Are Banks Bargains?
Many banks reported good third-quarter earnings and upbeat outlooks. We check them against Morningstar analysts' expectations.
The average stock in our global coverage universe is about fairly valued, according to the Morningstar Market Fair Value chart. While that means bargains likely are not lining the shelves, with a little digging you can uncover some underpriced stocks with good prospects.
One of the cheapest sectors in our coverage area is financial services. Although it's certainly not a closeout sale, the typical stock in the sector is 7% undervalued, trading at a market-cap-weighted price/fair value ratio of 0.93. And one particularly undervalued industry within that sector is banks.
Things seem to be chugging along in the banking sector, with many banks reporting upbeat earnings in the past few weeks. All six "Big Banks" ( Citigroup (C), Wells Fargo (WFC), Bank of America (BAC), JPMorgan Chase (JPM), Goldman Sachs (GS), and Morgan Stanley (MS)) exceeded analysts' earnings-per-share expectations. Only half, however, are currently selling at valuations that our analysts feel are compelling. In this article, we take a deeper dive into those three.
We also take a closer look at two banks that got a boost after beating consensus estimates, but whose prospects may not be as bright as they seem.
Three to Consider
Fair Value Uncertaintly: High
Economic Moat: Narrow
Price/Fair Value: 0.71
Citigroup reported that it benefited from strong demand in its investment banking and trading businesses in the third quarter. Morningstar senior equity analyst Jim Sinegal believes that while Citigroup remains very much a company in transition, the bank's progress over the past five years has been underappreciated. Sinegal believes that Citigroup is well positioned for a successful turnaround now that it has recapitalized and is refocused under new management.
Sinegal expects a combination of higher interest rates, lower capital needs, and continued operational improvements to boost returns on tangible common equity to more than 10% over the next five years from 7.8% in the third quarter. Citigroup's high capital levels provide a much bigger buffer against troubles than the bank had 10 years ago. With a common equity Tier 1 capital ratio of 12.6% and a supplementary leverage ratio of 7.4%, the bank is well-positioned to continue returning capital even in the event of an economic downturn, Sinegal says. He also likes the fact that the bank continues to return capital to shareholders and that it is shedding noncore operations, such as its consumer businesses in Brazil and Argentina.
Bank of America (BAC)
Fair Value Uncertainty: High
Economic Moat: Narrow
Price/Fair Value: 0.84
Bank of America beat earnings expectations during the third quarter, as net interest income and non-interest income both expanded. Meanwhile non-interest expense declined as the company's cost-cutting efforts continued to pay off, writes Sinegal.
Sinegal believes Bank of America's outlook is promising. The company's narrow moat derives from its deposit balances, which grew by 6% during the year, to $1.227 trillion. Roughly half came from consumers, and over one third of these deposits cost the bank nothing in interest expense, Sinegal points out. As the U.S. economy has improved and both consumers and businesses have become more willing to take on debt, Bank of America is once again able to put these deposits to work. Sinegal believes a growing demand for credit and an improving economy will drive both balance sheet and income statement growth over the next several years.
Wells Fargo (WFC)
Fair Value Uncertainty: Medium
Economic Moat: Wide
Price/Fair Value: 0.74
Wells Fargo's third-quarter results showed little impact from the sales scandal that ended the career of former CEO John Stumpf on Oct. 12, writes Sinegal. Importantly, Sinegal believes that the company is off to a good start in dealing with the problems created by aggressive and occasionally fraudulent sales practices. Average deposits expanded in the third quarter compared with the second quarter, with little change in the proportion of non-interest-bearing accounts. Period-end deposits also rose from June quarter levels. Primary consumer checking customers--those who actively use their accounts--expanded by 4.7% during the past 12 months, the same rate as in the prior quarter. This, in Sinegal's opinion, demonstrates that Wells Fargo is not only maintaining accounts, but that most accounts demonstrate a healthy level of activity--unlike the fraudulent accounts created over the past half decade.
Wells Fargo is the largest deposit-gatherer in major metropolitan markets across the country, says Sinegal. He estimates that more than one third of the bank's deposits come from markets in which Wells Fargo is the pre-eminent player, and more than two thirds are gathered in markets in which the company ranks among the top three. The firm's wide economic moat owes to its ability to generate exceptionally high levels of profitability: The bank builds on its funding advantage through efficient operations and solid underwriting, minimizing costs at the same time it maximizes revenue associated with every dollar held on its balance sheet. Still, Wells Fargo does face significant risks, including greater regulatory scrutiny and possible damage to its reputation, Sinegal notes. However, Wells Fargo is highly profitable and its returns and capital are fairly safe. In addition, its balance sheet strength is quite good. "Our base-case projections incorporate long-term returns on equity of 13%, well in excess of the bank's 9% cost of equity," he writes.
Two to Avoid
Regions Financial (RF)
Fair Value Uncertaintly: Medium
Economic Moat: None
Price/Fair Value: 1.18
Regions Financial's stock got a nice boost after beating consensus earnings expectations on Oct. 18, but third-quarter results were largely in line with our expectations, writes Morningstar analyst Eric Compton. Regions experienced tepid demand among middle market businesses for loans, a slight decline in net interest margins, and a continued focus on reducing expenses, announcing an additional $100 million in expected expense reduction. Although Compton notes that we were encouraged by the additional expense reduction potential, we also continue to believe that certain structural forces will make it difficult for Regions to get below a 60% efficiency ratio, especially without help from a better rate environment.
Morningstar sector director Stephen Ellis says Regions has done a lot to right the ship. After struggling through the financial crisis and its immediate aftermath, posting net losses during 2008-11, Regions Financial has stabilized, Ellis says, with much stronger asset quality translating into lower credit costs and leading to stable and profitable earnings performance. Regions has become a more focused and disciplined organization that can build on recent advances. However, Ellis thinks returns in excess of its cost of capital will elude Regions, given the persistent low-yield environment and the bank's relatively higher operational costs compared with peers. Our analysts believe Regions lacks a moat because it does not possess sustainable cost advantages (largely due to smaller scale than moatier banks) that are consistent with the bank moat framework.
SVB Financial Group (SIVB)
Fair Value Uncertaintly: High
Economic Moat: None
Price/Fair Value: 2.00
Silicon Valley Bank's shares jumped after the firm beat third-quarter consensus estimates by a wide margin and released an upbeat outlook. However, the quarterly results were mostly in line with our expectations, with a 19% increase in earnings per share from the previous quarter. Average loan balances also grew a bit quarter over quarter, but the biggest positive of the quarter, in Morningstar analyst Colin Plunkett's view, is that period-end deposits reversed their trend of negative growth, growing slightly from the previous quarter.
In SVB's preliminary 2017 guidance, the bank said it expects to continue increasing loan balances by high-teen levels, with deposits growing in the midsingle to high single digits. But that contrasts sharply with our view and with what we believe is happening within venture capital investing (and according to Pitchbook data), Plunkett says. Plunkett believes that SVB is entering a period of lower returns, with negative loan and deposit growth and increased charge-offs. Because of the soft funding environment driven by declining valuations, we believe startups will continue to burn cash while having difficulty raising new capital, decreasing the bank’s deposits. Not only does Plunkett believe the recent trend of decreasing deposits will accelerate as startup companies continue struggling to raise capital, he forecasts that five years from now, SVB will be a smaller bank.
Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.