5 'Best' Bank Stock Ideas from Sterne Agee

NEW YORK ( TheStreet) -- Even in the face of regulatory headwinds, a sputtering economic recovery and narrow rate spreads, there are a variety of winning approaches for banks to grow their earnings.

"Bank stocks have climbed a wall of worry this year," according to Sterne Agee analyst Peyton Green, and there's no question that the troubled sector has been a winner, with the KBW Bank Index ( I:BKX) returning 24% through Monday's close at 48.89.

So where do investors turn now? One approach is to keep focusing on some of the best-known industry names, which continue to trade at huge discounts to book value:
  • Shares of Citigroup closed at $41.83 Monday, returning 21% year-to-date, following a 44% decline during 2011. The shares trade for 0.8 times their reported June 30 tangible book value of $51.81, and for nine times the consensus 2013 EPS estimate of $4.53, among analysts polled by Thomson Reuters. The consensus 2012 EPS estimate is $4.09. Citigroup's great unwind continues, with CEO Vikram Pandit saying on Tuesday that since forming its runoff subsidiary City Holdings, "we have reduced its assets by over $600 billion," including the announced deal to sell Citi's remaining stake in the Morgan Stanley Smith Barney joint venture to Morgan Stanley (MS).
  • Morgan Stanley is valued even more cheaply than Citi, with shares closing at $16.61 Monday, or 0.6 times their reported June 30 tangible book value of $27.70, and 8.5 times the consensus 2013 EPS estimate of $1.95. The consensus 2012 EPS estimate is 89 cents. Morgan Stanley's shares have returned 15% year-to-date, after dropping 44% during 2011.
  • Bank of America (BAC) closed at $8.58 Monday, returning 55% year-to-date, following last year's epic drop of 58%. The shares trade for 0.7 times their reported June 30 tangible book value of $13.22, and for nine times the consensus 2013 EPS estimate of 91 cents. The consensus 2012 EPS estimate is 55 cents. While the shares remain attractively valued even after the year-to-date run-up, BAC is still saddled with mortgage putback risk, with loan repurchase demands rising by 41% just in the second quarter, to $22.7 billion, as of June 30.

One of the reasons for the big discount for so many of the largest U.S. banks is the fear of continued regulatory onslaught, with various sources of fee income being pressured, the seemingly endless and agonizing implementation of the Volcker Rule's limits on "proprietary trading," heightened annual scrutiny through the Federal Reserve's stress tests and increasing capital requirements.

Some voices are still calling for the largest U.S. financial companies to be broken up, with no consideration of how this would make the Unites States much less competitive internationally, in an area where we have always been an innovator. Rochdale Securities analyst Richard Bove on Tuesday refuted the notion that the U.S. financial industry was "broken," by pointing out that during 2011, "Wells Fargo earned more than IBM ( IBM), Wal-Mart ( WMT), or General Electric ( GE)," and that "Citigroup was one of only 15 American companies that earned more than $10 billion in 2011" earning "more than Pfizer ( PFE), Google ( GOOG), or Coca Cola ( KO)."

Bove added that during 2011, " JPMorgan Chase ( JPM) made more money than all of the companies listed above."

Getting back to regional banks with strong growth prospects for investors, Sterne Agee on Monday updated its "Best Ideas" list of bank stocks, with the names being "well diversified among key sector themes ranging from solid organic growth to those delivering profitability improvement via credit leverage," according to Greene.

Here are the five buy-rated banks on Sterne Agee's "Best Ideas" list, with the greatest 12-month upside potential implied by the firm's price targets.

5. PNC Financial Services Group
Shares of PNC Financial Services Group ( PNC) of Pittsburgh closed at $63.88 Monday, returning 13% year-to-date, following a 3% decline during 2011.

The shares trade for 1.3 times tangible book value, according to Thomson Reuters Bank Insight, and for nine times the consensus 2013 EPS estimate of $6.82. The consensus 2012 EPS estimate is $5.69.

Based on Sterne Agee's price target of $74, PNC's shares have 16% upside potential.

PNC's shares have underperformed most large regional banks this year, reflecting investors' concerns over increased mortgage repurchase demands, with PNC reporting a second-quarter mortgage putback provision of $438 million, leading to disappointing earnings of $546 million, or 98 cents a share, including 54 cents a share, after tax, for the mortgage repurchase provision. The second-quarter results compared to earnings of $811 million, or $1.44 a share, during the first quarter, and $912 million, or $1.67 a share, during the second quarter of 2011.

One major advantage for PNC in the current environment is that the acquisition of RBC Bank (USA) -- which included 424 branches in North Carolina, Florida, Alabama, Georgia, Virginia and South Carolina at a price below tangible book value -- has positioned the company's balance sheet for an expanding net interest margin, which is no mean feat in the current low-rate environment.

The company's net interest margin -- the spread between the average yield on loans and investments and the average cost for deposits and borrowings -- expanded to 4.08%, from 3.90% the previous quarter, and 3.93% a year earlier.

Sterne Agee analyst Todd Hagerman estimates that PNC will earn $6.90 a share in 2013, for a return on average assets (ROA) of 1.16% and a return on average equity (ROE) of 9.42%. The analyst said on Monday that the RBC Bank (USA) acquisition is "exceeding expectations as visibility surrounding revenue growth should become more apparent as investment spend is effectively complete," and that "increasing new client wins and a steady flight to quality in the Southeast, together with positive operating leverage and steadily falling funding costs, suggest PNC is on track to further improve its above-average profitability metrics."

PNC Chart PNC data by YCharts

Interested in more on PNC Financial Services Group? See TheStreet Ratings' report card for this stock.

4. The Bancorp
Shares of The Bancorp ( TBBK) of Wilmington, Del., closed at $9.39 Monday, returning 30% year-to-date, after declining 29% during 2011.

The shares trade for 1.1 times tangible book value, and for 11 times the consensus 2013 EPS estimate of 87 cents. The consensus 2012 EPS estimate is 51 cents.

Sterne Agee's price target for The Bancorp is $11, implying 17% upside for the shares.

The Bancorp specializes in prepaid cards, and with total assets of $3.2 billion as of June 30, the company is exempt from the Durbin Amendment's cap on debit card interchange fees, which the Federal Reserve implemented for banks with over $10 billion in total assets, in October 2011.

Sterne Agee analyst Matthew Kelley on Monday said that The Bancorp was one of his firm's "favorite small cap growth stocks in the financial sector," with operating revenue "expected to increase by 25% and 23% in 2012 and 2013," while fee income from prepaid cards "is expected to grow by 49% and 29% in 2012 and 2013 and will represent 33% and 35% of revenues, up from 28% in 2011."

Looking ahead, Kelley said that "with EPS growing at a 50% compounded annual growth rate over the next two years, tangible book value expected to grow to $10+ p/s and ROE expected to move into double digits, we believe the shares can trade at a higher P/E valuation in the coming quarters."

The analyst estimates that The Bancorp will earn 98 cents a share in 2013.

TBBK Chart TBBK data by YCharts

Interested in more on The Bancorp? See TheStreet Ratings' report card for this stock.

3. First Midwest Bancorp
Shares of First Midwest Bancorp ( FMBI) of Itasca, Ill., closed at $12.69 Monday, returning 25% year-to-date, following a 12% decline during 2011.

The shares trade for 1.4 times tangible book value, and for 14 times the consensus 2013 EPS estimate of 89 cents. The consensus 2012 EPS estimate is 45 cents.

Sterne Agee's price target for First Midwest is $15, implying 18% upside potential.

First Midwest had $8.1 billion in total assets at the end of the second quarter, with a stubbornly high level of nonperforming loans, which made up 3.90% of total loans as of June 30. Some analysts expect the company to announce a bulk sale of problem loans and/or repossessed real estate before the end of the year.

Sterne Agee analyst Kenneth James says that the consensus earnings view of First Midwest "continues to reflect well below potential profitability. The analyst estimates FMBI will earn a dollar a share in 2013, and said on Monday that the shares were "priced on the less expensive end of the group" of small-cap banks covered by his firm, "despite being a top-tier franchise from a deposit and core profitability perspective."

The analyst said that "despite spotty growth trends nationally, we believe loan growth trends could be a positive for FMBI over the balance of the year," and noted "that roughly 1/3 of the commercial lending staff overall has turned over in the past ~18 months towards more commercial and industrial oriented lenders," and that "the recently hired asset-based lending team had yet to be fully operational for a full quarter as of 6/30."

FMBI Chart FMBI data by YCharts

Interested in more on First Midwest Bancorp? See TheStreet Ratings' report card for this stock.

2. TCF Financial
Shares of TCF Financial ( TCB) of Wayzata, Minn., closed at $11.44 Monday, returning 12% year-to-date, following a 29% decline during 2011.

The shares trade for 1.4 times tangible book value, and for 11 times the consensus 2013 EPS estimate of $1.03. The consensus 2012 EPS estimate is a loss of $1.19, factoring-in TCF's balance sheet restructuring in March, which led to a first-quarter net loss of $282.9 million, or $1.78 a share.

During the first quarter, the company prepaid $3.6 billion in wholesale borrowings and sold $1.9 billion in mortgage-backed securities, as part of its strategy of moving away from longer-term residential and commercial real estate loans and MBS investments, to a focus on "originating high-yielding, low-risk, secured loans and leases funded by a low-cost, core deposit base," according to CEO William Cooper.

Based on Sterne Agee's price target of $14, TCF Financial's shares have 22% upside potential.

As one of the banks most affected by the Durbin Amendment, as well as the rules requiring banks only to provide overdraft coverage for debit card and ATM transactions for customers who previously opted-in for the service were implemented in July 2010, TCF Financial has been seeking to rebuild its revenue model by focusing on specialty lending, including equipment leasing, inventory finance and auto lending, which together made up 32% of the company's total loans and leases as of June 30, increasing from 27% a year earlier. During the second quarter, TCF grew these loans and leases 23% year over year, to $4.9 billion.

The company's net interest margin expanded to a very strong 4.86%, from 4.14% the previous quarter, and 4.02% a year earlier, reflecting the reduced interest expense and more profitable loan mix. Cooper said in July that "with rates low and even lower, we'll probably see some reduction in that very high net interest margin... somewhere around 4.6%, 4.65%," which is still a very high margin in the current rate environment.

Green said on Monday that "our recent meeting with management confirmed our belief that TCB's prospects remain brighter than the valuation suggests. We believe that improved credit quality, coupled with revenue growth, will lift TCB's ROA to 1.0% by 4Q13E and 1.2% in 2014E."

Sterne Agee estimates that TCF Financial will earn $1.05 a share during 2013.

TCB Chart TCB data by YCharts

Interested in more on TCF Financial? See TheStreet Ratings' report card for this stock.

1. TFS Financial
Shares of TFS Financial ( TFSL) of Cleveland closed at $8.94 Monday, for a flat year-to-date return, following a 1% decline during 2011.

The shares trade for 1.5 times tangible book value. The consensus Fiscal 2013 EPS estimate is 14 cents. The consensus EPS estimate for the 2012 Fiscal Year that ends Sept. 30 is four cents.

Sterne Agee's price target for TFS Financial is $11, implying 23% upside potential.

TFS Financial is part of a mutual holding company structure, with 73.5% of the company's common shares held by Third Federal Savings and Loan Association of Cleveland, MHC.

Main subsidiary Third Federal S&LA entered into an Office of Thrift Supervision Memorandum of Understanding, or MOU, in August of 2010. The OTS has now been folded into the Office of the Comptroller of the Currency. Under the MOU, Third Federal made a capital infusion of $150 million into the thrift subsidiary in October 2010, and was required by the regulators to submit a plan to reduce its concentration in home equity loans, which the company said it completed, by reducing these loans by reducing its home equity lending commitments, "$1.31 billion from June 30, 2010 levels, including $506.1 million in outstanding balances, to $3.83 billion" at the end of 2011, and further reducing its home equity lending commitments to $3.60 billion, as of June 30.

TFS Financial had $11.5 billion in total assets as of June 30.

The company said that it had met most of the terms of a subsequent MOU it entered in February 2011, addressing operations and risk management concerns, but would also need to improve its interest rate risk management.

Sterne Agee analyst Matthew Breese on Monday said that "we remain positive on TFSL given their progress in meeting MOU stipulations, improvement in the overall risk profile of the institution and overall valuation," and that "upon removal of the MOU we believe investors will turn their focus towards book value growth from share repurchases and potential for a second step conversion."

Breese said that "upon resolution of the MOU, we believe TFSL will return to repurchasing stock and possibly paying dividends," and noted that "since coming public in April 2007, the company has repurchased 24.1 million shares or 23% of the minority float.

A second-step conversion to full stock ownership could be a windfall for patient investors in TFS Financial, with Breese estimating that "fully converted tangible book value in current terms would equal $12.05-$12.91." TFSL Chart TFSL data by YCharts

Interested in more on TFS Financial? See TheStreet Ratings' report card for this stock.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.