Bank stock investors are braced for a disappointing first quarter, but there is still plenty of value in select mid-cap names, according to UBS analyst Stephen Scinicariello.
The KBW Bank Index has returned 9 percent this year, after a stellar 2012 return of 30 percent. Last year the industry feasted on a wave of mortgage refinancing and enjoyed the benefits of a recovering housing market, the continued improvement in credit quality and a return of investor confidence, most analysts are expecting mixed results for the first quarter.
Mortgage revenue is very likely to decline from its lofty fourth-quarter levels. The Mortgage Bankers Association on March 22 estimated first-quarter one-to-four family mortgage loan originations would total $482 billion, declining from $511 billion in the fourth quarter but increasing from $373 billion in the first quarter of 2012. For all of 2013, the MBA estimates that mortgage loan originations will total $1.432 trillion, declining from $1.750 billion in 2012.
The MBA projects a further decline in mortgage originations to $1.053 trillion in 2014.
Last year's bumper mortgage crop resulted not only from historically low long-term rates, but from President Obama's expansion of the Federal Housing Finance Agency's Home Refinance Program, which allowed qualified borrowers with loans held by Fannie Mae and Freddie Mac to refinance their entire loan balances, no matter how much the market value of their homes had declined.
In addition to lower origination fee income, banks are seeing lower gain-on-sale spreads when selling newly originated mortgage loans to Fannie Mae and Freddie Mac. Credit Suisse analyst Moshe Orenbuch on April 4 forecast "a 9 percent q/q decline in mortgage banking revenues for 1Q'13 which embeds a 6 percent decline in originations and a 20-25bp decline in GOS margins offset by some slight improvement in servicing revenues given the rise in rates."
Over the course of 2013, the continued improvement in the housing market may offset quite a bit of the expected revenue decline from lower origination volume and declining secondary market spreads. Improving loan servicing revenues, declining expenses for the maintenance of foreclosed property, lower servicing costs as collections staff is reduced and even credit recoveries on some charged-off loans, are all expected to benefit banks with large mortgage operations.
Wells Fargo is not the dominant mortgage player, with roughly 25 percent of origination volume. The company's mortgage banking revenue increased to $11.638 billion in 2012 from $7.832 billion in 2011. JPMorgan analyst Vivek Juneja last Friday estimated that Wells Fargo's mortgage loan origination fee revenue would decline to $8.042 million in 2013 from $12.200 billion in 2012, but also predicted the sharp decline would mostly be offset by other mortgage-related items, leaving a relatively small net revenue decline ranging from $334 million to $404 million.
Mid-Cap Value Plays
Along with the declining mortgage volume, banks continue to face a hostile rate environment, with most already enjoying all of the benefit of a decline in funding costs, since the Federal Reserve has kept the short-term federal funds rate in a range of zero to 0.25 percent since late 2008. Meanwhile, with the Fed doing everything it can to hold long-term rates down, most lenders are continuing to see assets reprice, leading to continued pressure on net interest margins.
Loan demand also appears soft, although select lenders will no doubt continue to post strong loan growth numbers. Scinicariello in a note to clients late on Tuesday said that for the mid-cap banks that he covers, "we project loan growth of 1.6 percent (lower than prior quarters), manageable NIM pressure of 6bps (with the potential to be less) but flat [net interest income], lower fee income driven by declining mortgage banking, flat expenses, [and] continuing credit improvement."
Another important seasonal factor for the banks in the first quarter is the annual bump in compensation expenses, following the payout of bonuses.
According to Scinicariello, "regional bank valuations are reasonable at 1.6X TBV and 13.2X forward earnings on average considering expected returns and risks." That average forward price-to-earnings ratio is far higher than the forward P/E ratios for the "big four" U.S. banks:
- Shares of JPMorgan Chase closed at $48.68 Tuesday, trading for 8.0 times the consensus 2014 earnings estimate of $5.82, among analysts polled by Thomson Reuters. The company will announce its first-quarter results on Friday, with a consensus EPS estimate of $1.39, matching its fourth-quarter results, but increasing from $1.19 in the first quarter of 2012.
- Citigroup closed at $43.89 Tuesday, trading for 8.4 times the consensus 2014 EPS estimate of $5.20. Citi will report its first-quarter results on Monday, with a consensus EPS estimate of $1.18, increasing from 69 cents in the fourth quarter, when the company took charges related to massive cost-cutting moves including 11,000 layoffs. Citi earned $1.11 a share in the first quarter of 2012.
- Bank of America closed at $12.25 Tuesday, trading for 9.3 times the consensus 2014 EPS estimate of $1.32. The company will announce its first-quarter results on April 17, with analysts expecting earnings of 23 cents a share, increasing from 3 cents a share, both in the fourth quarter and the first quarter of 2012. Bank of America's fourth-quarter results included charges related to the company's $10.3 billion mortgage putback settlement with Fannie Mae.
- Wells Fargo closed at $37.45 Tuesday, trading for 9.7 times the consensus 2014 EPS estimate of $3.88. Wells Fargo will also report on Friday, with a consensus first-quarter EPS estimate of 88 cents, declining from 92 cents in the fourth quarter, but increasing from 73 cents in the first quarter of 2012.
Of course, the more expensive regional banks lack the regulatory and political targets the biggest banks have on their backs and also have a much smaller burden from mortgage repurchase demands than Bank of America.
"Despite the significant appreciation, we believe regional bank stocks remain reasonably valued considering their long term earnings power and we believe that better-than-expected fundamentals should continue to drive the revaluation of the sector," Scinicariello wrote.
According to Scinicariello, four mid-cap "quality" regional banks stand out with "attractive relative valuation" relative to peer medians. All of them have "buy" ratings from UBS. Here they are, ranked by ascending upside potential to the analyst's price targets:
Shares of FirstMerit of Akron, Ohio, closed at $16.50 Tuesday, returning 18 percent this year, following a 2 percent decline during 2012. The shares trade for 1.6 times tangible book value, according to Thomson Reuters Bank Insight, and for 11.7 times the consensus 2014 EPS estimate of $1.41. The consensus 2013 EPS estimate is $1.25.
Based on a quarterly payout of 16 cents, the shares have a dividend yield of 3.88 percent.
The company in September agreed to acquire Citizens Republic Bancorp of Flint, Mich., in an all-stock deal valued at $912 million. Citizens Republic has $9.6 billion in total assets and owes $300 million in federal bailout funds received through the Troubled Assets Relief Program, or TARP. FirstMerit plans to purchase Citizens Republic's TARP preferred shares from the U.S. Treasury without itself becoming subject to TARP's restrictions, while also paying the government deferred dividends totaling $48.5 million. The merger is expected to be completed in the second quarter.
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The consensus among analysts is for FirstMerit to report first-quarter earnings of 31 cents a share, declining from 35 cents in the fourth quarter, but increasing from 28 cents in the first quarter of 2012.
Scinicariello on Tuesday raised his price target for FirstMerit's shares to $18.00 from $17.50, saying in his note to investors that "We believe the acquisition of CRBC provides longer-term growth opportunities." Scinicariello maintained his first-quarter EPS estimate of 32 cents and his 2013 EPS estimate of $1.28, but lowered his 2014 EPS estimate to $1.69 from $1.63, because of expected net interest margin compression.
"Given the size and importance of the CRBC deal, we expect FirstMerit to remain focused on integration throughout 2013 before ramping up inorganic capital deployment but gauging management's future appetite will be important."
Shares of KeyCorp of Cleveland closed at $9.85 Tuesday, returning 18 percent this year, following a 12 percent return last year. The shares trade for 1.1 times tangible book value and for 10.3 times the consensus 2014 EPS estimate of 96 cents. The consensus 2013 EPS estimate is 86 cents.
Following the completion of the Federal Reserve's annual stress tests, KeyCorp on March 14 announced raised its quarterly dividend by half a penny to 5.5 cents a share and also said its board of directors had authorized a new program for share repurchases of up to $426 million. Based on the new quarterly payout, the shares have a dividend yield of 2.23 percent.
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The company will announce its first-quarter results on April 18. The consensus among analysts is for KeyCorp to report a profit of 20 cents a share, declining from 22 cents in the fourth quarter, and matching its results for the first quarter of 2013.
Scinicariello's price target for KeyCorp is $11 and he estimates the company will report first-quarter EPS of 22 cents. The analyst on Tuesday lowered his 2013 EPS estimate for KeyCorp to $1.04 from $1.10 and lowered his 2014 estimate to $1.20 from $1.25, "to conservatively account for the timing of expense initiatives."
"KEY has several earnings levers including significant excess capital, funding improvement, market share opportunities, expense reduction, and franchise optimization," Scinicariello wrote, adding that the bank has an opportunity to expand its net interest margin, with $5 billion in higher-cost CDs maturing this year.
Shares of Comerica of Dallas closed at $34.95 Tuesday, returning 16 percent this year, following a 20% return during 2012. The shares trade just above tangible book value and for 12.5 times the consensus 2014 EPS estimate of $2.79. The consensus 2013 EPS estimate is $2.76.
Following the Fed's stress tests, Comerica raised its quarterly dividend by 2 cents a share to 17 cents, for a yield of 1.95 percent. The company also announced regulatory approval for share buybacks of up to $288 million through the first quarter of 2014.
Comerica will report its first-quarter results on April 16, with analysts expecting EPS of 68 cents, equaling the company's fourth-quarter results, but increasing from 66 cents in the first quarter of 2012.
Scinicariello on Tuesday raised his price target for Comerica's shares to $40 from $38, because of "a more favorable view of growth and margin mitigation." The analyst maintained his EPS estimates of 65 cents for the first quarter and $2.75 for all of 2013, while lowering his 2014 EPS estimate to $3.08 from $3.15, "as we foresee NIM recovery to take longer than we previously anticipated."
Offsets to the pressure on Comerica's net interest margin include "solid loan growth, deployment of significant liquidity, short duration of the MBS portfolio, and the fact that 85 percent of loans are variable rate," Scinicariello wrote.
1. Fifth Third Bancorp
Shares of Fifth Third Bancorp of Cincinnati closed at $16.39 Tuesday, returning 9 percent this year, following a 23 percent return during 2012. The shares trade for 1.4 times tangible book value, and for 9.7 times the consensus 2014 EPS estimate of $1.69. The consensus 2013 EPS estimate is $1.64.
Fifth Third on March 14 announced a "potential increase" in its quarterly dividend from 10 cents a share, with approval for the potential repurchase of up to $750 million in trust preferred securities. The company also received approval for the potential conversion of $398 million in convertible preferred shares to common shares. If the conversions are completed, the company has Federal Reserve approval for common share buybacks totaling up to $984 million.
Based on the current quarterly payout, the shares have a dividend yield of 2.44 percent.
The company will announce its first-quarter results on April 18, with the consensus estimate being a profit of 38 cents, declining from 43 cents in the fourth quarter and 45 cents in the first quarter of 2012.
Scinicariello's price target for Fifth Third's shares is $19, and on Tuesday the analyst lowered his first-quarter EPS estimate to 40 cents from 42 cents, while lowering his full-year 2013 EPS estimate to $1.71 from $1.78, and his 2014 EPS estimate to $1.79 from $1.87, "due to mortgage banking trends."
On a brighter note, Fifth Third's complicated 2013 capital plan could result in common-share buybacks totaling up to $1.084 billion, Scinicariello wrote, adding that "the potential replacement of $750MM of trust preferreds could bolster the NIM."
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