As an investor in several banking stocks, I took the recent round of earnings announcements as an opportunity to review the outlook of major US banks from both a macro and micro point of view. In my macro analysis, I found that large US banks are generally well-positioned for rising interest rates in the coming years.
This article represents my micro analysis, in which I will analyze Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), JPMorgan (NYSE:JPM) and Citigroup (NYSE:C) through the lens of 1) Price, 2) Margins, 3) Growth and 4) Risk. I will however focus most on WFC, as my most striking finding is that given the premium at which WFC is trading relative to peers, I struggle to see significant further upside for it based on its fundamentals.
1) Price: WFC trading at 40-100% premium vs peers
Wells Fargo has over time earned itself the reputation of being a conservative, well-run bank. Unlike some of its peers, it didn't engage in speculation during the financial crisis, preferring instead to rely on its core business of taking deposits and making loans. As a result, when markets froze, it was the only bank on Wall Street which did not require a capital injection, even though then-Secretary of the Treasury Hank Paulson eventually forced them to accept one (as remembered by himself in the documentary "Hank: Five Years From the Brink").
It seems reasonable that such a well-run bank should trade at a premium relative to peers. If we compare its Price / Tangible Book Value since the financial crisis, we see that this is indeed the case:
(Source: S&P CapitalIQ)
The premium is substantial, a whopping 40-100% over its peers. Let's assume, for the sake of argument, that this premium is justified today by fundamentals and by a history of conservatism and superior leadership. However, what are the factors which will drive WFC even higher in the future? Let's have a look at the possible sources of upside in WFC's fundamentals with respect to peers.
2) Margins: Wells' margins are healthy, but limited on the upside
The table below summarizes banks' margin structure for FY2013:
(Source: S&P CapitalIQ)
Looking at the big picture, Wells Fargo leads the pack in both Net Revenue Margins and Risk-adjusted Net Revenue Margins. In terms of Net Interest Margins however, WFC is middle of the pack, and not as well positioned as peers to take advantage of the expected rise in interest rates. As interest margins represent the price a bank charges to its clients, these are hard to change without losing business.
Most of Wells' margin advantage comes however from Non-Interest Margins, which I calculate as:
Non-Interest Revenues (e.g. fees, commissions etc.) - Non-Interest Expenses (e.g. salaries, admin costs, legal expenses etc.)
Essentially, the difference in margins lies in the fact that WFC is run more efficiently (cost management). There are however limits to the costs that a bank can cut, and at this point it seems like competitors have more "fat to trim." This is particularly true if we consider the following:
- JPM has incurred one-off legal expenses of $11.1bn in 2013, much of it relating to Bernie Madoff's Ponzi scheme, which won't re-occur next year
- BAC is engaging in a cost cutting program which some expect to yield annual cost savings of $9bn per year
- C fell slightly short of its cost cutting expectations in 2013 ($872m vs. $900m), but expects $1.1bn annually from 2014 onward
Therefore, there seems to be more future upside from margin expansion in WFC's peers. Let's move from margins to have a look at revenue growth.
3) Growth: Wells' net revenue is falling, rising interest rates will hurt mortgage volumes
(Source: S&P CapitalIQ)
WFC is the only bank in the group which saw net revenue fall in FY2013, despite a rise in loan volumes. Increases in earnings were driven by cost cutting, which is not a sustainable avenue to growth. Furthermore, as interest rates rise, borrowers will be more reluctant to take out large amounts of debt, which will hurt mortgage volumes (I expect credit cards and small-balance products to suffer less). As the bank with the highest proportion of mortgages/total loans, this will hurt WFC more than its competitors. I therefore don't see significant additional potential for growth with respect to competitors.
4) Risk: Capitalization levels across banks are comparable
The last factor I generally take into consideration when making an investment is risk. In the context of banking, I summarize risk through capitalization ratios, i.e. the equity cushion that a bank holds to absorb losses from bad loans. If a bank is significantly better capitalized than peers, it would be the case that either a) it is over-capitalized, and can employ the extra capital to fund more loans and grow the business or b) it is appropriately capitalized, in which case competitors would need to shrink their balance sheet to achieve its level of capitalization.
Either way, a better capitalization represents a business advantage. Looking at current capitalization ratios, we get the following picture:
(Source: S&P CapitalIQ)
From this picture, it emerges that WFC's capitalization is on par with its peers, at best. While WFC may have been netter capitalized during the crisis, competitors have more than caught up. Furthermore, given the definition of the Tier 1 Ratio = Tier 1 Capital / RWAs (risk-weighted assets), this picture is already risk-adjusted. Hence, the fact that WFC holds a higher proportion of mortgages (less risky because secured by collateral) is already taken into account. Hence, WFC cannot be considered "safer" than its competitors from a solvency point of view.
As an investor long WFC, I am starting to be uncomfortable with the stock's rich valuation, trading at 40-100% premium over peers. Analyzing the stock's fundamentals for drivers of future returns yielded the following results:
- Margins: WFC's interest margins (hard to change) are average at best, and its healthy non-interest margins largely depend on operational efficiencies. At present, there is little room for improvement here, while competitors have more "fat to trim," which they are addressing through cost cutting.
- Growth: WFC's is the only bank with declining revenue in FY2012-13. Growing future volumes will be challenging, as rising interest rates will discourage mortgage borrowers, a client segment WFC is particularly strong in.
- Risk: WFC cannot be considered "safer," as its peers are equally well capitalized on a risk-adjusted basis.
I therefore don't see significant upside from WFC's current valuation. In my view, other banks (e.g. BAC, C) offer better prospects at a cheaper price.
Disclosure: I am long WFC, BAC, C. 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: I may sell my position in WFC.