CIT Would Be Deal Gravy for Wells Fargo: Street Whispers

NEW YORK ( TheStreet) -- Wells Fargo ( WFC) needs "earning assets at attractive yields, given the low loan growth environment and the Fed's approach to make most every low-risk investment as unattractive as possible."

This is what Stifel Nicolaus analyst Christopher Mutascio said on Monday, when touting CIT Group ( CIT) as a potential takeout target for Wells Fargo.

Among the "big four" U.S. bank holding companies, Wells Fargo has been the big star through the credit crisis and its aftermath, with much stronger and consistent earnings performance, reflected in the considerably price ratios for its stock than its national competitors.

Wells Fargo's shares closed at $35.30 Friday, returning 29% year-to-date, following a 10% decline during 2011. The shares trade for two times tangible book value, according to Thomson Reuters Bank Insight, and for 10 times the consensus 2013 earnings estimate of $3.66 a share, among analysts polled by Thomson Reuters. The consensus 2012 EPS estimate is $3.31.

For the 12-month period ended June 30, Wells Fargo's operating return on average assets (ROA) was 1.30%, according to Thomson Reuters Bank Insight, while the company's return on average equity (ROE) was 11.57%.

Here's how those numbers compare to the remaining members of the "big four" club:
  • Shares of JPMorgan Chase (JPM) closed at $41.25 Friday, returning 26% year-to-date, following a 20% loss last year. The shares trade for 1.2 times tangible book value, and for eight times the consensus 2013 EPS estimate of $5.20. The consensus 2012 EPS estimate is $4.71. JPMorgan's ROA for the 12-months ended June 30 was 0.79%, while its ROE was 9.55%. The big story for JPMorgan Chase this year has been the "London Whale" hedge trade, which led to second-quarter losses of $4.4 billion for the company's Chief Investment Office. But JPMorgan still managed to earn a $5.0 billion profit during the second quarter.
  • Bank of America (BAC) has seen its shares return 64% year-to-date, through Friday's close at $9.19. The shares trade for 0.7 times tangible book value, and for 10 times the consensus 2013 EPS estimate of 91 cents. The consensus 2012 EPS estimate is 0.55%. Over the past four quarters through June, Bank of America's ROA was 0.52%, while the company's ROE was 4.84%. The company's mortgage putback drama continues, with repurchase demands increasing by 41% during the second quarter alone, to $22.7 billion as of June 30.
  • Citigroup (C) closed at $33.81 Friday, returning 28% year-to-date, following a 44% decline during 2011. The shares trade for 0.7 times tangible book value, and for 7.5 times the consensus 2013 EPS estimate of $4.53. The consensus 2012 EPS estimate is $4.09. Citi's ROA over the 12-month period ended June 30 was 0.55%, and its ROE was 5.78%. Truly long-term investors are hoping eventually to receive a major return of capital from the company, as its Citi Holdings subsidiary continues to wind down, and the company eventually reverses some or all of its deferred tax valuation allowance.

Wells Fargo has benefitted from very strong mortgage volume this year, with record-low rates, and President Obama's expansion of the Home Affordable Refinance Program, which allows qualified borrowers with loans held by Fannie Mae ( FNMA) or Freddie Mac ( FMCC) to refinance their full loan balances at much lower rates, no matter how much the market value of the home has declined.

But the refinancing wave won't last forever, and Wells Fargo faces the additional challenge of a narrowing net interest margin, which is the difference between a bank's average yield on loans and investments, and the average cost for deposits and borrowings.

According to Guggenheim Securities analyst Marty Mosby, among the largest U.S. bank holding companies, "Wells Fargo (WFC) has the most margin compression today expected over the next year," as the company has a large percentage of assets with original maturities of greater than three years, that are "repricing down now, lower than they were three years ago."

At a conference on Sept. 11, Wells Fargo Wells Fargo CFO Tim Sloan said that although the company achieved a "stable" net interest margin during the second quarter, in part because of "a 7 basis point linked quarter benefit from higher variable items," the margin for the third quarter "could be similar to what we experienced in the third quarter of last year when our net interest margin was down 17 basis points."

Mutascio last Monday downgraded Wells Fargo to a "Hold" rating from a "Buy" rating, saying that the expected 17-point decline in the company's net interest margin "would be nearly double the 9 basis points of margin compression we were anticipating this quarter."

Since Wells Fargo "does not need deposits, as it is flush with liquidity" and "does not need additional brick and mortar, as the profitability of branches is low in such a low interest rate environment and the company already has a coast-to-coast branching network," Mutascio sees CIT Group as a perfect fit, since the commercial lender does not have a branch network, but does have "$35 billion in higher yielding assets that have already been marked-to-market via Fresh Start Accounting," because of the company's bankruptcy filing in November 2009.

Mutascio said a combination between the two companies could "substantially improve CIT's earnings power by replacing its higher cost of funds with WFC's industry low cost of funds," and that there would be "no material reduction in cash on hand given CIT's high cash balances." The analyst also said that there would be "no meaningfully negative impact" to Wells Fargo's Tier 1 common capital ratio.

Based on his "base case assumptions," which include a price of $52 a share for CIT Group, or roughly $10.5 billion, "moderate cost saves of 20% of CIT's operating expenses base," acquisition funding of 50% cash and 50% stock, and "WFC benefiting from CIT's $4 billion net operating loss (NOL) carry forward," Mutascio estimates that the combination "could be 5% accretive to WFC's EPS - and up to 7% accretive if the acquisition was paid for in an all cash transaction."

Mutascio also listed U.S. Bancorp ( USB) as a possible acquirer for CIT Group. U.S. Bancorp has been an even stronger earner than Wells Fargo, with an ROA of 1.59% for the 12-month period ended June 20, and an ROA of 14.79%. USB's shares closed at $34.04 Friday, returning 27% year-to-date. With the company remaining profitable right through the credit crisis and among the best earners among the largest industry players, USB trades for 3.1 times tangible book value, and 11 times the consensus 2013 EPS estimate of $3.04.

According to Mutascio, an acquisition of CIT Group by U.S. Bancorp, assuming a 50/50 split of cash and stock, or a 100% cash deal, "would actually be more accretive" to earnings than an acquisition of CIT by Wells Fargo.

"However, we think the chances of a USB acquisition of CIT are lower than WFC," Mutascio said, "because USB may have traditional bank acquisitions higher on its radar screen in order to expand its geographical footprint."

"In addition, we believe WFC may be more comfortable (from a risk perspective) with CIT's specialty finance loan portfolios than USB, given its experience with such lending as evidenced by the fact WFC has purchased two portfolios from CIT in the past."


-- 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 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.