(Marketwatch) Now that earnings reports are in for the largest 10 U.S. banks, it’s apparent that investors expect some trouble from likely interest rate cuts by the Federal Reserve, even if the overall industry trend remains positive.
The group remains very strongly capitalized, with earnings-per-share growth benefiting significantly from share buybacks. Looking ahead, profits are expected to be pressured because of declining interest rates, which means buybacks will remain very important to support stock prices.
All the EPS results for the Top 10 banks came in above the estimates. This may not be much of a real surprise, because Wall Street is traditionally geared for underpromising and overdelivering. Every earnings season the majority of S&P 500 companies “beat” earnings-per-share estimates. A typical “beat rate” for the index is 70%.
Net interest margins and EPS estimate revisions
The Federal Reserve raised the federal-funds rate four times last year to its current target range of 2.25% to 2.50%. This year’s turnaround in policy led the Federal Open Market Committee to curtail its balance-sheet reduction that last year had pushed long-term interest rates higher. The committee and Federal Reserve Chairman Jerome Powell have indicated that the central bank is likely to begin cutting the federal-funds rate as early as July 31, after its next policy meeting.
All of this has helped push down the yield on 10-year U.S. Treasury notes to 2.04% from 2.69% at the end of last year. Many banks’ net interest margins have begun to be squeezed as interest rates paid on deposits have increased and long-term rate indexes (upon which interest for various loan types and loan renewals are based), have fallen. That said, the second-quarter figures still reflected favorable repricing for commercial loans at higher rates during 2018.
Sell-side analysts have revised their full-year earnings estimates to reflect lower guidance for net interest income from the banks, as well as the expectation for a large percentage of earnings to be deployed through buybacks and dividend payments, as credit quality and regulatory capital levels remain very strong.
The margins for Bank of New York Mellon are narrow because the bank is focused on institutional asset custody and administration for institutions as well as on asset management, rather than gathering deposits and making loans. Capital One Financial’s wide margins reflect its loan mix, which is about 46% credit-card loans and another 25% consumer loans (mainly auto loans).
Here are some comments from analysts about the banks on the list with majority favorable ratings:In comparison, the forward P/E ratio for the S&P 500 bank industry group is 10.3, and for the entire S&P 500 it is 17.1, according to FactSet. So the banks trade for about 60% of the index’s valuation, when a more normal level is closer to 70%.
Bank of America
Bank of America’s management team expects the company’s net interest income to increase 2% this year. That is down from the 3% guidance provided with first-quarter results. KBW analyst Brian Kleinhanzl has a neutral rating on the shares, but wrote in a report on July 17 that the net interest income guidance “could have been worse.” He added that management was continuing to control expenses, loan growth had improved and “results were overall solid.” He raised his price target for the shares by a dollar to $32 and increased his 2019 and 2020 EPS estimates slightly.
Citigroup has the highest percentage of “buy” or equivalent ratings among the sell-side analysts and the lowest forward P/E ratio. Oppenheimer analyst Chris Kotowski is among the believers, with an “outperform” rating and $108 price target for the shares. Following Citi’s earnings announcement, Kotowski wrote in a note to clients: “We continue to think the shares are compelling at only 106% of TBV [tangible book value].”
Morgan Stanley has the second-highest percentage of “buy”or equivalent ratings among the listed banks. In an interview on July 18, Edward Jones analyst James Shanahan said the 28% operating margin for the bank’s wealth management business was better than the margin of about 27% he had expected, and well above the company’s guidance of 25% to 27%. These are important numbers, because wealth management provides “about 40% of revenue and earnings,” he said.
“Wealth management has been a stabilizing force for earnings and revenue, and a valuation for the stock,” he said.
This means that if net interest income declines significantly, there is “significant risk for the stock,” he said.
Shanahan is in the minority, with a “hold” rating on Morgan Stanley’s shares.
Despite having the margin advantage from its credit-card and consumer-lending focus, Capital One Financial has been the worst performer among the 10 largest U.S. banks over the past three and five years (those figures for the group are below). Investors weren’t thrilled with the results of annual regulatory stress tests, which led to no increase in Capital One’s dividend, unlike all the other banks listed here. Investors also may be uncomfortable with the bank’s loan mix (discussed above).
KBW analyst Sanjay Sakhrani rates Capital One “outperform” and in a note on July 18 wrote that “solid” results “should come as a relief given the relatively stronger NIM this quarter and general strength in credit metrics.” His price target for the shares is $106.
Oppenheimer analyst Dominick Gabriele has a neutral rating on Capital One and wrote in a note on July 18 that the bank “may have seen peak cycle profitability, and trends in YoY domestic card growth are likely fairly stable around 3%-5%.” He believes consensus EPS estimates have “baked in” expected efficiency gains. Longer term, he believes “benefits down the road are likely,” as the bank continues to expand its deposit gathering.
Wells Fargo, irony and opportunity
Only 26% of sell-side analysts rate Wells Fargo a “buy” or the equivalent. The bank continues to work to resolve multiple investigations of its sales and service practices and is continuing its search for a new permanent CEO after Tim Sloan resigned abruptly in March. It is important to remember that sell-side analysts’ price targets are only for 12 months, which is a short period, especially when considering a bank going through a tremendous transformation.
Wells Fargo is operating under a Federal Reserve order that keeps it from expanding its balance sheet until the regulator is satisfied that its customer service problems have been corrected.
Then again, bank’s core banking business is strong and it has the highest dividend yield, by far among the banks listed here — nearly 4%.
Edward Jones analyst Kyle Sanders is in the minority with a “buy” rating on Wells Fargo and is confident in the bank’s progress with its remedial activities. “There’s not much upper management left” from before the customer-service scandals, and most of its board of directors has been replaced, he said during an interview on July 18.
What disappointed investors listening to the bank’s earnings call was interim CEO C. Allen Parker’s comments about the bank’s cost-cutting efforts. “While we’re making progress in continuing to address our expenses with urgency, we still have work to do,” he said, adding, “we anticipate that this could continue next year.” Wells Fargo’s shares declined 3% on July 16 after the earnings call.
Sanders said Parker’s comments indicated the regulatory order barring expansion of Wells Fargo’s total assets wasn’t likely to be lifted this year, and that the bank was still incurring extraordinary costs to get its house in order.
And this is where the opportunity lies. Sanders believes the order will be lifted in 2020. Yes, it is bad news if the order isn’t lifted this year, but we’re already in the third quarter and a lifting of the order in 2020 may boost the shares.
The elevated expenses and new management team point to another opportunity. In a commodity business with slow revenue growth, large banks are looking to wring-out as much expense as possible and improve their efficiency ratios. A bank’s efficiency ratio is its noninterest expense divided by its net income. Lower is better, and Well’s Fargo’s second-quarter efficiency ratio was a high 62.30%. These ratios are best compared between banks with similar business models. Wells Fargo is one of the nation’s largest four banks, but its relatively simple business model makes it fair to compare its efficiency ratio with that of a large regional bank.
BB&T’s second-quarter efficiency ratio was 55.10%. “Wells Fargo is 10 times as big and with scale, there is much more they can do with cost. There’s no way they should be at 62%,” Sanders said. He is confident Wells Fargo will be able to bring its efficiency ratio down significantly, “but achieving that has been pushed out a bit. That is why we saw disappointment among investors following the call,” he said.
So the eventual naming of a new CEO, the eventual lifting of the regulatory order, the potential improvement to profitability as expenses are better controlled, a high dividend yield easily supported by earnings, very strong capital ratios and excellent loan quality provide a compelling case for Wells Fargo’s shares for investors who can commit for several years.
Sanders believes Wells Fargo can continue to make annual double-digit percentage annual increases to its dividend payout “for the foreseeable future.” He also compared the current P/E valuation of 10.1 to an average of 12.4 (his estimate) over the past five years, showing potential for a substantial gain if and when investors return to their customary level of trust in the bank.