM’s board to overrule Dimon and push for a settlement of the Bear Stearns litigation. Given how badly the litigation has been going for JPM in court, it seems time really is money in this particular case.
In terms of Q3 earnings, the street has JPM down YOY on revenue and bottom line. Best guess is a “surprise” on the upside, but remember the hurdle is deliberately set low for a reason. In terms of valuation, JPM at 0.85 x book is arguably a much better value than WFC, but there is a reason for this too.
The level of risk at JPM is far higher than with WFC. JPM’s risk factors flow from a far more diverse list of businesses, accented by rogue hedge fund traders and Teflon coated managers. This makes JPM’s revenue and earnings far more opaque than its immediate bank peers – and more like the investment banks at Goldman Sachs (GS) and Morgan Stanley (MS).
The queen of the zombie bank dance party continues to be my least favorite name among the top four. At 0.5x book and sporting a 0.1% dividend yield, C remains more a preferred trading vehicle for hedge funds and prop desks than an investment. The 2 beta is another hint that C is more about trading than investing, at least in the traditional sense of that term. That once meant return of principal with a positive return. C does not fit into that category. More like a tech stock with financial exposure.
Until the management and board of C figure out a way to boost cash flow to investors above that of its peers, I see no reason to even think about recommending C to a value investor. The whole business model proposition of C was and is still today subprime, albeit with less aggressive exposure at default than during the pre-crisis years. Yet today C is still in a business with a “normal” internal loss rate target that is obviously higher than its peers. Investors need to be paid for this risk.
Remember that C has the highest loss rate of the top four banks as well as the least credible business model, so if they management does not pay investors for this risk there is no reason to own the stock. Finding a CEO with actual operating and management experience in the lending industry would be a plus as well. But I don’t want to ask for too much.
Bank of America (BAC)
BAC is right behind C in terms of a preponderance of negative factors. Under the tenure of Brian Moynihan, BAC has continued to destroy shareholder value in large chucks, losing key people and assets at a frightening and accelerating rate.
The core competency of BAC managers like Moynihan, lest we forget, is cost cutting, followed by firing capable people to make way for a deliberately minimalist business model. This is business model of “manage down” that stretches back to Ken Lewis and Hugh McColl and remains the core ethic of BAC today.
BAC has largely withdrawn from the mortgage market and remains mired in litigation regarding the legacy RMBS of Countrywide and Merrill Lynch. I continue to look for BAC to eventually sell or spin off Merrill to shareholders, a move that could be a precursor to a voluntary restructuring of the bank holding company.
Once a restructuring is complete, then BAC would arguably be in a position to rival WFC in terms of valuation -- albeit given new management. Frankly, you could break up BAC into 4-6 regional banks and probably enhance shareholder value significantly.
I have always argued that a voluntary Ch 11, restructuring of the litigation and sale of the BAC banks would easily repay all creditors and even a return for equity holders. If BAC faces rescission with respect to Countrywide claims, the idea of a restructuring will not seem so far out. Any funds who want to back a hostile takeover and restructuring of BAC, do give me a call.
If BAC and BK fail in their effort to push through a settlement of the Countywide put back litigation, then a restructuring of BAC becomes far more likely. The same adverse results in court that are making the Bear Stearns litigation a major headache for JPM are haunting BAC, only to a far greater degree.
Keep in mind also that like JPM, there is as yet no significant reserve set aside by BAC to fund an eventual settlement of the Countrywide litigation. Eventually, like Jamie Dimon regards Bear Stearns, Brian Moynihan will have to address this reserve issue regarding Countrywide and Merrill.
Bottom line on financials is that the best risk adjusted returns in the industry are not found in the four banks previously mentioned.