Bank Stocks Ready to Compete: Oppenheimer
"Credit quality is a gift that keeps giving because stable and good credit quality allows management to focus on optimizing returns."
This is Oppenheimer analyst Chris Kotowski's assessment of the opportunity and necessity for banks at this point in the credit cycle. Despite the "headwind" from the prolonged period of historically low interest rates, the analyst's view for the big banks has been that "over time banks will manage themselves to earn a competitive return. It is simply not an option for them to accept a single-digit return when the rest of the market is earning, say, 14 percent. That is an unstable dynamic that would cause capital to leach out of the banking system."
The "three levers" that banks can pull to bring their returns in line with the broad market, according to Kotowski, include pricing, "expenses and scope of the delivery system" and capital deployment.
The analyst also emphasized that the banking industry is cyclical and said that "we will never argue that the industry 'learned its lessons,' but on the other hand we are on the favorable side of the cycle where the managements have emerged from the fog of war and can now focus on the logistics of running a well-oiled machine."
Of course, investors are probably way too cynical to expect corporate executives to learn any lessons for the very long haul, with so much of their compensation still tied to relatively short-term results, however the investors themselves might have learned a key lesson, which is simply to avoid bank stocks whenever the U.S. economy shows clear signs of heading into a recession.
Fourth-quarter earnings results underlined the themes of cutting expenses and deploying capital. "Goldman Sachs, which through the first nine months had shown [a return on tangible common equity, or] ROTCE of just 9 percent, sharply [dropped] its full-year compensation ratio from 42 percent to 38 percent to bring the full-year ROTCE in at 11 percent," Kotowski said, adding that the company "has now kept its aggregate dollar amount of TCE flat at about $63B /- for two and a half years and used any earnings above this level to repurchase shares."
Several of the largest banks also outlined new efforts to cut costs and make more efficient use of capital in their fourth-quarter earnings announcements:
Citigroup announced several moves to lower its expenses by $900 million during 2013, with cost savings increasing to $1.1 billion by 2014, at the relatively meager cost of $300 million in annual revenue. The moves included the closure of 84 branches and the elimination of 11,000 positions, and new CEO Michael Corbat said all the right things during the company's fourth-quarter earnings conference call, including the company's need to "get to a point where we stop destroying our shareholders' capital, and the need to "run a smart and efficient business that's good at its allocation of its resources."
Morgan Stanley said it had already met its goal to reduce its fixed-income risk-weighted assets to $280 billion from $390 billion at the end of the third quarter of 2011 and was on track to lower the RWA to $255 billion by the end of 2013, and eventually to less than $200 billion by the end of 2014. The company also said it would accelerate its purchase of the remaining stake in its brokerage joint venture with Citigroup, to complete the purchase by the end of 2013, when its agreement with Citi last year called for Morgan Stanley to complete the acquisition by 2015. Having 100 percent ownership of the brokerage will enable "greater order flow capture," increase deposit funding and lower expenses by eliminating the joint venture agreements and expenses, according to the company. Morgan Stanley in 2012 reduced its work force by 7 percent and said it planned to cut staffing by another 10 percent in 2013.
Bank of America said that its fourth-quarter noninterest expenses declined 6 percent year-over-year, and that it had reduced its staff levels by 1 percent sequentially and 5 percent year-over-year. The company's deals earlier this month to sell servicing rights on roughly $300 billion in mortgage loans will also help to lower its legacy assets servicing (LAS) expenses by $1 billion during 2013.
Kotowski said that the big banks' cost savings "are still aspirational as opposed to realized," but that the "aspirations now seem to be more grounded given the stable and predictable performance in 2012. Thus, they have more credibility now than they did at any other time in the recent past when everything always seemed to be in flux."
Net Interest Income Bottoms
For the eight banks covered in his report, including Bank of America, Citigroup, Morgan Stanley, Goldman Sachs, Capital One, JPMorgan Chase, U.S. Bancorp and Wells Fargo, Kotowski said that fourth-quarter net interest income "ticked up by 1.3 percent linked quarter," and said that the sequential comparison was a "clean one," since the third and fourth quarters each had 92 days, and because Capital One's acquisition of HSBC's U.S. credit card portfolio was completed during the second quarter.
"Thus, the 1.3 percent NII growth seems mainly related to the 0.5 percent loan growth," Kotowski says, with non-real estate commercial and industrial lending being "the single biggest growth engine." January data from the Federal Reserve indicates a 4.8 percent year-over-year growth rate for C&I loans, although "the 'other consumer' category, which is dominated by auto lending and 'closed-end mortgages' (primarily jumbos) both started growing in January of 2012 and are now growing at 3.8 percent and 5.4 percent, respectively."
Kotowski said that during the fourth quarter, "fee income was clearly a bright spot, up 14.1 percent year over year," for the large-cap banks he covers, leaving out Goldman Sachs and Morgan Stanley.
For the group of six banks, investment banking fees were up 56 percent year-over-year, to $4.341 billion in the fourth quarter, while mortgage banking fees were up 31 percent year-over-year, to $7.214 billion. JPMorgan saw the most growth in mortgage banking revenue, rising to $2.035 billion in the fourth quarter, from $725 million a year earlier. Bank of America saw its mortgage revenue decline to $1.635 billion in the fourth quarter from $2.119 billion in the fourth quarter of 2011, reflecting in part the company's long-running dispute with Fannie Mae, which has now been resolved.
Other bright spots for fees included trust, asset management and brokerage fees, which rose 12.5 percent year-over-year to $11.232 billion, and card fees, which rose 7.2 percent to $5.102 billion.
When discussing Basel III capital requirements, which under the Federal Reserve's rules will be fully phased-in in January 2019, Kotowski said that the Bank for International Settlement's determination that Citigroup and JPMorgan Chase should have enhanced capital buffer requirements of 2.5 percent as systemically important financial institutions (SIFI) while Bank of America, Goldman Sachs and Morgan Stanley should have lower buffer requirements of 1.5 percent, are "of course ridiculous conclusions, and we encourage our readers to ridicule them whenever they meet with banking authorities."
The enhanced capital buffers for the SIFIs are added to the basic Basel III Tier 1 common equity ratio requirement of 7.0 percent. Kotowski expects all of the "big five" eventually to raise their Tier 1 common equity ratios to the 9.5 percent level, while "COF, USB, WFC and other retail-funded banks will probably run at a lower level."
The analyst expects all of the large-cap banks to hit their Basel III requirements years in advance, with "the big five getting to the mid-9s by the second or third quarter of 2013. After that, the accretion should go all for either growth or to the shareholders."
Kotowski has "Outperform" ratings on four of the eight names covered in the report, and said that his price targets generally assume "that the banks trade at their historical average of 70 percent of the market multiple."
Even though the company "threw an air ball for the second fourth quarter in a row" with the company providing guidance for 2013 based on its disappointing results, Kotowski said "we suspect that Street expectations are now at a level that the company will probably meet or beat and that the stock is oversold at just 8.7X our 2013 estimate." Capital One's shares closed at $56.24 Wednesday. Kotowski's lowered his 2013 EPS estimate for the company to $6.50 from $7.03, with a 2014 EPS estimate of $7.15. His 12 to 18 month price target for the shares is $68.00.
Citigroup's shares closed at $42.02, or 0.8 times their reported Dec. 31 tangible book value of $51.19. Kotowski's price target for the shares is $50.00. The analyst lowered his 2013 EPS estimate for Citi to $4.75 from $5.00, and estimates the company will jump to $5.63 in 2014.
Kotowski raised his price target by a dollar to $63, "based on 10.5x our FY2013 EPS estimate of $6.01." Oppenheimer's 2014 EPS estimate for JPMorgan is $6.50. JPMorgan's shares closed at $46.23 Wednesday, trading for 1.2 times tangible book value, according to Thomson Reuters Bank Insight.
Kotowski's price target for the shares is $27, "based on current tangible book value per share. Our expectation is that the stock will track TBV for the foreseeable future." The analyst estimates that Morgan Stanley will earn $2.47 a share in 2013, with EPS rising to $3.06 in 2014.
— Written by Philip van Doorn for TheStreet.com
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