Bank Stock Rally Faces Earnings Test
NEW YORK (TheStreet) -- The performance of the big money-center banks in the first quarter will hinge upon whether they spent time boosting profits in booming areas, or stitching up wounds in still-troubled ones.
On the upside, last quarter saw a continuation of capital markets improvements. Wealth management,
stock and bond issuance
, advisory services and proprietary trading divisions all had growth potential during the first quarter. At the same time, net interest margins appear to have grown further, while credit costs -- while still elevated -- are expected to continue to abate.
On the downside, lending is weak and new regulation has curtailed fee revenue from traditional sources like
overdrafts,
credit cards, deposits and the like. It's unclear how mortgage workout programs are actually faring, while charge-offs and foreclosures are still running high. It's also difficult to tell how much the fees from strong refinancing volumes and new home purchases have helped to counter those losses. Yet banks that took advantage of the shifting
interest rate environment early on with
smart hedging strategies may have offset housing losses entirely.
Collins Stewart analyst Todd Hagerman issued a report on Monday, citing the positive trends for the group in his upgrade of
Wells Fargo's
(WFC) - Get Report
stock to buy, and a reiteration of the same rating for
JPMorgan Chase
(JPM) - Get Report
and
Bank of America
(BAC) - Get Report
. He rates
Citigroup
(C) - Get Report
stock a hold.
"Bank stocks have soared this quarter as cheap valuations, combined with the likelihood that credit has finally reached an inflection point, have provided the necessary fuel to propel the group higher," Hagerman said in his report.
Deutsche Bank analyst Matt O'Connor also points out that negative elements are "known issues" and identifies several areas that have room for "potential positive surprises." Among them are higher margins due to low funding costs, mortgage revenue, sales of nonperforming loans and trading in FICC -- shorthand for fixed income, currency and commodities.
"In addition, we think more banks will talk about becoming profitable at some point this year," O'Connor predicts.
Of course, a lot also hinges on expectations too -- and the positive Wall Street sentiment on banks may end up leading to a rally that falls flat when they report. The KBW Bank Index soared 22% during the first quarter, with JPMorgan gaining 7%, Wells Fargo adding 15%, Bank of America climbing 15% and Citigroup soaring 22%.
This first week of the second quarter, they have continued to surge. Bank of America, for instance, has risen in every session this week, and has strung together five consecutive closes above $18, something the stock hasn't done since November 2008.
For the first quarter, the average estimate of analysts polled by
Thomson Reuters
is for Bank of America to earn 8 cents per share on revenue of $27.6 billion. The consensus view is that JPMorgan will report a profit of 65 cents per share, on $26.6 billion in revenue; Wells Fargo is projected to earn 40 cents per share on $21.6 billion in revenue; and Citigroup is forecast to report a slight loss but break even on a per share basis on $20.9 billion in revenue.
But with the bulls charging in ahead of the earnings reports, any minor disappointment -- in bottom- or top-line results, as well as in the trend for credit costs - could set the stocks back. For instance, O'Connor lowered his "normalized" annual profit estimate for Bank of America to $2.09 per share from $2.82 per share after doing a "deep dive" into the firm's profit fundamentals.
O'Connor says the elimination of certain fee income streams, along with reductions to Bank of America's home equity, auto and credit-card portfolios, and some other adjustments will have a much greater impact than the Street expects. The firm is also re-balancing its assets due to the changing interest-rate environment, which may limit profits in the near-term. Most analysts are assuming normalized estimates of $3 per share or more, according to O'Connor, something that's not realistic given the headwinds.
On the other hand, he calls Wells Fargo a "top pick" because of its asset exposure to a steep yield curve, as well as continued strength in its mortgage business. He also predicts further upside from battered-down Wachovia assets, and that Wells will pick up business as Bank of America and JPMorgan
get rid of some assets and customers.
"With the stock trading at about 8x our normal EPS estimate (vs. 9x for the overall group), we think the valuation is very attractive," says O'Connor.
Meanwhile, Citigroup's results stand to be muddled as ever, as the company keeps working through its bad mortgage bets and business divestitures. Nonetheless, its core business lines appear to have improved, since the Treasury Department announced plans to wind down its 30% common equity stake over the course of the year, its stock has jumped higher.
In a note to clients last week, Rochdale Securities analyst Richard Bove became one of a growing chorus of analysts and investors arguing that Citi's book value is understated. He said that its recent Primerica spin-off showed that there's more value in Citi Holdings assets than many had assumed, and proved that there is a market for other assets the firm is trying to sell.
" If this is the case, as I believe it to be, then the book value of Citigroup is understated," said Bove. "If that is true, which definitely appears to be the case, buyers for the stock that the government is about to sell are likely to line up. The issue will be sold sooner rather than later."
If this is indeed the quarter when credit costs finally move beyond stabilization to improvement, the next big question facing the money-center banks will be when they can start consistently growing revenue again. Bank of America, for instance, is expected to
post sequential growth on the top-line
for the first time in year.
Count Ladenburg Thalmann as a skeptic about where the growth is going to come from. The firm said in a research note this week that it sill has some doubts about the pace at which the big banks will be able to return to normalized earnings, saying it sees 2010 as a year when these companies will need to focus on reinvestment in order set the stage for future growth and that lack of visibility about credit has been replaced by lack of visibility about revenue.
"
We think normalized earnings means more than just lower credit and operating costs," the firm told clients. "To us, it means a return to growth levels that modestly exceed nominal U.S. GDP growth (recent economic forecasts are around 3.5%-4.5%)."
-- Written by Lauren Tara LaCapra in New York
.