Negative Sentiment Continues for Financials

We sat down recently with Zacks senior banking & financial analyst Neena Mishra in order to try to get a sense of when we might be seeing a bottom for financial companies – if indeed we’re not seeing one currently.

Understandably, you’ve got several Sell-rated stocks in your coverage. Can you tell us about one of your most-recently published Sell reports?

After reviewing the results of Zions Bancorporation (ZION), we have lowered our EPS estimates, based on our concerns for further credit deterioration and dilutive effect of the proposed capital raise. We are maintaining our Sell recommendation on the shares of ZION with a six-month target price of $22.00 per share.

This assessment came post-quarterly earnings results?

Yes. ZION’s 2Q08 operating earnings of $0.66 per diluted share were substantially below our estimate as well as consensus. The earnings for the quarter were mostly impacted by the sharp increase in provisions, coupled with impairment and valuation losses on securities. Ongoing weakness in the southwestern residential real estate markets, where the company has a significant exposure, continues to hurt the results.

Though loan and deposit growth were satisfactory, NIM [net interest margins] further declined during the quarter. The quarter was also characterized by good expense control.

Tell us about another Sell recommendation you have made recently.

Wilmington Trust’s (WL) 2Q08 operating earnings of $0.47 per diluted share were two pennies short of consensus. Results were hurt by 20 bps sequential margin compression and 85.0% sequential increase in loan loss provisions, which more than offset the growth in the non-interest income (mainly based on 21.9% increase in revenues for the Corporate Client Services).

Credit quality deteriorated during the quarter, with both non-performing assets (up 7 bps sequentially) and net charge-offs (up 14 bps) rising during the quarter. After reviewing the results, we are reducing our FY08 and FY09 estimates.

Also, Comerica’s (CMA) 2Q08 adjusted earnings from continuing operations of $0.58 per share were four cents short of our estimate. The miss mainly stemmed from a decline in net interest margin (down 31 bps sequentially to 2.91%) and a rise in the provision for loan losses.

Comerica is also heavily exposed to the real estate development downcycle, isn’t it?

This is true. Continued deterioration in the residential real estate development loan portfolio, mainly in California, resulted in the increase of nonperforming assets to 1.44% (up 37 bps sequentially) of total loans and foreclosed property.

As we suspect that the credit related costs will remain high in the coming quarters and the company may also need to cut its dividend, we have further lowered our EPS estimates and our six-month target price.

What is your current outlook for financials at this point?

Our outlook for the financial industry is currently negative. As a result of the meltdown in the housing and credit markets, these companies which had direct or indirect exposure to mortgages, have suffered the most, in recent quarters. The mess has also spread in a big way to CRE and residential construction loan books.

As a result, we have seen steep charge-offs and rising loss provisions, which have seriously threatened the profitability of the banks. In most cases, the financial companies have reported earnings substantially below consensus expectations during the recent quarters.

We expect the group’s earnings to remain flat-to-down through 2008, though it may derive some comfort from the decreasing rate environment and other actions by Fed to increase the liquidity in the markets. The challenging environment will also imply a changing mix of business for the banks. With most banks winding up their riskier mortgage loan business (subprime and no documentation loans), the profitability of the mortgage business will be significantly lower.

Further, as the housing turmoil and soaring oil prices are affecting the consumers in general, we may see higher losses in other asset classes as well. Tighter lending and underwriting norms will limit the lending activity and further hurt profitability. There are some attractive valuations currently, but with the negative sentiment for the broad industry, we do not expect any significant buying activity until we see the bottom of the housing market.

Neena Mishra is a senior analyst covering the financials industry for Zacks Equity Research.