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5 Banks Cutting Their Way to Bigger Profit

Stocks in this article: JPM WFC RF USB FHN

NEW YORK ( TheStreet) -- Guggenheim analyst Marty Mosby expects large U.S. banks to show "6% sequential growth in operating earnings" for the second quarter, when the sector's earnings season begins on Friday.

While many analysts have been focused on the " coming storm" from narrowing net interest margins, as short-term rates remain near zero and long-term rates continue to decline, Mosby said on Wednesday that investors should not "get lost on the headwinds for revenue growth," because, "as the Large Cap Banks are still in earnings recovery mode, efficiency improvements are just as important."

A bank's efficiency ratio is the number of pennies of overhead expense for each dollar of a bank's revenue, with adjustments made for certain items. Thomson Reuters Bank Insight defines the efficiency ratio as total noninterest expense plus income from minority interests divided by the sum of tax-adjusted net interest income and noninterest income.

Mosby said that "after improving 1.7 percentage points in 1Q12, we are forecasting a 2.5 percentage point gain in 2Q12's efficiency ratio, which is responsible for more than 100% of this quarter's expected sequential increase in EPS."

The analyst sees a silver lining for investors heading into second-quarter earnings, since "the recent downward pressure on our Large Cap Bank stock prices has pulled the stock prices further below the current recovery in earnings," which "has created pent-up positive momentum for our Large Cap Banks that could potentially provide the eventual catalyst for a traditional bank recovery trade if earnings per share can continue to growth through year-end 2012."

Over the past two years, most large banks have been allowing their loan loss reserves to decline, in line with the decline in loan charge-offs. This has padded earnings results, which is why analysts focus on "pre-provision" earnings. Guggenheim projects "sequential growth in pre-provision earnings per share... following a three year slide from 2008 through 2011," and suggests "this inflection point should result as revenues begin to grow, operating efficiencies begin to improve, and deployment of excess capital through acquisitions and share repurchases creates positive earnings momentum in 2012."

Mosby expects "favorable 2Q12 operating earnings surprises" with "double digit annualized sequential growth" in earnings from four large-cap banks covered by Guggenheim, including U.S. Bancorp (USB), Wells Fargo (WFC), M&T Bank (MTB), and SunTrust (STI), and said that the four are "are positioned to benefit the most by reporting better than expected earnings this quarter while generating strong earnings momentum."

The analyst added that "most of the banks with unfavorable earnings expectations relative to market expectations are related to unusual items, and include JPMorgan Chase (JPM), First Horizon National Corp. (FHN), Regions Financial (RF), and Zions Bancorporation (ZION)," and that "the inclusion of these large unusual items is inconsistent across the market estimates, making the consensus less useful for these banks."

Factoring in current stock price valuations, here are the three names Mosby expects to head higher on the strength of operating earnings improvements, followed by two names with "the best return-to-risk ratios and strong operating returns which should justify an eventual revaluation":

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