2001 Bank Analyst Forum: Strong Fundamentals Prevail

With most investors optimistic about an economic recovery, the securities analysts participating in Bank Director`s annual Analyst Forum held out a generally positive view about the financial services industry for the next 12 months, despite underlying concerns about credit quality and the potential for loan losses. And in the midst of the well-publicized tussle over Wachovia Corp., our panel opined on the validity of that merger fight and offered their insights about who will come out the winner. Joining Bank Director editor Deborah Scally for the wide-ranging discussion were Katrina Blecher, managing director of equity research, Sandler O`Neill & Partners; Stephen J. Gresdo, managing director, Second Curve Capital; David B. Hilder, managing director, Bear Stearns & Co.; and Thomas F. Theurkauf Jr., senior vice president, research, Keefe, Bruyette & Woods.

Bank Director:

Could you each describe how bank stocks are performing relative to the overall market and explain how the Federal Reserve Board`s rate cuts have affected that performance?

Tom Theurkauf:

The performance of the financial sector has tended to outperform the broader markets over the last several months. Our bank index is around 6% ahead of the S&P for the year to dateu00e2u20ac”aided and abetted by the Fed`s policy. There`s a powerful reflex on the part of investors to gravitate toward financial stocks when rates are headed lower. And in fact, last year was a good year for financial stocks compared to the Standard & Poor`s 500. This year, though, if you drill down and look at subsectors, separating thrifts from regional banks and regional banks from processing companies like State Street, there are important differences in terms of their performance. Last year the thrifts did exceptionally well, as did the processing companies. This year a lot of regional banks are doing very well, and I think that investors are becoming more comfortable that sooner or later, the Fed will prevail, and the economy will stabilize and begin to grow.

David Hilder:

I would add that the processing companies had an especially terrific 2000 and were up as much as 60%. So on an 18-to-24 month basis, they are actually still doing relatively well. But they`ve underperformed relative to the more traditional regional banks, as Tom said. Because the market seems to be more comfortable that the economy will recover, I think the real question is whether investors have become too optimistic. Are they really looking over the depths of what might be more credit problems that will surface in the next one, two, or three quarters? If we were to sit here three months, six months, or nine months hence, would the valuations of the traditional regional banks be as robust as they are today? Or would they be at the same valuation, but on lower expected earnings numbers?

Stephen Gresdo:

In addition to interest rates, which has helped buoy the financials vis-u00c3 -vis other sectors, we`ve also seen massive changes in the positioning of capital, i.e. so much money has flooded out of the technology sector. And where is it going to go in this environmentu00e2u20ac”an environment where the Fed is whacking rates? It`s all flooded into financials. You could cite some of the larger asset managers whose tech holdings have plummeted, and their financial holdings are now their largest holdings by a factor of 30% to 35%, compared to their second-largest sector. But while there`s been a lot of money moving in, as David said, you can get concerned now with some of these valuations. It seems like the banks that had some trouble last year have done relatively well this yearu00e2u20ac”some of these companies are trading at decent 13 to 14 P/Es off of 2002 numbers. You also have to wonder whether we are over the credit humpu00e2u20ac”and we`re probably not. I`m more concerned about the financials that have had operations hiccups than I am with the banks that have had more serious credit issues but are probably going to recover from them. So the playing field of regional banks still makes me kind of nervous.

Theurkauf:

There has also been a move toward smaller-cap names. We went through several years where there was absolutely no interest in the small cap stock. I don`t think this is just a bank stock or financial stock phenomenon. But in recent months there`s been interest in true community banks or small- to midsize regional banks, which has driven up those valuations. Part of it is interest rates, reflowing funds out of technology and into small-cap stocks. But in general there`s a movement out of megacap and into small cap. So it`s a three-prong effect for the little guys. How enduring that is, I don`t know. In the newest Russell 2000 ranking I think that there were a lot of banks added.

Gresdo:

I would argue that with the smaller caps you do get better fundamentals, and I would also say better front-line people and to some extent, better management. It`s funny, so many banks have been hell-bent to get bigger. You could almost say a lot of these banks have diversified themselves into mediocrity. They used to be smaller fast-growing banks; now they are larger slow-growing banks. And when you ask, “Can you grow 18% like you did three years ago?” they say, “No, we`re too big.” But as investors you have to ask, “Why did you get too big? I liked you better when you were growing at 18%, whereas maybe you can grow 10% or 11% assuming the economy grows at 3% to 4%.” So it`s interestingu00e2u20ac”a lot of these banks accomplished their missions of getting bigger, but now they are much slower growing. And as we`ve seen in the last 12 months, they become much more sensitive to things like capital markets. Investors and analysts are realizing that if you are a small bank in New York competing against Citi and Chase and Bank of New York, you could have a field day getting people to convert. You can grow organically 15% to 20% a year just catching the unsatisfied customers from these large banks.

Theurkauf:

Just a few weeks ago we put together a report on North Fork Bancorp. and visited with one of its branch managers who opened a branch seven months ago, and it had more than $100 million in deposits and it is making money. That`s pretty good stuffu00e2u20ac”typically it`s 24 months to break even. It`s such a massive market and it`s so concentrated at the top, that if you can just capture that 1% or half of 1% of people that aren`t so happy about their service at Chase or Citi, you can make a lot of money.

Hilder:

I could say the same of First Republic, a San Francisco bank that I would almost describe as a private banking thrift is building a niche in Manhattan with one office. It happens to be on Park Avenue. It is aggressive with its high-end mortgage product and other sorts of services, and it is doing very well, literally taking customers away from the very large mainstream New York banks.

Katrina Blecher:

The numbers speak for themselves, but the way I look at it is that the whole sector started taking off last year mostly because of market location, but also because banks tend to move in advance of interest rate expectations. The declines are usually because of liquidity. We saw that last year. This year investors were looking for more value-oriented names and then thrifts picked up in popularity and then interest rates came down. I don`t expect the same impetus going forward because of interest rates.

Bank Director:

What are analysts` top concerns right now?

Blecher:

Slowing earnings and credit problems. They go hand in hand.

Hilder:

I would say it`s credit and capital markets. There are a number of banks that don`t have any capital markets businesses of significance, but for banks that do, I`d say there`s a wide range of views about what will happen to capital markets revenues over the second half of the year. If you look the consensus estimates for the large brokerage firms, those imply a dramatic snap-back in market activity in the second half of this year which, from where I sit, seems unlikely. I think the banks that are hoping for that may be negatively surprised.

Blecher:

A lot of that is the investor`s fault. Historically, all capital markets institutions traded at a discount to the banks. People that invest in banks don`t want the volatility. I don`t think institutions that have large capital markets divisions are going to be able to keep their investors happy because they are never going to have the consistency that banks are used to.

Gresdo:

I`m worried about a recession. What if we hit the definition of a recessionu00e2u20ac”two consecutive quarters of negative growthu00e2u20ac”and the Fed keeps cutting rates and it doesn`t work? Will the U.S. look like Japan over the last 10 years? I don`t think so, but you always have to be concerned about a true slowdown, because a lot of investors are counting on a pick up, if not in the second half of this year then in early 2002. If that doesn`t materialize, then stocks in general are still going to be very much overvalued.

Theurkauf:

I agree with Steve`s assessment. A lot depends on investors` willingness to see through the trough period. Clearly that willingness is there now. My fear is that that`s going to get tested over the next couple of quarters, because we don`t know what the duration of the slowdown is; we don`t know what the depth of the trough is. On the credit side, which is my number-one concern, my worry is that credit problems tend to deeply lag the economy. In other words, even if we were to have a stabilization, or a rebound, or whatever you want to call it, it will take two or three quarters to work through the existing pool of problem loans. So I think that you can say with some degree of certainty that the next couple of quarters are going to be tough on the credit side, almost irrespective what happens with the economy. If we actually have a recession, it calls into question surveying, reserve adequacy, and all kinds of other issues. And that`s OK as long as people understand that risk/return dynamic. Right now my greatest concern is that a lot of people who own the stocks will think that they`ll perhaps have a bad quarter, but that everything will be OK after that. I view that as one possible outcomeu00e2u20ac”there are many other possible outcomes that are much less rosy. The belief is broadly held, to our clients anyway, that the economy is going to turn; it`s going to be very manageable. The fact that stocks are being purchased now indicates that the market is a discounting mechanism. Investors are saying, “Of course we know it`s going to be slow.”

Hilder:

I have a somewhat more optimistic note. I had a long discussion yesterday with Bear Sterns` chief economist Wayne Angell, a former Fed governor, and his view is that this will be a long cycle. To him this means that although there is a decline in capital spending, which we are all seeing and feeling, he believes that the Fed, by lowering rates dramatically, has prevented the second step of a bad recession: a real estate crash. So if the real estate markets remain relatively healthy, which they have so far, he feels that will prevent a much worse recession, a much deeper credit problem for the banks. The Achilles heel for the banks historically on the credit side has been real estate. The 1990-91 recession was certainly a great example of that. I think if the real estate markets remain at or near their current levels in terms of occupancy, vacancy, and absorption rates on the commercial side and there`s a lack of price declines on the residential side coupled with declining mortgage rates, you could have a relatively mild saucer-shaped correction and recovery. I think that`s a real possibility, and certainly that`s what Angell is betting on. The banks should hope that that`s how it turns out.

Bank Director:

How does all this translate into the market for mergers and acquisitions and bank valuations?

Theurkauf:

If you go back to the heyday of bank M&A or the most recent heyday of `97 and into `98, most of those deals were disastrous from a shareholder perspective. It`s difficult to measure cost savings and revenue enhancements, but it`s easy to measure earnings. The earnings disappointments were pretty broad-based. It`s also easy to measure stock performance after deals are announced. The interesting thing about the last year or two is that pricing is down and volumes of deals are way down, but they are more sensible. Interestingly, the earnings guidance seems more realistic and therefore, the stocks have behaved a little bit better. So this return to more-rational pricing is, from the buyer`s perspective, a very good thing. We clearly had a period of overpromising and underdelivering in the late 90s, so I hope bank managements have learned from that.

Hilder:

I think over the next two to three years volume will pick up. Not necessarily with megadeals, but with purchases of smaller franchisesu00e2u20ac”deals that are either fill-in, in-market consolidation, or near-market consolidation. I think the change in accounting rules to mandate purchase accounting and eliminate poolingu00e2u20ac”eliminating the amortization of pure goodwill and therefore allowing the continuing of stock purchase plans and the relatively faster divestitures of unwanted pieces of an acquired franchiseu00e2u20ac”makes those kind of purchases much more attractive. Again, the megadeals, I suspect, will come back someday, but it`s much harder to predict when that will happen. I would look for a lot of relatively smaller cash or cash-and-stock purchases that increase market share and, though I don`t think it would be advertised this way, increase pricing power.

Blecher:

I think we are going to see a return of deals. At the current time I don`t think they are in shareholders` best interest, and certainly not in earnings` best interest, but what we see is that with banks, they keep getting into problem sectors again and againu00e2u20ac”their memories tend to be short. Deals tend to benefit management, which is clearly a factor. The other benefit to them is that if your earnings are going to be soft for one reason or another, you no longer have to come to the Street and say what is bringing them down. But even more than large transactions, I see a lot more possible purchases of lines of business. These divestitures boost earnings, including the way you can account for the goodwill: the seller gets done on day one, and the acquirer gets to amortize it up to 10 years.

Theurkauf:

I was talking to some bankers the other day about this topic of purchase-method deals and product-line acquisitions, and the other thing they are kicking around is that it may be possible to take some of the larger regionals and dismember them to create a lot more value than is reflected in the current share price. I won`t name names, but you could think of regional banks that have been unable to grow their earnings for years and years and years. If you sell their branches or sell their asset management operations, or trust, or other operations, that creates value. Purchase accounting will allow for that. It harkens back to the 1980s with the LBOs in the corporate sector, where you buy something and start spinning off or selling divisions to create more value. It`s an interesting proposition.

Gresdo:

You could almost allude to this shift toward purchase accounting as the “Full Employment Act for Investment Bankers.” For 10 years banks have tried to buy everything in sight, and now they`re as big as they can possibly grow. When they hit this roadblock investment bankers say, “You`re too big to grow, so we`ll help you split everything out and sell it.” So deals are going to get done, yes. But deals are tough to do. They`re tough on people. Banking is a people business and it`s tough to keep the business going during a merger despite how financially creative or how good it looks on paper, or even how much it might make sense. You`ve always got to assume that you are going to have a significant slowdown in revenue. Theurkauf: It`s even a deeper issue than that, because the competitors are fully aware of what`s going on, and it energizes them. Look at what`s going on in New Jersey with Commerce Bank. They are full board now because they are going to have the Summit/Fleet merger to deal with and Fleet, of course, is going to do its level best to play defense and keep customers. Banks like Commerce don`t have to deal with conversions. It`s a pretty remarkable operation.

Gresdo:

Commerce is amazing. It is one of those banks that is truly a retailer. I was lucky enough to attend what they call a “Wow Day.” We were down there with their 3000-plus employees and it`s remarkable. They have fun. They take out full-page ads. There is nothing more they want to do than steal every good Summit employee and every Summit customer. And they are getting there by doing crazy little gimmicksu00e2u20ac”it`s amazing. And as good as the Fleet/Summit merger might have looked on paper, and as much as Summit`s shareholder might make money three years down the road, those same shareholders are probably going to look back and say “It`s harder than we thought” because of more-focused competition.

Theurkauf:

And for the next 12 to 24 months Fleet is going to be a very inward-looking company by necessity. That`s not necessarily true for the guy across the street who is after that customer base.

Bank Director:

Let`s talk about another major deal that has made headlines recently. How do you assess the market`s reaction to the struggle by First Union and SunTrust to acquire Wachovia Corp.?

Hilder:

For the moment, at least all three of those companies are going to be totally focused on themselves and not as focused on their competitors.

Theurkauf:

Companies that can economically acquire customers and economically acquire revenues are the ones where the long-term price charts work the best. That doesn`t mean you can`t make money trading KeyCorp today. I mean maybe KeyCorp is going to go up two dollars and you can make money. But it`s the Commerce Banks [of New Jersey] of this world that are figuring out a way how to crack the code and acquire customers. They are the ones that are going to do well. If that`s one of the underpinnings, and I think it is, of getting your share price up, it makes it doubly more difficult if you are embroiled in a deal for 18 months and dropping the ball on customer acquisitions. I believe all three companies recognize that it`s going to be tough to grow revenues. Because of that, they are willing to go through the agony it takes to get this done. They are doing that to pull that cost lever, because that`s the only lever they can pull.

Bank Director:

Will anybody come out the winner?

Hilder:

I would agree that what sparked this series of proposals was Wachovia`s recognition that it was about to hit the wall of no revenue growth and, ultimately, no earnings growth, and perhaps have even deeper financial troubles. I would view the behavior of First Union and SunTrust somewhat differently. I think First Union was presented with a deal that was too good to refuse, in the sense that Ken Thompson certainly knew that it was not the optimum time for him to engage in a merger, but he was presented with a high-quality franchise with in-market consolidation at a very reasonable price, and he had to make a few concessions in order to get that done. I think on the part of SunTrust, there was bitter disappointment that 15 years of conversations had resulted in a deal with someone else. So I think the motivations are somewhat different. Does anyone come out the winner? It`s possible. If First Union`s proposal to acquire Wachovia wins shareholder approval, that probably is a long-term win for First Union because it will have acquired a valuable franchise at effectively no premium. There would be a period of disruption and difficult integration, but I think the outcome would be a positive over the long term for First Union.

Gresdo:

I think that over the long term David may be absolutely right. I don`t know if there is a quick solution. At the risk of sounding too glib from a shareholder and investor standpoint, who is really going to win out in this mating dance between SunTrust, First Union and Wachovia? The answer is BB&T. It is going to make money and won`t miss a beat. I do think the optimal outcome is probably what`s going to happen, which is First Union winning its bid for Wachovia. There will be some disruption, but I think it`s the better combination, and it has the most likelihood for faster revenue growth. I also think First Union has the most momentum of the two suitors. We`ve actually taken a survey on our website, bankstocks.com., soliciting opinions from Wachovia employees, and about 90% said they just feel better with First Union. So from a people standpoint, I do think that`s the optimal combination.

Blecher:

Long term, I agree, it goes back to the winner becoming the loser. Whoever doesn`t win is going to be able to start going out, getting customers, getting employees to start building up their business again. And if either institution hasn`t hurt their credibility on the Street too much, I think that could be the best growth. That`s assuming that any of the three institutions haven`t hit a wall for revenue.

Hilder:

I think whichever bidder for Wachovia loses will inevitably remain under a bit of a cloud with investors and analysts for some timeu00e2u20ac”perhaps unfairly. I say unfairly, because there will be a view that the bank needed to do a deal because it was slowing down. We`ve seen it in the cases of Bank of New York and with Mellon, and it takes a while for that cloud to dissipate.

Bank Director:

So is it ever worth it to get embroiled in a hostile deal?

Hilder:

Yes. I do think that there is at least one example of a hostile takeover in banking that was successful and that was Bank of New York`s purchase of Irving in 1987-88. It took a very long time to be finally resolved. But that was an example, I think, of a transaction where Bank of New York felt that it needed certain types of technology. It needed really to capture the investment that Irving had made in its systems at that point, and the quickest and fastest way to do that was through an acquisition rather than trying to duplicate what somebody else had built, and it worked. I think if you look at what`s happened to Bank of New York`s stock price in the intervening 13 or 14 years, you`d say it was worth all the effort. Clearly there are other examples of hostile takeover attempts that didn`t turn out as well: Wells Fargo/First Interstate, where Wells prevailed but then had massive integration problems; Bank of New York`s proposal for Mellon, where Bank of New York was never able to consummate the acquisition. I don`t think that hurt Bank of New York over the long term, but it certainly left it under a cloud for a while.

Bank Director:

Looking at revenue strategies for the next 12 months or so, what sorts of businesses do you see as being good ventures at this point?

Gresdo:

Anything that touches consumer lending and the middle markets is still a good growth strategy. I`m less optimistic on capital markets-type strategies, investment banking-type strategies. Some of the banks that have bought insurance brokers have created a decent revenue stream out of that, although it`s usually not as big an earnings impact as they would like. But I still think if done well, retail and middle-market banking is successful. North Fork is doing a great job. It is putting up great numbers in a very competitive environment just by being a good small-business lender. Commerce is doing to the same thing in New Jersey and Philadelphia on the retail side.

Theurkauf:

I wouldn`t be surprised if in the next two to three years, you see some companies, if not abandon the private banking sector, lessen their enthusiasm for it, because it`s expensive and it takes time to turn a profit in that business. The world is filled with competitors in the wealth management sector. So if you`re Northern Trust or maybe Brown Brothers, you already have the advantage. But now every regional bank wants that space. It`s brutally competitive. I think it`s a great sectoru00e2u20ac”it`s profitable and it`s growingu00e2u20ac”but I would be a little bit cautious.

Gresdo:

The projections that a lot of banks have put behind private banking are just astronomical: 20% to 25% top-line growth and ROEs in the mid-20s. A lot the success of this business is predicated on the creation of personal wealth, which hasn`t been happening over the past year and a half, given the stock market. I think there have been some nonrealistic expectations in that sector.

Hilder:

Actually, I was about to name asset management and financial advice as an area of good growth over the long term. I would agree that 25% growth is unrealistic, but I think if you look over the last 25 years, the growth in securities assets has been consistently twice the growth rate of deposits. It`s not easy, and clearly it has to happen for many of the banks through acquisitions of asset management or brokerage or financial advisory businesses. The danger is, as Tom pointed out, that it`s expensive to deliver, and it`s not something that appeals to 125 million Americans. It appeals to probably less than 25 million Americans. But there is a huge demand for financial advice. I think the lesson people have learned in the last two or three years regarding the stock market has been that wealth creation has not been easyu00e2u20ac”you can`t make money just by buying the hottest telecom or technology or media stock. Therefore, people with significant wealth or those who aspire to have significant wealth need some sort of advice. I think the banks, although not as well positioned as perhaps some of the large brokerage firms or the large mutual fund complexes, absolutely need to position themselves there. They are not all going to win, but I think it is a business that has superior growth to traditional banking.

Bank Director:

One final question. What would each of you name as a truly great banking franchise today?

Blecher:

I`d go with Bank of New York, and for a traditional bank, I would say Wells Fargo, even though Wells Fargo is not the old Norwest. I like franchises that have something unique to them, and I think it`s going to be a really tough time to be growing revenue. I don`t see most banks being able to accomplish what the Street is projecting. I love the processing business. I love anybody that is doing something that doesn`t have a lot of competition that helps the pricing in the marketplace. I think that one of the best revenue drivers this time around will be expensesu00e2u20ac”having the management skills to control costsu00e2u20ac”because that`s one of the few things you can control as the economy is staying still.

Gresdo:

I would say the best bank in the business is Commerce in New Jersey. I`ll even give you two other names. I will run the gamut. I think Commerce is a great bank and it`s a great company. I think another great company is Capital One Financial. It is just tremendous in the way it approaches the business and the way that it has been able to create value despite what`s happening to the competition and despite what`s happening to the consumer and the environment. Last, the more I get to know it, I would have to name Golden West Financial. I think it`s just a great company. You can put these three in your kids` college funds. They are all good at what they do.

Hilder:

My best franchise also would be Bank of New York. I would also say Mellon has a franchise that is very good and is probably less appreciated by the market, as reflected by its lower multiple. And among traditional banks, I would actually name Commerceu00e2u20ac”but not Commerce of New Jerseyu00e2u20ac”Commerce of Kansas City and St. Louis. It is not as celebrated as many of the others that we`ve named, but it is a bank I know well, a well-constructed franchise in the Midwest that is thoughtfully managed. For a bank of its size, its management has done a great job with technology development.

Theurkauf:

Well, I have a warm spot in my heart for the processors as well, but I would say State Street is my favorite, in terms of the attractiveness of the business and its position globally and domestically. And on the traditional side, I would have to agree with Steve about Commerce in New Jersey. The separation between it and its peers is remarkable. We are talking about mid-teens growth, where I think the average deposit growth rate is 4% or 5%. It`s three times faster. We are not talking about a little difference here. And then on the larger side I would say Wells Fargo. Even though its stock has been hammered over the last week or two, it`s quite a banking franchise. |BD|