Bigger Is Better As Banks Rebound

Investor's Business Daily

When Fidelity Bank, an eight-branch community bank in Dearborn, Mich., failed on March 30, the superregional bank Huntington Bancshares (NASDAQ:HBAN - News) quickly snapped up the operation.

The takeover speaks volumes about the current banking sector.

Big U.S. banks are no longer going belly up or taking bailout money. Fidelity, with a comparatively puny $818 million in assets, was the largest bank to fail so far this year.

Smaller banks, on the other hand, are continuing to face pressure and shut down. Sixteen banks have failed so far this year, according to the Federal Deposit Insurance Corp. That's a slowdown from 26 failures through March last year, and 42 in the first three months of 2010. Despite the deceleration, the heat is still on the market's smaller players.

"The dynamics of the market have been extremely favorable for the bigger banks," said analyst Richard Bove with Rochdale Securities in an interview.

Earnings among larger banks have, on average, increased for 10 straight quarters. Capital-to-asset ratios are the highest since 1938, Bove says, and big bank liquidity is at a three-decade high. Banks are using the windfall to pay down debt as they clear the remnants of toxic real estate assets from their portfolios.

Small banks are battling for a shrunken pool of quality real estate and business loans. They are wrestling with reporting and compliance costs linked to increased federal regulations. And they are grappling with the loss of debit card fees and overdraft charges, also due to federal rules, which had been a reliable revenue stream.

In addition, Federal Reserve policies keeping interest rates artificially low continue to apply pressure.

The result: "Community banks are getting squeezed" said Paul Davis, community banking editor with American Banker Magazine.

Still, bank stocks have been rallying hard since October. And in spite of the divide between the two levels of banks, smaller banking groups have been the ones to climb into the top ranks of industries tracked by IBD.

The West/Southwest regional banks group ranked No. 3 among 197 industries as of Thursday's IBD. Midwest banks claimed the No. 14 spot, while the superregional banks group — home to Huntington Bancshares — held a No. 31 ranking. IBD's industry group for big banks, Banks-Money Center, ranked No. 80. The rankings are based on six-month stock price performance.

BusinessAt the most basic level, community-scale banks take in deposits from customers and lend to homebuyers and businesses. Another piece of their revenue has traditionally come from debit card, credit card, ATM and account fees. Those streams were sharply reduced by the staggered implementation of restrictions from the Dodd-Frank Act, signed into law in July 2010.

Bigger banks have more revenue streams. And they can more easily go to the stock market, if needed, for capital. Before the banking meltdown in 2008, smaller banks tended to be more conservative. They had less debt and tended to keep more durable commercial loans as a larger portion of their portfolios.

Bigger banks and investment banks were the ones more often levered up with derivatives at 30 times equity.

But big banks also received the bulk of the federal bailout funds. And they are seeing a hefty benefit as consumers find their feet and credit quality improves.

"Loan losses are going down, and they are going down dramatically," Bove said.

Also, commercial and industrial loans are up 17% so far this year, Bove says — five times the normal growth rate. He attributes that largely to European banks shedding customers and selling assets on the cheap as they exit U.S. markets.

In addition, the deposit coffers of big banks are still swollen with investment capital withdrawn from stocks and mutual funds.

Yet, in spite of all those advantages, it's still difficult to find many bank stocks that fit the bill for CAN SLIM, IBD's investing strategy. Among the biggest banks, Wells Fargo's (NYSE:WFC - News) quarterly earnings have grown nicely, but revenue is declining. Goldman Sachs (NYSE:GS - News) continues to show decreases on both its top and bottom lines.

Bank of America (NYSE:BAC - News) is up 71% year-to-date and has three quarters of impressive earnings acceleration. But analysts see EPS down 29% in Q1, and the stock is just barely above 10.

In the superregional banking group, only one stock, Regions Financial (NYSE:RF - News), holds an EPS Rating above 80. It trades below 10 a share.

In the Midwest banks group, 20 of 61 stocks hold EPS Ratings above 80. Only two of those, Associated Banc (NASDAQ:ASBC - News) and First Midwest Bancorp (NASDAQ:FMBI - News), trade more than 400,000 shares a day and are above 10 a share. Both show recovering earnings, as revenue continues to decline.

Across all the banking groups, just two stocks have shown real promise as leaders. Texas Capital Bancshares (NASDAQ:TCBI - News) is headquartered in Dallas and Signature Bank of New York (NASDAQ:SBNY - News), in New York City. Texas Capital is just under $9 billion in assets. Signature weighs in with just over $11 billion.

Texas Capital has turned in a steady stream of powerful quarterly earnings growth and rising revenues. Signature's earnings growth slowed sharply over the past two quarters, although revenue growth has held steady and above 20%.

Both companies, Davis explained, have the advantage of being commercial banks located in diverse and rebounding commercial markets.

"They are beneficiaries of being in the right place at the right time," he said.

Market & ClimateDodd-Frank continues to redefine the market for many banks. The rules, which restrict types of investment vehicles, leverage rates and disclosure rules as well as the fees banks are permitted to charge, were designed to have a lesser impact on banks with assets below $10 billion.

But analysts generally agree that larger banks can leverage economies of scale in dealing with compliance and disclosure issues. That means the rules have a disproportionate impact on smaller banks.

Still, the level of oversight and regulation intensifies for banks that reach $10 billion in asset level, according to Fred Cannon, director of research with Keefe, Bruyette & Woods.

"There is a line there that they really don't want to cross," Cannon said.

So, while there is pressure to consolidate, many smaller banks are looking for equally small partners with which to join forces.

"I don't think you'll see a lot of community banks selling to larger institutions," Davis said. But, he added, community banks have to consider merging with one another in order to achieve cost savings and, over time, pool capital for growth.

Despite the challenges, bank stocks have turned up after a tough year last year. They have rallied hard as the broad market picked itself up in October. Cannon says the leading factor behind that run was a sense of mending sovereign debt wounds in Europe. While many of the rallying banks had no direct connections to overseas markets, the "risk on" switch had flipped, lighting up the overall environment for financials.

"You are going to miss what is really going on if you just look at the U.S. financials," Cannon said.

OutlookThe U.S. economy is continuing its slow recovery. Europe looks like it's on track, for the time being, to settle its sovereign debt problems. China's economy is a wild card, with the question of a hard landing still in play.

The Fed appears set to hold interest rates low. The Volcker Rule, which targets trading activity, is the next component of Dodd-Frank. It's set to roll out in July.

The rally in banking stocks since October has been based largely on stock prices rising to reflect book values — the assets on a bank's balance sheet. Banks seen as the most risky, the ones that saw stock prices drop far below their book values, have generally rebounded the most this year.

Going forward, Cannon believes banks will continue to rally, but with the focus shifting from risk and book value to earnings. Q1 results, he says, will figure squarely into what happens next.

"In our view, it will really come down to earnings from here on," Cannon said.

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