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Bank Turn
By Francis X. Gilpin
Associate Editor
The bullish stampede toward bank stocks since the 2000 tech bust has run out of breath.
Still, Edward R. Najarian, a senior analyst at Merrill Lynch & Co. Inc., likes a handful of large-cap regional banks that he follows, such as Wachovia Corp. But, speaking to a group of investment managers at the Oct. 11 CFA Tampa Bay meeting, Najarian said: "I don't expect a massive rebound."
He blamed two huge factors:
• Short- and long-term interest rates are almost indistinguishable, inhibiting the ability of banks to make money on the spread between what they pay depositors and what they can charge borrowers - the phenomenon known as a flattening yield curve.
• The quality of loans, which has held up well in the low interest rate environment of the earlier party of the decade, is bound to deteriorate within the next two years and banks must increase their low loss reserves in anticipation, putting extra strain on earnings.
It was a nice run, while it lasted.
"If you turn the clock back to when the tech bubble was bursting," Najarian said at the meeting, "banks were the anti-tech."
Burned investors, who didn't flinch when they bid up Internet flashes-in-the-pan to ridiculously high price-to-earnings ratios, sheepishly retreated to the safety of stodgy financial services. "Needless to say, as the money poured out of those companies, it poured into banks," recalls Najarian. "When the Nasdaq was at 5,000, my companies were trading at eight, nine, 10 times earnings."
Between 2000 and 2004, banks out-performed the Standard & Poor's 500 stock index. This year, however, Najarian says his regional banks are down about 12% against the S&P 500.
Tough times ahead
The banking picture could get worse before it gets better, according to Najarian.
Credit quality has shown marked improvement since 2002. So banks reduced their loan-loss provisions as a percentage of outstanding loans, giving a nice boost to their bottom line.
But higher interest rates and the preponderance of adjustable-rate mortgages at some institutions are going to increase delinquencies and defaults.
Najarian doesn't see loan problems showing up on the books for another quarter or two.
In hot real estate markets such as Florida, banks have recouped more of their loan losses through quick resale of foreclosed properties. But those circumstances may change and banks will have to tuck away even more in reserves for the potential write-offs.
"They're going to have to take a little bigger hit to earnings, as they take credit losses," Najarian says of 2006 and 2007. Prepare for only single-digit earnings growth in bank stocks for the next two to three years, he adds.
Are any regional banks bucking the trend? Najarian says Wachovia may do it.
Only about half of the Charlotte, N.C.-based bank's earnings come from the vulnerable business of managing the interest rate spread, with the rest fee earnings. Typical regional banks depend on the rate spread for about 60 percent of their net income.
"Having that little extra fee tilt is good," says Najarian.
Besides better revenue diversification, Wachovia's fee income is derived more from asset management and securities brokerage than declining mortgage origination.
Najarian says Wachovia's loan portfolio yields a little less than competitors due to higher underwriting standards. But, in the coming years, he says that will become a positive while other banks absorb losses from their bad credits.
There are two other elements that Wachovia has going for it, says Najarian. The stock is cheap. And the bank is the biggest in the nation's fastest-growing region, the Southeast. Bank of America Corp. does maintain the top spot in deposit share over No. 2 Wachovia in the Sarasota and Tampa markets, even with Wachovia's purchase of SouthTrust Corp. earlier this year.
"Fundamentally, you would say at 10 times earnings, 4.4% dividend yield, I should be waving in this stock all day," Najarian says of Wachovia. "Oh, by the way, they're going to purchase a ton of stock over the next 12 months."
Investor concern about Wachovia's desire to buy another financial institution is what has depressed the stock price, which has generally slid downward since late May.
Speculation initially centered on MBNA Corp., which B of A picked up instead. Another big credit card issuer, Capital One Financial Corp., has publicly disavowed any marriage talk with Wachovia. Morgan Stanley & Co. Inc., under new management, is no longer for sale.
The most logical Wachovia target would be Long Island's North Fork Bancorp. Najarian says he believes the two banks talked last spring, but Wachovia backed away for now because the New York bank was asking too much.
Najarian is less enthused with Wachovia's cross-town rival in Charlotte.
"Let me tell you," he says about B of A, "they have pretty much screwed up their balance sheet management."
Interest in interest rates
The Merrill Lynch analyst drew a big crowd to the University Club of Tampa because many of the chartered financial analysts who belong to CFA Tampa Bay work for the regional banks that Najarian tracks.
One audience member asked if AmSouth Bancorporation and SunTrust Banks Inc. will get bought out.
Najarian answered yes, within the next five years.
SunTrust is the more attractive of the pair, Najarian says. "Honestly, SunTrust has more fat to cut," he says. So it would be easier for an acquirer to achieve immediate cost savings. The Atlanta bank's branches are also more cosmopolitan.
AmSouth, based in Birmingham, Ala., is seen as dowdy and concentrated in rural areas of the South. AmSouth would be a logical choice for Fifth Third Bancorp to take out as part of the Cincinnati bank's Southeast expansion.
SunTrust will probably wait at least another two years because its executives have signaled that they want to buy one more bank before they put themselves up for sale.
As for investors looking at the entire industry, Najarian says history shows that bank stocks should be hitting their lows for this economic cycle about now, if the Federal Reserve does respond to critics and stops raising short-term rates with Chairman Alan Greenspan's retirement in early 2006.
If Greenspan's tight-money policies are maintained, however, the pain for those holding onto bank stocks may continue.
"The market," Najarian says, "is really in a conundrum right now about when to get bullish on bank stocks."
One Man's Opinion
Here are the thoughts of Merrill Lynch analyst Edward J. Najarian on some of the Southeast regional banks that operate on the Gulf Coast and report third-quarter results this month:
Bank of America Corp.
His rating: Neutral
His take: A $6 billion after-tax loss from bad bets in the derivatives market has yet to be reflected on the balance sheet.
BB&T Corp.
His rating: Neutral
His take: Write-offs should rise as management gets back into the acquisition game in 2006.
Fifth Third Bancorp
His rating: Sell
His take: Net margin pressure means interest income won't help offset expensive staff and branch expansion.
Regions Financial Corp.
His rating: Sell
His take: Exposure to hurricane-devastated areas didn't dent September quarter results, but population declines could have a lasting impact.
SunTrust Banks Inc.
His rating: Neutral
His take: Trading and trust fees are solid, but loan reserves are too low for the write-offs ahead.
Wachovia Corp.
His rating: Buy
His take: Investment banking and advisory fees are getting stronger and the company is repurchasing 15 million shares.
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