Buy the banks—the regional banks, that is.
Weeks before the sweeping rescue plan that Treasury Secretary Henry Paulson announced on Sept. 19, regional banks PNC Financial Services Group (PNC), BB&T (BBT), and SunTrust Banks (STI) already emerged as the financial stocks of opportunity, as they had become way undervalued.
They became even more undervalued on Sept. 22, when regional bank stocks declined on concern among some investors that they could be hurt by the Treasury's proposal to shield from losses investors in money-market funds, which compete with the banks' deposits. "I think the risk is overblown," says Jeffrey Kleintop, chief market strategist at LPL Financial. The idea behind the stocks' decline, says Kleintop, is that because many of the banks have their mortgage securities designated as "held for investment," they haven't taken writedowns, and that if they then sell them they have to write them down. But most assets are held near their fair value at the regional banks, says Kleintop.
What is more important is the conversion of Goldman Sachs (GS) and Morgan Stanley (MS) into bank holding companies, he says. It means that if Goldman and Morgan want to develop a large deposit base in order to diversify and lower their cost of funds, they would have to do so by buying regional banks. "This means the biggest regional banks may now attract potential buyout bidders, which might help lift their valuations," says Kleintop.
With the fast-moving events in the federal government's efforts to save the beleaguered financial system, the attractiveness of the regionals' shares has definitely grown. Shares of these banks had been in a free fall until the Treasury and the Federal Reserve Board announced the bailout of Fannie Mae and Freddie Mac on July 15. Before then, things were beyond bleak: The S&P 500 Regional Bank Index had plunged to 45 by that day, from 140 in mid-February of 2007. The index has nearly doubled since then, to 80.31 on Sept. 18.
Look Who's a Haven Now
Some of the regionals hold a lot of the preferred shares in Fannie and Freddie as cash equivalents to support the loans they provide. The preferreds could have wiped out the regionals had the two giant providers of liquidity to the mortgage market collapsed. PNC, for example, had to take a charge of $80 million.
"Once the deal to bail out Fannie and Freddie came together on July 15, the scope of the problem became clear, and it became obvious that the regional banks would benefit from the continuing operations of Fannie and Freddie, even though the sizable dividend of about 7% on the preferreds has been suspended," says Kleintop. The regional banks now have become a " haven of safety," he adds. The banks' shares are already 60% above their 52-week lows and continuing to move upward. "They are now attractive buys and represent good value," says Kleintop. The Regional Bank Index still has a long way to go to regain its old highs, he notes.
Shares of PNC, whose primary markets include Delaware, Florida, Massachusetts, New Jersey, Ohio, and Pennsylvania, have rallied sharply, hitting a new high of 81.21 a share on Sept. 19, up from 49 on July 15. The stock dropped to 75.60 on Sept. 22. But PNC could still post double-digit gains that outpace the overall stock market, says Kleintop. Second-quarter revenues jumped 19% from a year ago, while net interest income, which accounts for some 48% of revenues, climbed 32%.
Although PNC and BB&T have moved up considerably, they are still better positioned to power ahead and outpace their peers, says Patrick Schumann, an analyst at Edward Jones. He warns, however, that in view of the volatility of the financial stocks, "one must be nimble" and ready to take advantage of the stocks' sharp swings.
PNC's 44% stake in BlackRock (BLK), the largest publicly traded U.S. asset manager, is considered a plus, contributing significantly to the bottom line, analysts say. Also a big positive is PNC's low exposure to collateralized debt obligations (CDOs) and structured investment vehicles. That, on top of PNC's relatively good capital levels and low debt ratio of 6.8, helped PNC's strong results.
Richard Bove, an analyst at investment firm Ladenburg Thalmann (LTS), rates PNC a buy, with a 12-month price target of 77 a share. Another bull is R. Scott Siefers, who follows PNC at Sandler O'Neill & Partners. He has a 12-month price target of 80.
Zacks Investment Research puts analysts' consensus earnings-per-share estimate for PNC for 2008 at $4.95 a share, for 2009 at $5.34, and for 2010 at $6.05.
Healthy Deposit Growth
BB&T, which has a large presence in the District of Columbia, Georgia, North Carolina, South Carolina, and Virginia, is one of the well-managed regional banks, says Eric Oja, an analyst at Standard & Poor's. It remains undervalued despite the stock's swift rally in the past few days, adds Oja, who rates the stock a buy. He is in the process of adjusting his price target of 40 in view of the stock's fast advance to 41.14 a share on Sept. 19 from 32.45 on Sept. 15. It closed on Sept. 22 at 39.23. Right now, it is trading at 14.5 times his estimated 2008 earnings estimate of $2.75, while its peers trade at around 16 times. Deposits are growing at a healthy pace, he notes, and BB&T doesn't have a large exposure in subprime mortgage loans.
SunTrust Banks, one of the largest bank holding companies in the Southeast, mainly in Alabama, the District of Columbia, Florida, Georgia, Maryland, Tennessee, and Virginia, provides a wide range of services such as credit cards, mortgage banking, insurance, and brokerage and capital markets services. It had long underperformed its peers mainly because of its exposure to home construction loans. But its stock has since recovered, says David George, an analyst at investment firm Robert W. Baird, who rates both SunTrust and PNC outperform. Despite SunTrust stock's strong runup, to 59.20 a share on Sept. 19 from 45.90 on Sept. 15, the stock still has upside momentum, says George. It closed at 53.88 on Sept. 22. He first recommended the stock in July when it was trading at 30. The bank has substantial presence in fast-growing metropolitan areas in the South, notes George, such as the District of Columbia and Florida.
Zacks Investment puts analysts' consensus earnings estimates for SunTrust at $3.37 a share for 2008, $3.35 for 2009, and $4.51 for 2010.
Some analysts predict that with the recovery in the regional bank sector, consolidation may be the next catalyst for buying their shares, with Goldman Sachs and Morgan Stanley as the likely acquirers. In the meantime, investors who stuck with the regionals are finally enjoying the fruits of their patience.
Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.