Bank stocks certainly didn’t make investors money in 2011 despite many market pundits, analysts and traders constantly pushing the bargains that were to be found in the U.S. banking sector such as the once mighty Bank of America (BAC) and the former global banking powerhouse Citigroup (C). They were pushing them heavily as many of these once mighty institutions are now trading at significant discounts to their book value per share. In fact from the start of 2011 the KBW Bank Index (BKX), which includes24 U.S. banks, such as global giants Bank of America and Citigoup to large regional players, plunged 25%, while the broader S&P 500 Index (SPY) essentially ended the year flat.
This plunge definitely doesn’t appear to be another repeat of the Global Financial Crisis, which sent the KBW Index crashing for more than three successive quarters ending at a new low in March 2009. The key drivers of the current problem are that many of the major U.S. banks have significant hangovers from toxic investments, substandard credit portfolios with substantial ongoing borrower and investor litigation over claims of misrepresentation and fraud relating to subprime loans and property foreclosures. They have also seen a large proportion of their fee revenue dry up as all of sectors of the economy have engaged in significant cost cutting measures. This is then combined with a new regulatory regime that has seen many of the major banks placed in a financial straight jacket preventing them from being able to adequately leverage their balance sheets and aggressively pursue new business opportunities. These effects are being felt across the board from major global institutions, regional banks and investment banks.
I believe that all of these factors have caused many of the major U.S. banks to become highly unattractive investments that will deliver unsatisfactory stockholder returns for years to come. Primarily as they are still struggling to come to grips with the new regulatory regime and contain the ongoing fallout from the subprime lending bubble and the Global Financial Crisis. The five banks I have analyzed all received Federal Government TARP payments to keep them solvent and prevent them from failing during the Global Financial Crisis (`GFC´). They have all failed to deliver solid investor returns over the last year and I believe will also fail to do so in 2012. As always use my analysis as a starting point for conducting your own due diligence prior to investing.
Bank of America Corporation
BAC is the eighth largest bank in the world and provides banking and financial services to individuals, small to medium enterprise, corporations, and governments primarily in the United States and internationally. It services its customers through a network of approximately 5,900 banking centers and 18,000 automated teller machines. Its five-year return is around -87% and it is down 58% since the start of 2011, currently trading at around $6. This gives it a market cap of $57.7 billion and it has a 52-week trading range of $4.92 to $15.31.
Increased regulatory hurdles, a poor economy, decreased business activity, a depressed housing sector and low consumer discretionary spending have all impacted on the earnings and income of the banking industry in the U.S. and this has been no different for BAC.
BAC has delivered three successive quarters of declining earnings, with earnings in the third quarter dropping by 7% to $15.9 billion. This is an overall decline of 13% since the fourth-quarter 2010. However, net income bounced back in the third quarter with a massive 170% rise to $6.2 billion, from a second-quarter loss of $8.8 billion, although the second-quarter loss was caused by a substantial legal settlement paid by BAC as a result of ongoing litigation. Overall BAC’s balance sheet strengthened during the third quarter with cash and cash equivalents dropping by 0.3% to $683.6 billion and total debt dropping by 5% to $748 billion.
The current tight credit markets and low consumer demand for investment and lending products as well as the far tighter regulatory and capital requirements means it is extremely difficult for BAC to leverage its capital to aggressively pursue future earnings opportunities. While these issues affect many other banks BAC has its own unique problems that are directly affecting its ability to perform and deliver solid returns to investors.
Overall BAC does not stack up well when compared with its competitors. It has a forward P/E of 6, which compares favorably against Citigroup’s (C) 6.4, JPMorgan’s (JPM) 7 and Wells Fargo’s (WFC) 9. However, its extremely high PEG ratio of 11 indicates that it currently has very poor future growth prospects and this is substantially higher than its competitors, such as Citigroup with a PEG of 0.6, JPMorgan with a PEG of 0.94 and Wells Fargo’s PEG of 0.77. In addition, BAC has an extremely poor return on equity of -1%, which is substantially lower than Citigroup’s 6%, JPMorgan’s 11% and Wells Fargo’s 12%.
Overall BAC has substantially inferior performance indicators when compared with its competitors and this can be attributed to its own unique problems that include a highly toxic balance sheet and lending portfolio. It has an uncomfortably high debt-to-equity ratio of 3, with a return on equity of -1.4% indicating that it is highly exposed to any further economic headwinds that may arise from worse-than-expected economic performance and the ongoing effects of the European sovereign debt crisis. Another deeply concerning indicator when coupled with a negative return on equity and return on assets of -0.1%, is that BAC is trading at a deep discount of 71% to its book value per share. This indicates that many of its assets may in fact have inflated values or be worthless as management is unable to effectively utilize them to generate increasing earnings and net income.
BAC’s troubled mortgage division has racked up billions of dollars in legal bills over the last couple of years and it has also already paid a large settlement to mortgage investors and is facing another legal challenge with AIG commencing litigation against BAC for $10 billion with regard to investments made in collateralized debt obligations. AIG claims that the quality of these investments, made between 2005 and 2007, were misrepresented and falsified.
BAC has a large exposure to impaired loans with a loan loss provision in the third quarter 2011 of $3.4 billion. The bank is also the subject of ongoing regulatory investigation into its foreclosure practices and allegations that it hindered a prior investigation.
In 2011, Warren Buffett made a substantial investment in BAC totaling $5 billionand many believed that this indicated the bank was indeed on the road to recovery as Buffett was taking such a substantial stake in the bank. On this news BAC’s stock price rose, peaking at $8.36 in late August 2011, but since then its price has dropped by 28% to its current trading price. In addition, this capital injection did no favors for existing investors as it diluted common shareholders in the process as Buffett received options and preference shares in exchange for the investment.
For these reasons I believe that any investment in BAC is fraught with a high degree of risk as it has a recent history of consistently delivering negative surprises to the market, which leaves me wondering how many more skeletons BAC has hiding in its closet. While BAC will never be allowed to collapse, possibly resigned to wander the banking world forever as a shuffling zombie, I do not believe that it will deliver solid returns to investors for quite some time and certainly not until it has resolved many of its innumerable problems.
Citigroup Inc.
Citigroup is the eleventh largest bank in the world and it operates globally offering the full spectrum of banking and wealth management services to over 200 million customer accounts in approximately 160 countries. Since the start of 2011 it has dropped in value by 43%, currently trading at around $28, giving it a market cap of $82 billion. It has a 52-week trading range of $21.40 to $51.50.
As with BAC the increased regulatory environment and poor economic climate have had an effect on earnings with Citigroup’s third-quarter earnings dropping by 2% to $18.2 billion, which is an overall 4% decline since fourth-quarter 2010. However, net income bounced back in the third quarter rising 15% to $3.7 billion. Overall Citigroup’s balance sheet strengthened during the third quarter with cash and cash equivalents rising by 4% to $29 billion and total debt dropping by 1% to $623 billion.
Overall Citigroup does not stack up well when compared with its competitors. It currently has a similar forward P/E of 6.4 to BAC’s 6, JPMorgan’s 7 and Wells Fargo’s 9. However, its return on equity of 6% is lagging behind HSBC’s (HBC) 12%, JPMorgan’s 11% and Wells Fargo’s 12%.
Citigroup has a highly leveraged balance sheet with an uncomfortably high debt-to-equity ratio of 3.5 combined with a low return on equity of 6% and a low return on assets of 0.6%. This raises two concerns, firstly that its future performance is highly exposed to any further economic headwinds that may arise from worse-than-expected economic performance and the ongoing effects of the European sovereign debt crisis. Secondly, as Citigroup is trading at a deep discount of 54% to its book value per share, many of Citigroup’s assets may be reported at inflated values or be incapable of generating a return for the bank.
I also feel uncomfortable with high Citigroup’s considerable exposure to impaired loans, with a loan loss provision of $32 billion booked in the third quarter 2011.
Citigroup appears to have switched its focus to growth in emerging markets as means of increasing earnings and net income. This strategy would make considerable sense if its core U.S. operations were stable and consistently profitable with little future growth potential. However, it is my concern that this is only a band aid solution to increase short-term earnings that will create further distractions away from bringing its core U.S. operations back to consistent profitability and leading to further deterioration in its U.S. business.
While I do not believe that Citigroup represents the same risk as BAC, for all of the reasons discussed I do not believe that it will provide investors with solid low-risk returns over the short- to medium-term. In fact should a double-dip recession eventuate or further economic headwinds batter the global economy as a result of the European debt crisis then fragile U.S. banks such as Citigroup will be among the first to feel the impact.
Capital One Financial Corp. (COF)
Capital One provides banking, financial products and services in the United States, Canada, and the United Kingdom. It primarily serves consumers, small businesses, and commercial clients through branches, the internet, and other distribution channels. Since the start of 2011 it has risen by 2% in value currently trading at around $45, giving it a market cap of $20 billion. It has a 52-week trading range of $35.94 to $56.26.
For third-quarter 2011, Capital One reported a 2% increase in earnings to $2.3 billion. Net income fell by 11% in the third quarter to $813 million and the company reported a weaker sheet for this period with cash and cash equivalents falling by 3% to $44.8 billion. Total debt also fell during this period by 12% to $34.3 billion.
Overall Capital One stacks up well when compared with competitors. It currently has a forward P/E of 7, which compares favorably against BAC’s 6, Citigroup’s 6.4, JPMorgan’s 7 and Wells Fargo’s 9. Capital One’s return on equity of 12% is comparable to HSBC’s 12%, JPMorgan’s 11% and Wells Fargo’s 12%.
Currently Capital One has total loan loss provisions of $4.3 billion and in the third quarter 2011 increased loan loss provisions by 81% to $622 million. This is smaller than both Citigroup and BAC but I still feel it leaves the bank vulnerable to further lending losses. In addition, Capital One’s debt-to-equity ratio of 1.17, while not optimal and substantially less than Citigroup’s 3.5 and BAC’s 3, still indicates that the bank may encounter further earnings and income volatility should any further economic headwinds arise.
Overall Capital One, despite receiving a $3.6 billion TARP investment in 2008, appears to be back on a more solid financial footing that bodes well for the company’s future. However, at this time I do not believe that it represents an optimal investment choice due to concerns over decreasing future net income, a highly leveraged balance sheet and increased exposure to bad debts.
Sun Trust Banks Inc. (STI)
SunTrust provides various banking and financial services to consumer and corporate customers in the United States. It operates approximately 1,668 full service banking offices. Since the start of 2011 it has dropped 37% in value, currently trading at around $19, which gives it a market cap of $10 billion. It has a 52-week trading range of $15.79 to $33.14.
For the third quarter 2011 SunTrust reported a 0.7% drop in third-quarter 2011 earnings to $2.4 billion. Net income rose by 19% in the third quarter to $212 million and the company reported a weaker balance sheet for this period with cash and cash equivalents dropping by 3% to $39.3 billion. Long-term debt also fell during this period by 42% to $1.7 billion.
Overall SunTrust does not stack up well when compared with its competitors. It currently has a forward P/E of 10, which compares favorably against BAC’s 6, Citigroup’s 6.4, JPMorgan’s (JPM) 7 and Wells Fargo’s (WFC) 9. However, SunTrust’s return on equity of 4% is less than HSBC’s 12%, JPMorgan’s 11% and Wells Fargo’s 12%.
Currently SunTrust has loan loss allowances of $2.6 billion, which while smaller than the major banks does not bode well for a mid tier bank. For the third quarter 2011 it reported an 11% decrease in loan loss provisions to $347 million.
Its debt-to-equity ratio of 1, while not optimal, is substantially less than many of its competitors such as Citigroup’s 3.5 and BAC’s 3. However, I have a preference for companies with a debt to equity of less than 1 as I believe that if it is greater than 1 it does not bode well for the company’s future performance should any further adverse economic events arise.
Overall SunTrust, despite receiving $4.9 billion in TARP financing and being seen by many investors in 2008 and 2009 as a bank to be concerned about, has recovered to be in a far stronger position, than it was three years ago. However, it is still trading at less than 77% of its pre-GFC peak price and will struggle to produce strong future earnings in the current poor economic environment and tighter regulatory environment. At this time I do not believe that it represents a solid investment choice and I do not see it as a candidate for further research and analysis.
The Goldman Sachs Group Inc (GS)
Goldman Sachs is one of the largest investment banks in the world providing investment banking, securities, and investment management services to corporations, financial institutions, governments, and high net-worth individuals worldwide. Since the start of 2011 it has dropped by 44% in value, currently trading at around $95, giving it a current market cap of $47 billion. It has a 52-week trading range of $84.27 to $175.34.
For the third quarter 2011 Goldman Sachs reported a massive 51% drop in earnings to $3.6 billion and for the same period net income dropped by 136% to -$393 million. However, the one glimmer of good news was the company reported a stronger balance sheet for the third quarter 2011, with cash and cash equivalents rising by 14% to $307 billion, although long-term debt rose by 4% to $217.7 billion.
Overall Goldman Sachs does not stack up well when compared with its competitors. It currently has a forward P/E of 7.5, which compares favorably against JPMorgan’s 7 and Morgan Stanley’s (MS) 8. However its return on equity of 8% is less than JPMorgan’s 11% and Morgan Stanley’s 8.7%.
Goldman Sachs despite reducing its long-term debt in the third quarter 2011 does not have a particularly strong balance sheet with a high debt-to-equity ratio of 3.3. This does not bode well for price stability or the company’s future earnings if we were to see a double-dip recession eventuate or further economic headwinds from a prolonged European debt crisis or Chinese property bubble collapse.
The company also has a particularly poor profit margin of -7.7%, which when considered in conjunction with its poor return on equity of 8% makes me believe Goldman Sachs is experiencing considerable difficulty in translating earnings into income. The bank is also trading at a discount of 28% to its book value per share of $132.44, which when coupled with a low return on equity and a return on assets of 0.63% leads me to believe that the assets have been overvalued. All of which doesn’t bode well for future net income growth and increased stockholder value. At this time despite the significant trading discount with regard to book value per share I do not believe Goldman Sachs is a sound investment and does not justify further research and analysis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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