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NEW YORK (
TheStreet) -- 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.
KBW Bank Index(I:BKX) has returned 9% this year, after a stellar 2012 return of 30%. 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 U.S. 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(FNMA) and
Freddie Mac(FMCC) 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 forecasted "a 9% q/q decline in mortgage banking revenues for 1Q'13 which embeds a 6% 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(WFC) is not the dominant mortgage player, with roughly 25% 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% 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 (NIMs).
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 for the mid-cap banks that he covers, "we project loan growth of 1.6% (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(JPM) 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(C) 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(BAC - Get Report) 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: