Don't Bank on Financials

7/20/2009


Untitled Document

When is a bank not a bank? If you regularly follow financial news, you may have heard this one already.

Companies ranging from investment banks such as Morgan Stanley ($28; MS) and Goldman Sachs ($150; GS) to consumer-finance companies such as American Express ($24; AXP) officially became “bank holding companies,” gaining access to the federal Troubled Asset Relief Program (TARP).

Whether or not you consider these companies banks, most of them performed a lot like banks over the last 18 months, as shown in the chart below. Since the start of 2007, the S&P 1500 Financial Sector Index has fallen 58%, at least 13 percentage points worse than any other sector index. Within the sector index, the Banks Group Index is down 60% and the Diversified Financials Group Index is down 56%.

As of July 9, the total stock-market value of the banking and financial-services companies in our Quadrix universe was $1.29 trillion, down 58% from $3.09 trillion at the end of 2007. Despite the huge stock-market declines, the average Quadrix Value score for these stocks is a middling 48. The average Overall score is just 42, reflecting weak fundamentals.

Pulling off the TARP

As of early June, the U.S. Treasury had deployed $435 billion in TARP funds to more than 600 companies, reflecting both direct investments and guarantees. Insurer American International Group ($14; AIG) and the automobile industry combined to receive about $155 billion in TARP funds, and most of the remaining $280 billion went to large financial institutions.

The 12 banks or diversified financials with the largest stock-market value at the end of 2007 combined to receive $178 billion in TARP funds. Collectively, these 12 companies have seen their stock-market value fall 45% since the end of 2007.

Two of the companies no longer trade. Merrill Lynch and Wachovia were purchased by Bank of America ($13; BAC) and Wells Fargo ($24; WFC), respectively, and both acquirers are among the 10 remaining companies from the big 12. All 10 of the companies still trading have seen their market values fall over the last 18 months. But despite those declines, the 10 stocks average a Value score of 42, with none higher than 65.

In response to eroding Quadrix scores that indicated weakening fundamentals in the financial sector, we began reducing our exposure to the big banks and diversified financials in late 2007. By April 2008, we were almost entirely out of the sector. At the moment, we recommend only one financial stock, insurer Aflac ($31; AFL), a Long-Term Buy.

But as weak as they are, financials remain an important part of the market, and we’re asking ourselves the same question on a lot of investors’ minds: “Is it time to get back into the big banks?” That is quite literally a trillion-dollar question. And our answer? The time has not yet come.

Bullish case

• Massive consolidation in the industry has reduced the number of players, which should in turn reduce competition for the stronger companies in the years ahead. As of July 9, there were 423 bank stocks in our Quadrix research universe, which requires a minimum stock-market value of $25 million. The current count is down 25% from 567 companies at the end of 2007. Since then, roughly 80 U.S. banks have failed, while many others were acquired by larger, stronger competitors, often at bargain prices.

• The S&P 1500 Financial Services Sector Index posted an operating profit in the March quarter, bouncing back from record losses in the December quarter and marking the first profitable quarter since the September 2007 period. Of the 12 banks or diversified financials with the largest stock-market values, 11 posted an operating profit in the first quarter and all were projected to make money in the second quarter. Sector profits should continue to rise in coming quarters as the operating environment for banks improves. Net interest margins, or the spreads between what banks pay to borrow money and what they collect from loaning out those funds, remain solid. S&P 1500 financials averaged a spread of 3.4% in the most recent quarter, down modestly from the average of 3.6% over the last eight quarters.

BY THE NUMBERS, FINANCIALS DON'T LOOK GOOD
As of July 9, the total stock-market value of the banks and diversified financials in our Quadrix research universe was $1.29 trillion, down from $3.09 trillion at the end of 2007. The average Quadrix Overall score for banks and diversified financials was 42, down from 55 at the end of 2007. Despite the huge declines in stock prices, Value scores remain unimpressive.
— Average Quadrix Scores —
— Overall —
— Value —
Number of
– Companies –
Total Stock
– Mkt. Value (Bil) –
Industry Groups
July
9
End of
2007
July
9
End of
2007
July
9
End of
2007
July
9
($)
End of
2007
($)
Banks & Div. Fin’ls
42
55
48
69
578
716
1,292
3,087
  Banks
40
52
47
70
423
567
586
1,556
    Commer. Banks
39
57
49
76
305
401
543
1,408
    Thrifts/Mtg. Fin.
42
39
43
57
118
166
43
148
  Diversified Fin'ls
46
65
50
63
155
149
706
1,531
    Diver. Fin’l Svcs.
49
59
50
57
35
37
289
688
    Cons. Finance
61
60
69
78
22
26
51
108
    Capital Markets
42
69
45
62
98
86
366
735
Notes: Quadrix scores are percentile ranks, with 100 the best. Averages exclude total returns of more than 100%.

• Relative to consensus earnings estimates for 2010 and 2011, bank stocks look cheap. For instance, Bank of America trades at 22 times the 2009 estimate, 11 times the 2010 estimate, and five times the 2011 estimate.

• With federal stress tests over and many banks now able to issue stock and float debt offerings without government guarantees, uncertainty about companies’ capital positions has decreased.

Bearish case

• We have not seen the last of losses on bad loans. Even after government stress tests, internal audits, and months of poring over balance sheets, nobody really knows the value of many outstanding loans. Assuming the government’s worst-case scenario is realized, financial firms’ losses through the end of next year could top $450 billion, and may reach $800 billion, depending on whose estimates you believe. To put these losses in perspective, all the financials in the S&P 500 Index combined to earn about $160 billion in 2007.

• Many firms have issued stock in recent quarters to raise cash. Of the 259 financial companies in the S&P 1500 Index, 62% saw their share counts increase over the four quarters ended March, versus just 39% for the same period a year earlier. We expect massive additional dilution in the wake of large stock offerings in the June quarter. Consensus estimates reflect dilution. But estimates for share counts vary widely, suggesting nobody is certain about the dilution expected.

• While stock prices are cheap relative to profit estimates, the estimates themselves are suspect. In addition to concerns about dilution, estimates may be overly aggressive. Can Wells Fargo ($24; WFC) earn $7.3 billion this year, $9.9 billion in 2010, and $16.4 billion in 2011? Wells Fargo has never before earned more than $8.5 billion in a year. The consensus projects robust growth, but it’s tough to commit real dollars in the face of such uncertainty about the sector.

• With an average Quadrix Overall score of 42 and Value score of 48, shares of banks and diversified financials do not stand out.

A glance at our recommended lists will tell you our take on the sector. As of yet, we don’t see a compelling reason to buy up downtrodden financials. The fundamentals are too weak and the future too cloudy to warrant a Buy rating.

THE MIGHTY, FALLEN
The 12 banks or diversified-financial companies below were the largest in the U.S. as measured by market value at the end of 2007, but their combined market value has fallen 45% since then. Merrill Lynch and Wachovia were acquired by other companies on the list. Of the nine firms that received TARP funds, six have paid back those funds.
——–——— Quadrix Scores * ——–———
—— Overall ——
——— Value ———
Stock Market
—— Value (Bil.) ——
12-Month Total
—— Return ——
TARP Funds
——— (Billions) ———
Company (Price; Ticker)
Current
End of
2007
Current
End of
2007
Current
($)
End of
2007
($)
Past 12
Months
(%)
2007
(%)
Received
($)
Paid
Back
American Express
($24; AXP)
56
64
62
73
28.6
60.8
(32)
(13)
3.4
Yes
Bank of America
($13; BAC)
63
49
65
83
102.2
183.1
(27)
(19)
45.0
No
Bank of New York Mellon
($29; BK)
42
76
51
48
34.4
55.5
(13)
19
3.0
Yes
Citigroup ($3; C)
23
48
37
91
16.0
146.6
(79)
(45)
50.0
No
Fannie Mae ($1; FNM)
1
11
13
43
0.7
39.1
(91)
(30)
None
NA
Goldman Sachs
($150; GS)
49
93
37
89
75.3
85.5
(4)
9
10.0
Yes
J.P. Morgan Chase
($35; JPM)
30
72
27
95
135.4
146.6
14
(7)
25.0
Yes
Merrill Lynch (NA; MER)
NA
37
NA
64
NA
45.8
NA
NA
None
NA
Morgan Stanley ($28; MS)
30
37
47
93
37.7
56.1
1
(21)
10.0
Yes
U.S. Bancorp ($17; USB)
38
53
48
70
33.1
54.8
(20)
(8)
6.6
Yes
Wachovia (NA; WB)
NA
49
NA
93
NA
75.2
NA
NA
None
NA
Wells Fargo ($24; WFC)
41
54
29
80
114.8
102.1
24
(12)
25.0
No

* Quadrix scores are percentage ranks, with 100 the best.      NA Not available.     Sources: Compustat, U.S. Treasury.


FORECASTS FINANCIALS
Consensus estimates project substantial share dilution for many financial stocks over the next 18 months, though the warrants (which allow holders to buy shares at a set price) bailed-out financials granted to the government represent only a small portion of the new shares. Consensus estimates for shares outstanding reflect only analysts providing both net-profit and per-share-profit estimates.
Shares
P/E
Quad
Company (Price; Ticker)
Most
Recent
Federal
Warrants
2009
Consensus
2010
Consensus
2009
2010
2011
Value
Overall
Industry
American Express
($24; AXP)
1,156
24
1,148
1,177
28
18
9
62
56
Consumer Finance
Ameriprise Financial
($24; AMP)
224
0
243
260
10
8
7
84
28
Capital Markets
Bank of America
($13; BAC)
6,431
272
7,749
8,736
22
11
5
65
63
Diversified Financial
Citigroup ($3; C)
5,385
653
15,361
23,348
NM
13
7
37
23
Diversified Financial
Fifth Third Bancorp
($7; FITB)
572
44
700
773
NM
NM
6
28
8
Commercial Banks
Franklin Resources ($70; BEN)
232
0
231
227
22
16
NA
37
57
Capital Markets
Goldman Sachs
($150; GS)
551
12
529
545
11
10
9
37
49
Capital Markets
J.P. Morgan Chase
($35; JPM)
3,759
88
4,231
4,080
25
12
7
27
30
Diversified Financial
Morgan Stanley
($28; MS)
1,012
65
1,542
1,522
32
8
8
47
30
Capital Markets
Wells Fargo
($24; WFC)
4,249
110
4,482
4,794
16
13
8
29
41
Commercial Banks

NM Not Meaningful.     NA Not Available.     * Quadrix scores are percentile ranks, with 100 the best.

Sources: U.S. Treasury, Reuters.

 


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