Banks Are Becoming Utilities; Why That's A Good Thing

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Includes: BAC, C, GS, JPM, USB, WFC, XLF, XLU
by: Eli Inkrot

Summary

Many have suggested that with increased regulation, banks are becoming more like utilities.

On the surface, this may seem like rather poor news.

However, there are a variety of mitigating factors that could actually make this a good thing.

Occasionally, you'll hear the argument that banks are becoming (or ought to become) more like utilities. Here's the basic outline of that idea. Prior to the financial crisis, many banks were earning higher returns on capital. Then the crisis happened and in comes regulation. Now, as compared to years ago, banks are required to have higher capital requirements, be more prudent about capital allocation and so on.

Essentially, the increased regulation and requirements creates a situation where the large banking institutions are apt to earn lower returns. And incidentally, this is already observable. In 2005 or 2006, Wells Fargo (NYSE:WFC) was earning 18% or 19% on equity as compared to something closer to 11% today. Or take U.S. Bancorp (NYSE:USB), which had returns on equity over 20% a decade ago as compared to something below 13% more recently.

So, the idea that banks are becoming more like utilities could very well be true. The growth rate as it relates to capital requirements could slow, and naturally, the largest players have more scrutiny today as compared to years ago. Yet, I'd like to point out a couple of items.

First, while an aspect might constrain growth, that doesn't necessitate that it must destroy it. As an illustration, should we see rising rates in the future, this could very well provide a boon to the banks' profit growth and in turn negate some of the slowdown related to greater regulation. Higher holding requirements could be offset by generally favorable industry tailwinds. This doesn't have to occur, but it's conceivable that items like these could "net out."

The second thing I'd like to mention is that comparing a bank to utility may not be as bad as it first appears. Even if growth does slow in the future, there are a couple of important differences. For one thing, banks don't have the same capital intensity as utilities. A bank may have to pave a parking lot at a branch, but it's not the same as the constant upkeep on infrastructure buildout.

Perhaps more pertinent is the relative valuation. This isn't a perfect gauge, but it gets the concept right. As of this writing, the Utilities Select Sector SPDR ETF (NYSEARCA:XLU) is trading around 17.5 times earnings. In comparison, the Financial Select Sector SPDR ETF (NYSEARCA:XLF) is trading around 13.5 times earnings, with companies like Wells Fargo, JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C), U.S. Bancorp and Goldman Sachs (NYSE:GS) exchanging hands with P/E ratios in the 8-13 range. This is an important difference, in my view. Let's see why.

Dividend Yield

Many of the large banks have been stymied in their ability to significantly increase their payout ratio as a result of regulation. Take Wells Fargo as an example. Back in 2005, the company was paying out around 45% of its profits and trading around 14 times earnings. This resulted in a dividend yield of about 3.2%. Today, the company is paying out just 35% of its earnings, but the dividend yield is still around 3.2%. This is possible because the valuation is now lower (closer to 11 times earnings).

So you have the same dividend yield, only a safer (lower) dividend payout ratio. Granted, it is true that future earnings growth could be slower (although that's yet to be seen). However, you could make the counterargument that the lower payout ratio simultaneously opens up the door for future dividend growth that outpaces earnings growth. On the whole, I'd prefer the same yield with a lower valuation.

Share Repurchases

The second reason that the lower valuation matters (i.e., banks trading at 10 or 11 times earnings instead of, say, 15) relates to share repurchases. Presently, JPMorgan has the goal of returning 55-75% of its profits back to shareholders as a net payout ratio. The current dividend payout makes for about 29% of earnings, leaving 25-45% to go towards share repurchases.

Last year, the company earned $24 billion, meaning that perhaps $6-10 billion could be used for share repurchases annually. Using, say, $6 billion a year, that equates to $30 billion in the next five years (without presuming profit growth from here).

Should shares trade with an average earnings multiple of 10, for example, this could mean the company would be able to retire perhaps 450 million shares (and that's assuming an increase in the share price each year). If, instead, the shares were to trade at, say, 15 times earnings, you might only expect to see 300 million shares retired or thereabouts.

So, the lower valuation allows the share repurchase program to be more effective. Fewer shares outstanding equates to a higher EPS growth rate and the potential for greater per share dividend growth as well. And these numbers don't have to hold exactly for this idea to carry weight. As long as the company is using funds to repurchase shares, the long-term owner would much prefer for JPMorgan to buy out past partners at 10 times earnings as compared to 15. The "bang for your repurchase buck" goes a lot further this way.

Regulation

A lot of people automatically discount this as a negative, but it has some positive aspects. A bank may not be able to deploy all of the funds it wants to, but it's not like those monies are then wasted. Instead, banks are being "forced" to bolster their balance sheets and maintain stronger financial standings. It's sort of like when a teenager earns his or her first paycheck and the parents force you to save a portion of it instead of blowing it all. Forced saving may not always be the worst thing in the world, especially if it makes you better down the line.

So let's put it all together. A lot of people are saying that the increased regulation has made banks much more like utilities. Which may be true - banks are apt to be more like utilities today as compared to a decade ago. However, I don't see this necessarily as the worst of possibilities.

First, the implied slow-growing nature that most fear from this situation is not yet known. It could be that regulation hinders growth, but other factors ultimately increase it or keep it moving at a reasonable rate. So, the "future growth will be diminished" argument may or may not come to fruition.

More pertinent, in my view, are the relative valuations. It's not like it's slow growth and a 15 or 17 times earnings multiple. Instead, it's the possibility of slow growth and something closer to 10 times earnings for a lot of these companies. In turn, you still collect a solid dividend yield, the share repurchase programs can be quite effective at lower valuations and you're also dealing with a potentially safer vehicle. Banks may be becoming more like utilities, but that could very well be good news.

Disclosure: I am/we are long 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.