Profitability Crunch

Scott Siefers, a managing director at Sandler O’Neill + Partners in New York who covers large-cap stocks such as Wells Fargo & Co., U.S. Bancorp and KeyCorp., talks about whether profits are permanently softened at banks and what banks are poised to do better.

The financial sector has continued to take a real beating and many banks are trading at less than their book value. Does it surprise you that this has lasted this long?

It has surprised me this kind of valuation discount has lasted this long. It is becoming less surprising as time goes on. The pace of the economic recovery has been slow. I doubt we would have thought last year the European crisis would be this profound. Investors are thinking more and more about long-term earnings and returns, both for the group and individual financial stocks. People making the bear case suggest this is a group whose returns are under more than cyclical pressure, that this is a semi-permanent erosion in returns for investors. If, in fact, banks are not going to earn in excess of their cost of capital over a period of time, than maybe they should trade at a discount to tangible book, or less than the premium historically.  I don’t know that we have enough evidence to declare that is, indeed, the case. But this has been such a prolonged period of suboptimal return. Until you can refute the bear argument, it does seem we’ll be in this depressed valuation environment for a period of time.

Do you think this is a permanent or temporary period of low profitability?

I tend to be optimistic about the U.S. economy. It’s the most dynamic large economy in the world. It’s been an economic miracle for decades. But we’re certainly not in the interest rate bull market that we were in for the last quarter of a century. We’ve seen some of the negative ramifications of that kind of addiction to debt. A lot of the growth drivers of the last 10 or 25 years are changing. Housing was so much a part of the nation’s consumption. Spending came as people borrowed against the value of their homes. So it makes it harder to drive that growth.

There was deterioration in net interest margin in the most recent quarter and the Fed has promised to keep interest rates low through 2013? What is that going to do to banks?

Unfortunately, that’s going to persist, until we get a more accommodating interest rate environment. Rates are just so low so there is almost nothing you can do to lower your own funding costs. Banks have found ways to incrementally lower their funding costs. In the next six months or so, that level will be completely utilized. It almost doesn’t matter how deft you are at managing the interest rate environment, almost everyone is in the same boat.

What are banks doing about it?

There is a much more heavy focus on addressing costs. The cost side is a company’s most controllable leverage. We’ve seen a number of companies address cost savings.  You’ll also see this punitive rate environment result in more M&A (mergers and acquisitions). That would help us address the excess capacity and excess cost issue. One of the problems right now is we have a lot of capital chasing finite returns. A frothy M&A market would work in our favor.

Forward looking statement:  

Bank capital requirements are likely to remain significantly higher than they’ve been for at least the last decade. It’s going to be very difficult to duplicate the kind of returns we’ve seen historically. Wells Fargo & Co., PNC Financial Services Group and U.S. Bancorp are names that seem to perform well regardless of the environment. They can navigate tough environments, they steal market share from competitors and they focus more acutely on the cost side than competitors do. There are ways to generate superior returns; it’s just not going to be as easy. The names I gave you are among the industry’s best in terms of generating returns for shareholders. 

Scott Siefers