Bank Earnings Pour In
The banking industry is on solid footing, and while Wells Fargo is creating negative headlines, the first quarter of 2018 was a good one for many financial institutions. Expanding revenue and net income, increased capital-return programs, solid returns on equity, and generally positive commentary, despite an increasingly competitive lending environment, were the norm. A narrowing of spreads on US Treasury instruments may pose a challenge to net interest margin expansion in the group, but there are other opportunities to capitalize on a surging LIBOR and the increasingly volatile equity market environment. All in, the performance in the first quarter of 2018 was “more good than bad” for the banks, and we continue to look for the right price to consider ideas, with many financial entities now trading well in excess of tangible book value per share.
By Brian Nelson, CFA
The banking (XLF, KBE, KRE) business model is quite simple. Borrow cheap. Lend expensive. Capture the spread and charge a layer of fees for ancillary services. Banks use cash to make more cash, a concept that differs from traditional operating entities that use cash to buy productive assets to create goods to then generate cash proceeds. In some respects, cash flow at banks is somewhat arbitrary, meaning that traditional free cash flow analysis for financial entities doesn’t have a lot of value.
The arbitrary nature of free cash flow when it comes to the financial sector is why we deviate from the tried-and-true discounted cash flow process and apply a residual income model that captures the value of the equity of the bank grossed up or down by the present value of future economic value generation. We think this approach is more reasonable than arbitrarily forecasting cash inflows and outflows at a bank, and it also targets the inherent capital position of the entity, which is critical when it comes to financial strength, confidence in the enterprise, and durability of the business.
Whether one is looking at the spread between the 2- and 10-year Treasury or the gap between the 5- and 30-year Treasury, both are looking quite narrow, extending to or near post credit-crunch lows. Though a rising interest rate environment may pose opportunities at many of the banks, the threat of a narrowing yield curve may make the lending environment much more difficult. The economic environment is quite healthy, which means net income margins may hold up well, but a narrowing spread environment, if not a detriment, may not help the banks much.
A surge in the London Interbank Offered Rate (LIBOR), however, could help offset much of the narrowing of the yields between near-dated and long-dated US instruments and help bottom lines across the sector. Many of the banks posted strong results during the first quarter of 2018, revealing solid net-income growth, improved equities trading and sales performance, healthy returns, and reinforced capital positions. We’re maintaining our fair value estimates across the banking sector.
JP Morgan Posts Strong First Quarter But Shares Not Cheap
On April 13, J.P. Morgan (JPM) released better than expected first-quarter results, with CEO Jamie Dimon saying that “2018 is off to a good start with our businesses performing well across the board, driving strong top-line growth and building on the momentum from last year.” We thought J.P. Morgan’s first quarter was one of the best of the big banks.
During the first quarter, J.P. Morgan’s consumer deposit growth was solid, client investment assets grew nicely, and equities revenue bounced back as volatility picked up across the markets during the period. The bank’s investment-banking division continues to be the top performer with respect to global fees, including in M&A activity, but the company did note that the lending environment remains “intensely-competitive,” a condition perhaps exacerbated by narrowing spreads.
J.P. Morgan’s book value ratcheted up to $67.59 in the period, while tangible book value leapt to $54.05, the latter up 3.9% on a year-over-year basis. The bank’s common equity Tier I capital (CET1) of $184 billion drove a healthy ratio of 11.8%, support for the bank to keep returning cash to shareholders. During the first quarter of 2018, J.P. Morgan returned $6.8 billion to shareholders--$4.7 billion of net repurchases and the balance coming from dividend payments.
J.P. Morgan generated an ROE (return on equity) of 15% and a ROTCE (return on total common equity) of 19% during the quarter, both measures up considerably from last year’s levels and offering support to our fair value estimate of $96 per share. Stocks that generate economic profit, or an ROE greater than a reasonable estimate of their COE (cost of equity) generally deserve valuations north of tangible book value. Shares of J.P. Morgan aren’t necessarily cheap, however.
Citigroup Plans Big Capital Returns in Coming Periods
Citigroup (C) exceeded estimates when it reported first-quarter 2018 results April 13. The company’s performance was solid, with revenue advancing 3% and net income jumping 13% thanks in part to a lower effective tax rate. Earnings per share leapt to $1.68, a 24% increase from the $1.35 per-share mark in the year ago period, as the bottom line was bolstered by a 7% reduction in the number of shares outstanding. CEO Michael Corbat described the market environment as “uneven,” and we think the view may reflect the competitive lending environment, volatility across equities, and the wind-down of some of the bank’s legacy assets.
Citigroup’s book value came in at $71.67 per share at the end of the first quarter of 2018, while its tangible book value stood at $61.02, both measures unfortunately falling on a year-over-year basis (due in part to a negative impact from tax reform), the latter by ~7%. This stands in stark contrast to the advancing pace of book value at J.P. Morgan, for example. Citigroup’s ROE and ROTCE came in at 9.7% and 11.4% during the period, respectively, while the company returned $3.1 billion of capital to shareholders in the period. Citigroup plans to return at least $60 billion from 2017-2019, a measure that would have to get the thumbs up from regulators.
The company’s common equity Tier I Capital (CET1) ratio stood at 12.1%, higher than J.P. Morgan’s but likely required as it unwinds some of its legacy assets. Said differently, though the higher capital base speaks to greater resiliency, the quality of the loan book has a great deal of influence on the assessment of whether the capital base is sufficient. This is partly why Citigroup keeps a higher CET1 ratio than J.P. Morgan, in our view, a relationship that coincidentally impacts the magnitude of return on capital. Due to Citi’s marginal value-generation compared to J.P. Morgan’s, our $75 per-share fair value estimate of the bank, for example, isn’t as marked-up as the premium over tangible book we assign to J.P. Morgan.
Wells Fargo Still Fighting Negative Consumer Perception
The fines keep adding up at Wells Fargo (WFC), as according to Reuters, the CFPB is seeking as much as $1 billion for its auto insurance and mortgage lending misdeeds. An investigation into its wealth-management unit is also ongoing, and we expect Wells to be under the microscope for some time, with little potential for a positive upside surprise. As with Warren Buffett, we think the bank will be able to get through its current public-relations nightmare, but it will take time for consumers to forgive and forget. The Fed is not taking matters lightly and has come down hard on the bank due to its alleged shady business practices, from February 2:
Responding to recent and widespread consumer abuses and other compliance breakdowns by Wells Fargo, the Federal Reserve Board…announced that it would restrict the growth of the firm until it sufficiently improves its governance and controls. Concurrently with the Board's action, Wells Fargo will replace three current board members by April and a fourth board member by the end of the year.
In addition to the growth restriction, the Board's consent cease and desist order with Wells Fargo requires the firm to improve its governance and risk management processes, including strengthening the effectiveness of oversight by its board of directors. Until the firm makes sufficient improvements, it will be restricted from growing any larger than its total asset size as of the end of 2017. The Board required each current director to sign the cease and desist order.
Wells Fargo, however, still delivered against expectations in its first-quarter 2018 results, released April 13, despite revenue falling to $21.9 billion from $22.3 billion in the year-ago period. Preliminary net income advanced to $5.9 billion from $5.6 billion during the first quarter of 2017, and diluted earnings per share increased to $1.12, better than the $1.03 of the year-ago period. It seems that Wells Fargo is handling the “negativism” quite well, and we think government bodies are likely going to hit the bank with nothing more than a slap on the wrist for its alleged wrongdoing. Any fines that it places on the bank, for example, ultimately in some, way, shape or form either impact taxpayers or the consumer, so oversight parties won’t be too harsh on the bank, in our view.
Wells Fargo’s capital position is solid, with a CET1 ratio of 12% at the end of the first quarter. Its ROE and ROTCE came in at 12.4% and 14.5%, better than the marks at Citigroup but still below those at J.P. Morgan. Annualized net charge-offs as a percentage of average total loans came in at 0.32%, slightly worse than the December 2017 quarter but a 2 basis-point improvement on a year-over-year basis. The bank’s book value came in at $37.33 per share and its tangible book value came in at $31.33 per share at the end of the first quarter of 2018, both measures up 5% on a year-over-year basis, but roughly flat sequentially. Our fair value estimate of Wells Fargo is $54, a premium relative to book, but below the $60+ per-share highs achieved earlier in 2018.
Morgan Stanley Putting Up Records
Morgan Stanley’s (MS) first-quarter 2018 results, released April 18, were awesome, the best the bank has put up ever, in our view. Net revenue of $11.1 billion and net income of $2.7 billion were records, and the company noted that quarterly performance reflected “significant operating leverage achieved through strong expense discipline.” For the first quarter of 2018, the bottom line came in at $1.45 per share, well ahead of last year’s mark of $1 per share. The volatile equity markets helped sales and trading revenue, and it seems like volatility may be here to stay, with the “low-vol trade” effectively busted earlier this year.
During the first period of 2018, Morgan Stanley’s annualized ROE came in at 14.9% and its return on average tangible common equity came in at 17.2%, levels that fall just shy of J.P. Morgan’s, but ones that came in above management’s “target range.” The company’s Wealth Management division continues to hit the ball out of the park, with record pre-tax income in the quarter of $1.2 billion and a pre-tax margin of 26.5%. The company’s CET1 ratio is much higher than even Citigroup’s, coming in at 15.6%, meaning Morgan Stanley is well-capitalized, in our view. The bank ended the first quarter of 2018 with a book value and tangible book value per share of $39.19 and $34.04, respectively. Our fair value for Morgan Stanley, which assumes continued value-creation, stands at $51 per share.
Strong Operating Leverage at Bank of America
Bank of America’s (BAC) first-quarter earnings results, released April 16, were solid in almost every respect. Revenue advanced ~4% on a year-over-year basis, and management noted that tight cost controls drove operating leverage for the 13th consecutive quarter, helping to generate double-digit earnings per share growth to the tune of 38% on a year-over-year basis. Its first-quarter earnings-per-share mark of $0.62 was a record, and the bank returned more than $6 billion in capital to shareholders during the period through dividends and buybacks.
Bank of America’s ROE and ROTCE came in at 10.8% and 15.3%, respectively, not quite matching the marks achieved by J.P. Morgan, but they were quite respectable, nonetheless, advancing considerably from ~8% and 11.4% during the prior-year period, respectively. Bank of America’s Consumer Banking division remains the star of the show, in our view, with pre-tax income surging more than 19% on a year-over-year basis, to $3.62 billion in the quarter.
The bank’s net charge-offs came in at 0.4% annualized rate in the quarter, a measure higher than that at Wells Fargo, but still considerably below the measure in its December quarter (0.53%) and modestly better than that in the year-over-year period (0.42%). Bank of America ended the first quarter of 2018 with book value per share of $23.74 and tangible book value per share of $16.84, both down modestly on a year-over-year basis. Our fair value estimate of Bank of America stands at $27 per share.
Conclusion
The banking industry is on solid footing, and while Wells Fargo is creating negative headlines, the first quarter of 2018 was a good one for many financial institutions. Expanding revenue and net income, increased capital-return programs, solid returns on equity, and generally positively commentary, despite an increasingly competitive lending environment, were the norm. A narrowing of spreads on US Treasury instruments may pose a challenge to net interest margin expansion in the group, but there are other opportunities to capitalize on a surging LIBOR and the increasingly volatile equity market environment. All in, the performance in the first quarter of 2018 was “more good than bad” for the banks, and we continue to look for the right price to consider ideas, with many financial entities now trading well in excess of tangible book value per share.
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.