In an earlier article, I argued that the Street consensus on Bank of America (BAC) and Wells Fargo (WFC) has it all mixed up. Management at BofA, in my view, is taking the right steps to boost EPS and ROE by strengthening the balance sheet. On the other hand, Wells Fargo, according to my estimates, has less margin of safety and upside. A weak transaction environment and issuance of shares will restrain EPS expansion. Although it has a strong brand name, at this moment, the upside is not so bright. Accordingly, I rate BofA a "buy" and Wells Fargo a "hold". This analysis comes under the context of my overall bullish outlook on financials.
I turn now to assessing Regions Financial (RF) and SunTrust Banks (STI). Analysts currently rate the respective companies a "sell" and a "hold" - a consensus that I am more or less in agreement with. From a multiples perspective, both companies are expensive. Regions trades at 24.8x and 8.8x past and forward earnings, respectively, while SunTrust trades at 18.2x and 9.6x past and forward earnings, respectively. The two also offer very low dividend yields of around 1%. Given concerns over regulations, TARP repayment, strategy execution, and high betas, both firms, in my belief, are skewed more towards risk than reward.
At the third quarter earnings call, Regions' CEO, O.B. Grayson, argued that management is in fact delivering on its strategy, but that the business environment looks weak at least in the near future:
"The third quarter results provide additional evidence that our disciplined efforts are paying off, that we are successfully executing our business plans as we deliver another quarter of progress. Regions earned $101 million or $0.08 per diluted share this quarter. Adjusted pretax pre-provision income rose to $540 million, up 19% year-over-year and the highest level in more than 3 years, demonstrating ongoing improvement in our core business performance.
Further, adjusted pretax pre-provision income exceeded the loan loss provision for the second consecutive quarter, which is critical to Regions' achieving sustainable profitability. Although results met our expectations and demonstrated incremental progress, signs of a weakening economic recovery and reduced consumer and business confidence began to surface during the third quarter, causing us to take an increasingly cautious and disciplined stance on credit quality. This environment led to a $200 million linked quarter rise in gross non-performing loans, inflows largely driven by investor real estate credits".
At the same time, I anticipate credit trends improving and a quicker than expected repayment of TARP debt. It would be best if the company were to issue common stock and use the funds raised to mitigate leverage in the business. This would strengthen confidence and attract investor entry.
Towards cleaning off the balance sheet, management has been aiming to sell Morgan Keegan - a process that is dragging out much longer than what many investors were expecting. Rumors surfaced that Stifel Financial would be the suitor, but thus far nothing has materialized. A buyout from Stifel would likely attract a higher premium than from other competitors, since more relative cost synergies could be gained in the process. As to the supposed "culture clash" that would follow a sale - I find that this is almost never as big of a concern as the media makes out. Differences can be put aside when the profit motive is strengthened. A much greater concern is that, as the company fails to execute on selling two-thirds of Morgan Keegan's book value, top associates have exited the firm. Ironically, the delay caused by the deliberation over "culture clash" issues are actually leading to an HR problem.
In any event, a sale could strengthen the current Tier 1 ratio by around 90 basis points. Management also has an opportunity to unlock value through franchises.
Consensus estimates for Regions' EPS are that it will turn positive in 2011 at $0.17 and then grow by 182.4% and 47.9% in the following two years. Assuming a much lower multiple of 15x - but still a slight premium to peers - and a conservative 2012 EPS of $0.41, the rough intrinsic value of the stock could be as high as $6.15.
As for SunTrust: opportunities for the firm include a drop in loan loss reserves, more aggressive capital allocation policy, and Robinson Humphrey. Even still, major challenges arise from mortgage repurchases and sinking NIM, which will limit returns to shareholder value.
Consensus estimates for SunTrust's EPS are that it will turn positive in 2011 at $1.13 and then grow by 70.8% and 39.9% in the following two years. Assuming a multiple of 15x and a conservative 2012 EPS of $1.76, the rough intrinsic value of the stock could nevertheless be as high as $26.40.
Notwithstanding the near-50% margin of safety for both firms, I believe much more attractive financials exist with greater risk/reward.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.