Large Bank Recap: Favoring JP Morgan and Citigroup Over Goldman and Bank of America

Includes: BAC, C, GS, JPM
by: Adnan Zaman

As the large banks report Q1 results, there is a clear theme evolving: though the credit environment is improving, revenue growth, especially from commercial banking, is quite hard to come by. Banks have been able to post decent profits by releasing reserves held against questionable loans because delinquencies are improving, but profits from their core operations have been lackluster as revenues have been stagnating. This explains the weak share price performance from the overall sector.

The overall banking index is down about 10% over the past year, while Bank of America (NYSE:BAC) is down about 30%. Even Goldman Sachs (NYSE:GS) is down nearly 10% since the start of the year and JP Morgan (NYSE:JPM), arguably the best positioned bank in the country, is down 5% since reporting earnings last week. As these banks trade closer to book value, with some even falling below book value, does it make sense to start buying shares on the recent post-earnings weakness? Though shares of several of the banks are starting to look cheap, there may be better strategies than owning the shares. I'm going to do a quick recap of the recent results before suggesting some potential strategies.

I'll start with Bank of America, which reported dismal results last Friday. It’s hard to find many positives in the results, but it did manage to eke out 1% revenue growth quarter over quarter (q/q), largely driven by improvements in sales and trading and investment banking from a very weak Q4. Besides that, there is a laundry list of negatives: spread income was down 4% q/q, loans declined 1% year over year (y/y), capital markets was down 16% y/y, trading was down 25% overall (even worse than guidance of 20-25% driven by the 25% decline in FICC, mortgage revenue was down 40% with originations falling 18% (better than guidance), there was a $1b expense related to mortgage reps & warranties plus another $2b of other "one-time" mortgage related expenses, and to top it all off, operating expenses were higher than analysts estimated at over 70% of recurring revenue.

Operating expenses are expected to remain high, especially given the mortgage mess the company is still trying to work its way out of - a recent article mentioned that 85% of all Countrywide mortgages are delinquent. The only real silver lining amidst all this negative news is that credit quality trends are improving, as with all money center banks and BofA has shown some progress in dealing with its problem mortgages. NPAs represented just 3.4% of loans, down 3% q/q and charge-offs fell 11% q/q, enabling the bank to reduce its reserve to 4.29% of assets vs 4.47 last quarter. What's still troubling is Bank of America's inability to improve its capital ratio faster; one could have guessed this would be the case when it was not allowed to increase dividends. Tier 1 capital ratio improved only 8 bps to 11.3% while the Tier 1 common equity ratio improved only 4 bps to 8.64%. Though BofA expects to be above 8% based on Basel III rules by the end of 2012, its ability to increase dividends meaningfully in the meantime is questionable.

Citigroup's results were not much better than BofA's, but there were a few more bright spots. Revenues were lower as expected year over year, but the company saw growth across the board sequentially from last quarter. Over 60% of deposits are held outside the U.S, and the company saw good growth year over year and strong margins from both Asia and Latin America. Consumer loans are up 17% in Latin America and 16% in Asia, two markets that produce about as much income from consumers as does the U.S. for Citigroup.

Similar to Bank of America and JP Morgan, Citigroup released more of its reserves than analysts expected due to improving credit, enabling the company to exceed analysts' forecasts. Though one would prefer to see stronger earnings driven by revenue growth, I think the story at Citigroup continues to develop with a steadily improving asset base and growth coming from international markets. Non-performing loans (NPLs) were down 22% from last quarter, driven by a 31% decrease at Citi Holdings (CH), the "bad bank" created a couple years ago. CH assets have continued to wind down. As it shed another $22 billion in the past quarter, CH's assets are down 6% q/q and 33% y/y and currently represent 17% of total assets. NPLs now represent just 2.3% of total assets, down from 3% last quarter and 4% a year ago. Despite a larger than expected reserve release ($3b vs est. of $2b), the coverage increased to 2.2x vs. 1.9x with a reserve ratio of 5.8% at the end of the last quarter. NIM improved sequentially to 3.34% and return on equity improved to 7.3% from 3.2% last quarter. Citigroup has been among the most successful in rapidly restructuring its ailing balance sheet - Tier 1 capital ratio increased to 13.3%, up 40 bps from last quarter and Tier 1 Common Equity ratio was up 60 bps to 11.3%. Management is confident that the company will exceed the Basel III Tier 1 Common Equity ratio target of 8-9% by the end of 2012 while returning capital to shareholders in the meantime. Citigroup boasts an improving balance sheet, higher dividends in the near future and a book value almost 5% above the current share price.

Goldman handily beat all expectations, yet shares have been selling off since the earnings release as most of the over performance was generated by the company's Investing & Lending division. Goldman reported EPS of $1.56, well ahead of consensus EPS of $.82; pro-forma EPS adjusted for the cost of redeeming the Berkshire Hathaway (NYSE:BRK.B) preferred was $4.38. While the Investing & Lending performance was impressive, it is a division that Goldman will have to reduce over time to comply with the Dodd-Frank Act, which limits proprietary investments to a maximum of 3% of capital. Currently Goldman's I&L book is about $47 billion, split roughly evenly between debt and equities. Given I&L is essentially a private equity / hedge fund style book, its outperformance in a given quarter is discounted as "one-time" by analysts, though it can meaningfully outperform again in the future if capital markets continue to perform well. I&L helped both FICC and Equities as FICC decreased 27% y/y from a very strong Q1 2010 and Equities were up 18% y/y. Excluding I&L, FICC was down 28% y/y and Equities was down 7% y/y compared with FICC declines of 22% y/y and 31% y/y at Citigroup and BofA, respectively, and Equities declines of 9% y/y and 27% y/y at Citigroup and BofA, respectively. Trading revenues at JP Morgan were just 4% lower y/y. Investment Banking was down 16% q/q compared with JP Morgan's decline of just 1% q/q. Investment management was up 16% y/y.

Goldman's capital ratios have been strong, allowing the company to repay its expensive loan from Berkshire Hathaway. Even after repaying the obligation, Goldman's Tier 1 common equity ratio was 12.8%, down from 13.3% last quarter. Goldman reported that it is already boasting a Basel III Tier 1 common ratio of over 8%, which means the company will be able to continue share repurchases ($1.5 billion in the past year) and increase dividends in the next couple years. Though most of this sounds pretty good, the biggest question mark for Goldman is "How will future regulation affect the company's ability to continue growing profits?" With Dodd-Frank regulation expected by the end of the summer, there will be more certainty soon, but in the meantime, investors are worried whether Goldman will be able to generate mid- to high-teens ROE in the current environment. ROE would have never been 16% this past quarter without the I&L beat, and until Goldman can convince investors that it can generate such levels of ROE without relying on its internal hedge fund, the shares are probably not going to be flying high anytime soon.

JP Morgan, like Citigroup, beat analysts' estimates by releasing more reserves than analysts were expecting. While revenues were a bit weak on slower than expected loan growth, the results were not all bad. Even if one reverses the contribution from the reserve release of $.29 and also backs out $.26 of charges related to higher costs on MSRs and foreclosures, Q1 EPS would be $1.25 versus consensus estimates of $1.15. Investment banking performance was solid, declining just 1% y/y with trading down 4% y/y. Sequentially, FICC was up 82% q/q and equity was up 25% q/q. JP Morgan's heft is being felt in the marketplace as evidenced by its role in the AT&T (NYSE:T)/T-Mobile merger, where it provided a backstop for the entire loan, likely winning the company the prized role in one of this year's largest deals.

In retail banking, deposits were up about 5%, similar to Citi and BofA, but analysts were hoping for loan growth despite the run-off of problem loans. Nevertheless, commercial loan revenue was up 7% with NPLs down 2% q/q. NIM was a bit weak, remaining at 2.9% compared with Citi's improvement to 3.3%. Expenses were in line with guidance and forecasts, and though a bit high, the company is investing in future growth, having increased retail specialists by 15% and having opened 131 new branches. NCOs were down 48% y/y. Overall card NCOs were down 88 bps q/q to 6.97%; excluding WAMU, legacy Chase NCOs was 6.2%, which contributed to the larger than expected reserve release. JP Morgan's Tier 1 common equity ratio increased 20 bps to 10% and it estimates that under Basel III, its Tier 1 common equity ratio is already about 7.3%. As such, the company has already been approved to repurchase $15 billion of stock, $8 billion of which may be made this year.

Given uncertainty about the impact of Dodd Frank and Basel III, most investors are shying away from the brokers as a whole, hurting Goldman's share performance. I can't blame them, as future projections are up in the air with its biggest profit engine in limbo. JP Morgan is large enough, with exposure to several different businesses, so that Dodd-Frank's impact is not as big. Furthermore, JP Morgan is arguably the best positioned in the market, having cherry-picked Bear Stearns and WAMU assets during the crash at the best prices (unlike BofA's blunders with Countrywide and Merrill). JP Morgan's strength in all of its markets from consumer banking to investment banking is evidenced through its rapid expansion in retail banking and its advisory wins including AT&T/T-Mobile over others such as Goldman and Morgan Stanley. With the two companies trading in the same range, JP Morgan with a 2011 P/E of 9x and 2012 P/E of 8x compared with Goldman Sachs' 2011 P/E of 11x and 2012 P/E of 8x, I'm more comfortable with JP Morgan's ability to meet or exceed its forecasts, without relying on one-off wins. In addition, trading at just 1.1x book value compared with Goldman Sachs' 1.3x book value, JP Morgan has less room to go down, in my opinion.

As for Citigroup versus Bank of America, Citigroup has not only done a better job with its financial restructuring, having shed more of its troubled assets and having put more of its mortgage woes behind it, it also has more opportunities for growth with its international exposure. Given Citigroup's much stronger balance sheet position, Citigroup's ability to return capital to shareholders is more likely than Bank of America's. Both companies are cheap, Citigroup trading at just .97x book value and BofA trading at .93x book value. Comparing P/E ratios, Citigroup's forecasts suggest a 2011 P/E of 10x and 2012 P/E of 8x while BofA's estimated 2011 P/E is 10x and 2012 P/E is 7x. In this case, I am more comfortable with Citigroup's ability to meet or exceed future expectations, not only given past performance, but also given its potential growth in international markets.

For those who are comfortable with options, my preferred play is to sell JP Morgan's January 2012 $37.50 puts, which provide nearly 20% downside protection and approximately 50% returns on a margin account. That means, an investor does not lose the first dollar until JP Morgan goes below its 52 week low, which is unlikely barring larger macroeconomic problems. As for Citi, I would sell the January 2012 $4.00 puts, which provide over 50% returns on a margin account, but a little over 15% downside protection. Another way to play Citigroup is through the C-H security, which are Citigroup's T-DECs or Dividend Enhanced Common (mandatorily convertible preferred). You can read more about those securities in this post.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in JPM over the next 72 hours.

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