The Upside To Rising Interest Rates: Citigroup And Wells Fargo

Includes: C, WFC
by: Convex Strategies

Since the beginning of May, US treasuries have been sold pretty heavily, presumably as a way to front-run "tapering" of asset purchases by the Fed. As a result, the 2Y10Y spread has climbed to 185 basis points (.31% on the 2-year, 2.16% on the 10-year) as of Friday.

The expansion of this spread is a strong net positive for my two favorite banks right now: Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C). Both of these stocks are trading at substantial discounts to both the broader market and their historical norms. With regard to their historical valuations, I don't expect big banks like these to trade as richly as they did for much of the previous decade. Increased capital requirements, reduced leverage, the loss of prop trading operations, and additional regulations has made banking a less profitable (but hopefully more stable) business.

WFC has a historical P/E closer to 14, while Citi's is 16. Currently, WFC trades at 11.5X earnings and C trades around 11X earnings when normalized for one-time charges. On a forward basis, WFC trades at 10.4X EPS and C at 9.77.

With the above valuations as context, let's consider the impact of widening NIMs.

WFC had a rather weak NIM of 3.48% in Q1 '13, compared to 3.91% in the year prior. In Q1 2011, WFC enjoyed a NIM of 4.05%. Looking at the company's 2004-2005 annual reports, NIMs were nearly 5% (4.86-4.89% to be exact). The drastic compression is attributable to record low mortgage rates across the board. In 2005, the 10-year traded around 4%.

Citigroup doesn't depend on mortgages as much as WFC does, so its NIMs are essentially flat since 2011 at 2.94%. I was unable to find NIMs for Citi pre-2009.

Though it's futile to forecast exactly what the cost of capital and what the average yield of earning assets will be three years from now, these banks may be entering the most favorable banking environment in decades. With short-term rates expected to remain "exceptionally low" until early 2016, the longer-end of the yield curve starting to perk up, continued improvement in housing, and 3-4% GDP growth by 2015, the earnings upside for these two names is pretty exciting.


2013 pre-tax income for WFC should come in around $31 billion; 10X pre-tax has typically been a reasonable valuation for solid companies. And that's $31 billion pre-tax with NIMs bottoming out - continued steepening of the yield curve would have a transformative impact on WFC's bottom line. 10X pre-tax implies 45% upside in the shares, so you've got a very wide margin of safety. Even 8X pre-tax generates 16% upside; the valuation gets significantly more compelling as NIMs expand. WFC should earn $3.90 in FY14, so at a reasonable 13X EPS you've got about a one year IRR of 24%.

I recently argued that David Tepper's call for 50% upside in shares of Citi is definitely plausible. Based on (rising) estimates now calling for $5.33 in FY14 earnings (and these will continue to rise as the curve steepens, ceteris paribus), Citi would have to trade at about 12X earnings; roughly one-third of its historical multiple. This is definitely possible - I think they'll get there.

Disclosure: I am long C, WFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long Citi LEAPS, Long WFC common