Banks' Experience Shows 'Isolated' Shortfalls Aren't Always What They Seem

When a high-profile company surprises the market by announcing operating difficulties, a predictable refrain typically rings out through the market: The offender's problems are its own stupid fault, so don't expect anyone else in the industry to suffer.

We heard it this Thursday after Lucent (LU Quote) warned of lower-than-expected earnings, and Wednesday when Gateway (GTW Quote) disclosed its own shortfall. Those two may well turn out to be unique to their sectors, but often the truth is a lot more complex. A little digging by investors can reveal that the underperforming company is more like a canary in the coal mine, signaling wider trouble, than an isolated bad apple.

Cutting Deep

Over the past 12 months, this has been the case in the banking sector, the site of earnings blowups by several institutions, including First Union (FTU Quote), Bank One (ONE Quote), U.S. Bancorp (USB Quote) and National City (NCC Quote).

In January 1999, First Union became the first large bank to announce lower-than-expected earnings; it then cut its profit outlook again in May. The shortfalls were the result of First Union's failure to make large acquisitions perform as desired, analysts said. Yet, though many banks had done equally substantial acquisitions in the preceding years, no effort was made by most members of the analytical community to identify which other banks could face similar merger-related problems. Investors were similarly blase. After First Union's May upset, investors dived back into the market and pushed the KBW Bank Index up nearly 7% in the following month or so.

But in the rest of the year, Bank One, National City and U.S. Bancorp all slashed earnings predictions, seriously pressuring their shares. And some think problems at all three can, in some measure, be laid at the feet of large mergers.

Too Big to Succeed

"First Union had done a lot of acquisitions, and that's what killed Bank One and U.S. Bancorp," says Jonathan Iseson, manager of Bluewater Partners, a Long Island-based bank-focused hedge fund that has no position in any of the three banks. "Analysts always swear that something's not an industry problem."

Charles Peabody, a bank analyst with New York-based Mitchell Securities, says National City's earlier mergers contributed to its 1999 stumbling. (Peabody rates National City a sell and Mitchell has done no underwriting with the institution.)

Bank One didn't comment, but in an August conference call after first slashing profit forecasts, John McCoy, Bank One's then-chief executive, implied that integrating credit-card assets from acquired companies had hampered its ability to compete in the card business. First Union and U.S. Bancorp didn't comment. A National City spokesman said his bank's 1998 acquisition of First of America wasn't seen by the bank as "a contributing factor behind our shortfall."

Squeeze Play

Another source of cross-sector blues for banks has been lower lending margins, something that National City complained about in its November warning. (TheStreet.com has explored shrinking lending margins.) Again, analysts made little effort to find which other institutions might suffer. But a little homework may have benefited their clients: Only three week's later, U.S. Bancorp partially blamed a tighter margin when it announced in early December that earnings would fall below analysts' expectations.

Investors always need to be on the lookout for forces that can affect a whole industry. Indeed, one bank-stock hedge fund manager who requested anonymity looks at the pressure on earnings and arrives at the following diagnosis: Banks are in the process of reverting to a lower level of profit growth after a decade of big changes that only temporarily boosted profitability.

This runs contrary to the prevalent view among analysts that a new age of finance has begun, in which most large banks' profits can increase 10% to 15% a year over the next few years.

By contrast, the hedge fund manager says banks' earnings will slow right down and grow around the same rate as the economy, which is 4% to 6% a year (not adjusted for inflation). Few banks' profits will manage to exceed that, he says. "We're just getting reversion to the mean," the manager adds.