Citi, Bank of America Best Bets for Capital Return, Says Nomura

NEW YORK (TheStreet) -- Sell-side analysts have overwhelmingly positive outlooks for stocks of the largest U.S. banks, although there has been some difference of opinion recently about JPMorgan Chase (JPM) and Citigroup (C).

Nomura Securities on Wednesday initiated its coverage for the U.S. brokerage and capital market sector, with a "neutral outlook" for the sector as a whole.

Normura analyst Steven Chubak in a report wrote that universal banks face "considerable regulatory pressure and are more exposed to areas of relative weakness," such as trading and mortgage banking, "but for whom valuations are reasonably attractive."  The analyst sees brokers having better growth prospects than the big banks, but trading at "premium valuations."

For Bank of America (BAC), Nomura initiated a "buy" rating, with a price target of $19, implying potential upside of 15% from Wednesday's closing price of $16.58.  Bank of America's shares trade for 1.2 times their reported Sept. 30 tangible book value of $13.62, and for 10.4 times the consensus 2015 earnings estimate of $1.59 a share, among analysts polled by Thomson Reuters.  The consensus 2014 EPS estimate is $1.32.

Nomura estimates Bank of America will earn $1.27 a share in 2014, with EPS rising to $1.51 in 2015.

In support of the $19 price target, Chubak wrote, "Using our 2016 model forecasts as a proxy for normalized earnings, our analysis suggests that BAC can generate a mid-cycle [return on equity] ROE of ~15%."  Nomura also expects "significant excess capital generation" of $11 billion during 2014.

According to data supplied by Thomson Reuters Bank Insight, Bank of America's return on tangible common equity for the first three quarters of 2013 was a rather unimpressive 7.44%. 

But Bank of America has "the most upside" among the universal banks from a rise in interest rates, according to Chubak.  Long-term interest rates have already risen considerably, although they are still low from a longer-term perspective. But most banks need to see a parallel rise in interest rates, which can only happen when the Federal Reserve raises the short-term federal funds rate, which has been locked in a range of zero to 0.25% since late 2008.  The Federal Open Market Committee has repeatedly said it was unlikely to raise the federal funds rate at least until the U.S. unemployment rate falls below 6.5%.  That may happen sooner than previously expected, since the unemployment rate improved significantly to 7.0% in November from 7.5% in October.  The Department of Labor will announce the December unemployment rate on Friday.

Following years of major settlements of mortgage repurchase demands from investors, "the remaining liability does not pose a risk to BAC's capital position, although expenses should remain elevated," Chubak added.

Bank of America trades at a higher forward P/E multiple than its peers, showing that investors agree the company is well positioned to benefit from the continuing economic recovery, with an increasing deployment of capital reducing the share count and raising EPS.

JPMorgan Chase

Nomura went with a neutral rating for JPMorgan, with a price target of $61, implying upside from Wednesday's close at $58.87. JPMorgan's shares trade for 1.5 times their reported Sept. 30 tangible book value of $39.51, and for 9.3 times the consensus 2015 EPS estimate of $6.33.  The consensus 2014 EPS estimate is $5.97.  The shares have a 2.58% dividend yield, based on a quarterly payout of 38 cents.

"We like JPM's earnings profile/mix, but the current capital shortfall should dampen near-term return prospects," the report said. "Pressures in FICC and Mortgage Banking should also limit revenue growth, with few opportunities on the cost side given already best-in-class efficiency ratios."

Nomura also forecasts "mid-cycle ROE potential of ~14% for JPM."

JPMorgan's return on tangible common equity for the first three quarters of 2013 was 11.59%, however, that includes the third-quarter net loss springing from a $9.15 billion provision for litigation reserves. The company's $17.5 billion in fourth-quarter residential mortgage-backed securities settlements had already been reserved for, but it also said its $2.6 billion in settlements over its role in the Bernard Madoff affair would lower fourth-quarter after-tax profits by $850 million.

Even with the hit to fourth-quarter profits from the Madoff settlement, it seems likely JPMorgan will come close to the 14% ROE figure cited as a potential "mid-cycle" level by Nomura. 

"We expect legal costs will remain elevated, though analysis suggests that JPM is adequately reserved for remaining mortgage risks," Chubak wrote. 

And if that really happens, investors may push JPMorgan's P/E multiple higher during 2014. 

But Chubak believes JPMorgan's stock price already reflects its potential earnings power, and he sees "limited opportunity for more meaningful near-term earnings growth given continued pressures on FICC and Mortgage Banking, and limited expense opportunities given already best-in-class efficiency."

Chubak's neutral view of JPMorgan stands in contrast to Jefferies analyst Ken Usdin, who on Wednesday initiated his firm's coverage of the company with a "Buy" rating.

Citigroup

In contrast to Usdin of Jefferies, who on Wednesday initiated his coverage of Citigroup with a "hold" rating, saying "investors must be patient" as the bank's capital deployment story unfolds, Chubak initiated Nomura's coverage of Citi with a "buy" rating, with a price target of $70.00.

That price target implies 28% upside over Citigroup's Wednesday closing price of $54.81.  Like JPMorgan, Citigroup is among the five cheapest U.S. bank stocks on a forward P/E basis.

Citi's shares trade just above their reported Sept. 30 tangible book value of $54.22, and for 9.3 times the consensus 2015 EPS estimate of $5.91.  The consensus 2014 EPS estimate is $5.29.

Chubak wrote, "We see unparalleled ROE potential at Citi under the new capital rules, as [core operating unit] Citicorp efficiency targets are realized by 2015E and [runoff subsidiary] Citi Holdings turns profitable."

"We also see significant excess capital generation/best-in-class payout potential as the drag from Holdings moderates and DTA utilization accelerates."  DTA stands for Citi's deferred tax assets valuation allowance, which is expected to accelerate as the company's noncore assets continue to decline.  The company's DTA at the end of the third quarter stood at roughly $53 billion, with about $38 billion excluded from regulatory capital.  Those figures show quite a bit of potential for Citigroup to lower its share count through share repurchases and prop up its EPS over the next few years.

The shares could see a major catalyst in March, after the Federal Reserve completes its next round of stress tests for large financial firms, immediately followed by the regulators' review of large banks' plans to deploy excess capital through dividend increases, share buybacks and acquisitions. 

Citi is primed for "meaningfully higher long-term payout potential relative to peers," according to Chubak.

Chart

The following chart shows the performance of Bank of America, JPMorgan Chase JPM and Citigroup against the KBW Bank Index (I:BKX) and the S&P 500 since the end of 2011: 

BAC Chart data by YCharts


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

>Contact by Email.

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.

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