Core Banking Businesses Very Profitable Despite Writedowns and Loan Losses

Since earnings season gets underway in full force this week, the headlines are going to look bad for the financial services industry as loan losses and asset writedowns lead to severe first quarter losses. However, investors need to focus on where these losses are coming from and how the core banking business is holding up during this mess.

I bring this up because the media would have you believe that the banking business is broken and loan defaults by consumers on their mortgages, credit cards, car loans, and student loans are crippling the banks. Interestingly, that is simply not the case.

Consider the first quarter earnings report from Wachovia (WB) issued yesterday morning. The company reported revenue of $7.9 billion and a loss of more than $300 million, or $0.20 per share. That sounds bad, and it is, but digging deeper into the company's income statement reveals that more than 90% of WB's business remains extremely profitable, as you can see from the numbers below.

Why is this important? Because these three segments represent 93% of Wachovia's business and all three are very profitable even in today's economy. Now, should you simply ignore the losses from asset backed securities and leveraged loans? Of course not. Those losses are real and are resulting in capital infusions, equity dilution, and dividend cuts that are melting away shareholder value.

That said, the banking operations are here to stay whereas record levels of structured product issuance and leveraged loans are not. For those investors who are willing to take a long term view, these large banks are going to make a lot of money from their core businesses going forward, and investors need to take this into account when trying to value financial stocks. Wall Street will not ignore these short term losses in the coming days, weeks, and even months, and they shouldn't, but two or three years from now the core business segments highlighted above will be the driving force behind bank earnings, and as a result, bank share prices.

Full Disclosure: I do not have a position in Wachovia.
I simply used their numbers as an example since they just reported yesterday morning, before all of the other banks. Given that Wachovia purchased Golden West Financial and AG Edwards at the peak of the market, there are likely better investment opportunities in the banking sector, taking both fundamentals and senior management teams into consideration. That said, Wachovia's numbers are relevant because most banks have similar profit margins in their core banking businesses.

Comments

[ponchovilla]

Chad: Since you like to have fun with numbers I am most interested in your projection of Wachovia as a new entity taking Q1 numbers as shown. Forget the trash and forget the potential goodwill impairment. Then use historical average key ratios for "Banking" plus "Chad factors". Then project a value of the stock 2-3 yrs down the rd. Think of this as a graduate school exercise. Let us know what Q1 tells you projected in the future.

[venividivici]

This guy does not have a position in Wachovia and I wonder if he has a position in any American bank or investment bank. But he suggests we buy them because they are great long term investments.
The fact is these industry people are no different from car salesmen or real estate agents. All they ever want you to do is buy buy buy or at the very least don't sell. It is all about recruiting new lemmings to test if the cliff dive is still fatal.