Aranca Views

US Banks:
Fundamentals Ahead of Valuations?

A Research Note By

Subarna Poddar
January 15, 2015

www.aranca.com

01

US Banks Valuation
Irrational caution on the part of investors

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

US banking sector underperforming the market over last seven years

S&P Banks Select Industry Index vs. S&P 500 Index
2500

US banks underperformed the broader

market after the onset of the global economic

2000

crisis in early 2007.

The S&P Banks Select Industry Index

indicated negative return of 3.65% YoY in the

1500

last 10 years compared with 7.67% YoY by

S&P 500.
In 2008, banks and financial institutions were

1000

at the center of this crisis and accumulated

huge subprime assets, which led to significant
losses in their books.

500

Since 2009, banks have tried to restructure

their balance sheets and operations. Most

S&P Banks Select Industry Index

Jan-15

Jan-14

Jan-13

Jan-12

Jan-11

Jan-10

Jan-09

Jan-08

Jan-07

Jan-06

the broader market indices.

Jan-05

level, although they continue to underperform

0
Jan-04

banks have almost returned to the pre-crisis

S&P 500 Index

Source: Bloomberg

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

Valuations below pre-crisis level

PB band chart of top 10 US banks
3.0
2.1x

2.5
Banking stocks are trading at a significant

discount to the pre-crisis level valuation.

1.5x

2.0

While the US banks current PB of about 1.0x

0.3x during the economic crisis, it is below the

high of 2.1x during the pre-crisis period.
The difference in valuation is despite an

improvement in bank earnings to the pre-

crisis level.

Net Profit (millions)

is a significant improvement over the low of

1.5

0.9x

1.0

0.3x

0.5
Following are the top 10 banks we used for analysis:

0.0
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
Jun-08
Oct-08
Feb-09
Jun-09
Oct-09
Mar-10
Jul-10
Nov-10
Mar-11
Jul-11
Nov-11
Mar-12
Jul-12
Nov-12
Apr-13
Aug-13
Dec-13
Apr-14
Aug-14
Dec-14

1.Barclays Group US, Inc.(BCS US)

2. Bank of America Corp. (BAC US)
3. Bank of New York Mellon Corp. (BK US)
4. Citigroup Inc. (C US)
5. Goldman Sachs Group, Inc. (GS US)
6. HSBC North American Holdings Inc. (HSBC US)
7. JPMorgan Chase & Co. (JPM US)
8. Morgan Stanley (MS US)
9. US Bancorp (USB US)
10. Wells Fargo & Co. (WFC US)

Source: Bloomberg

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

Current valuation appearing to suggest irrational caution on the part of investors

PB/RoE scatter chart of top US banks in 2007 vis--vis 2014
40%
35%
GS

2007 RoE

30%
25%

USB

20%
WFC

JPM

15%

BAC

10%

MS

BK

5%

A comparison between the 2007 and 2014

0%

PB/RoE ratios of the top US banks indicates

-5%
0.0x

the RoE of the banks has not reached the

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

2.5x

3.0x

3.5x

2007 PB

pre-crisis level.
40%

Book value of the banks rose in the last two

35%
30%

base to comply with BASEL III norms, leading

25%

to a fall in PB.

Current RoE

years, as the banks increased their equity

20%

USB

JPM

WFC

15%
10%

5%

BAC

MS

BK
GS

0%
-5%
0.0x

0.5x

1.0x

1.5x
2.0x
Current PB

*Bubble size denotes Market Cap

Source: Company filings, Bloomberg

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

02

Operational Performance
Operational improvements to warrant re-rating?

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

Is valuation pertinent given improvement in banking operations?

Operating margin of top US banks
80%

60%

In recent years, US banks revenues have

40%

risen above the pre-crisis levels due to high

net interest income, trading income,
investment banking, asset management, and

20%

fee income.
With regard to efficiency, US banks managed

0%

to keep the cost-to-income ratio below 60%.

Operating margin improved considerably, but

-20%

is yet to reach the pre-crisis bars.

-40%
2004

2005

2006

2007

2008

2009

2010

2011

2012

BCS US

BAC US

BK US

C US

GS US

HSBC US

JPM US

MS US

USB US

WFC US

2013

Source: Company filings, Bloomberg

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

Improvement in bottom line on low provisions

Net profit margin of top US banks
60%

40%

US banks earnings are growing as

20%

improvement in asset quality and writing off

bad loans is leading to low provisions

0%

The bottom line improved majorly due to a

decline in loan loss provisions, which reduced

-20%

to 4.4% of the total revenue of the top 10 US

banks in 2013 from 28.3% in 2008.
-40%

The average ROE of US banks trended

upward after 2009 to 7.7% in 2013 from just

0.3% in 2008. However, it has not touched

-60%

the 2007 level of 11.9%.

-80%
2004

2005

2006

2007

2008

2009

2010

2011

2012

BCS US

BAC US

BK US

C US

GS US

HSBC US

JPM US

MS US

USB US

WFC US

2013

Source: Company filings, Bloomberg

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

NIM consistently below pre-crisis level with sustained deterioration

Net interest margin of top US banks
7%

6%

5%

The declining NIM barely supported

4%

revenues, whereas capital gains, as a % of

total revenue, increased.

3%

NIM remained much below the pre-crisis level

due to ultra-low FED rates.

The end of QE would lead to a rise in US

2%

1%

interest rates, which would help improve the

NIM of US banks.

0%

-1%
2004

2005

2006

2007

2008

2009

2010

2011

2012

BCS US

BAC US

BK US

C US

GS US

HSBC US

JPM US

MS US

USB US

WFC US

2013

Source: Company filings, Bloomberg

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

Trading income rises with rebound in stock markets

Capital gains as a % of total revenue

WFC US

USB US

MS US

JPM US

Trading income rose considerably with

HSBC US

improvement in the stock market and high

GS US

proprietary trading.
High trading income (although substantially

C US

low as a % of total income) is susceptible to a

downturn in the stock market.

BK US

BAC US

BCS US
-20.0%

-10.0%

0.0%

10.0%

20.0%
2013

30.0%

40.0%

50.0%

60.0%

70.0%

2007

Source: Company filings

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

10

Gradual improvement in lending growth

Lending growth of top US banks
200%

150%

100%

Lending activity remained the key driver of

growth in interest income. Low FED rates

50%

were not conducive for the NIM environment

of US banks.
Loans of the top 10 US banks increased at a

0%

CAGR of 12.8% from 200407 compared with

2.3% from 200713.

-50%

-100%
2005

2006

2007

2008

2009

2010

2011

2012

BCS US

BAC US

BK US

C US

GS US

HSBC US

JPM US

MS US

USB US

WFC US

2013

Source: Company filings, Bloomberg

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

11

Lending growth in different sectors supported by US economic upturn

Commercial loans grew significantly on high private investments
50.0%

Improvement in the US economy supported

40.0%

the overall growth of the banking industry.

With advancement in public spending, the

30.0%

real estate loan segment experienced stable

growth.
20.0%

Increasing economic activities added to the

loan growth in private sectors, leading to a

boom in the commercial loan segment.

10.0%

Loans to non-financial corporations grew

0.0%

more than 5%.

Despite improvement in consumer sentiment,
-10.0%

consumer lending remained below the precrisis levels due to corporate and household
-20.0%
2005

de-leveraging.

2006

2007

Real Estate Loans

2008

2009

Commercial Loans

2010

2011

2012

2013

Consumer Loans

Source: Company filings

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

12

Decline in non-performing loans compared with those in pre-crisis level

Non-performing loans and coverage ratios of US banks
4.5%

160%

4.0%

140%

3.5%
120%

Non-performing loans (NPLs) declined

3.0%
100%

compared with those in the pre-crisis level.

2.5%

The average non-performing asset (NPA)

level of the top 10 US banks fell to 2.2% in

80%
2.0%

2013 from 4.1% in 2009.

60%

The coverage ratio of the top US banks

deteriorated consistently from 133% in 2004

1.5%
40%
1.0%

to 85% in 2013. This highlights the extent of

under-provisioning to cushion profitability.

20%

0.5%

0.0%

0%
2004

2005

2006

2007

NPL %

2008

2009

2010

2011

2012

2013

Coverage Ratio (%)

Source: Company filings, Bloomberg

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

13

Lending growth supported by stable rise in deposits

Deposit growth of top US banks
140%

The per capita and disposable incomes of US

120%

citizens increased, driven by an increase in

100%

job creation. This supported the deposit

growth.

80%

Loan growth was majorly funded by high

60%

deposits. The CAGR of US banking deposits

stood at 9.1% from 200413, driven by high

40%

disposable incomes of US citizens. Loans

increased at a CAGR of 5.7% during the
same period.

20%

0%

The combined loan-to-deposit (LTD) ratio

-20%

reduced to 71% in 2013 from 94% in 2004, as

banks restricted lending to risky portfolios and

-40%

implemented strict KYC norms.

The liquidity of banks improved with the LTD

ratio coming down significantly.

-60%
2005

2006

2007

2008

2009

2010

2011

2012

BCS US

BAC US

BK US

C US

GS US

HSBC US

JPM US

MS US

USB US

WFC US

2013

Source: Company filings, Bloomberg

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

14

03

Regulatory Measures
Eliminating risk factors

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

15

Introduction of regulatory measures to strengthen US banking system

Market
Stabilization

During the 200710 financial crisis, the lack of transparency in the market became

a concern for regulators; hence, the US FED decided to intervene directly in

financial markets to reduce volatility and stabilize prices.

Key financial reforms include removing risky assets from banks balance sheets and

BASEL III

raising more long-term sustainable capital. The BASEL III guidelines introduced the
concept of core Tier 1 equity capital, capital conservation buffer, and counter
cyclical buffer to cope with severe downturn and risk of failure.
Strong banking
supervision

The Dodd Frank Act was formed to create a sound economic foundation to increase

Dodd Frank Act

Volcker Rule

jobs, protect consumers, rein in Wall Street and big bonuses, end bailouts and Too
Big to Fail, and prevent another financial crisis.

The Volcker rule was introduced to limit banks speculative trading activities, restrict

proprietary trading, and regulate derivatives to reduce risk taking.

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

16

Most top US banks are way above their BASEL III regulatory requirements
Basel III Compliance US Banking Sector

Tangible Common Equity Ratio

Tier 1 Risk-Based Capital Ratio

10.0%

18%

9.0%

16%
Regulatory
requirement as
per BASEL III

8.0%
7.0%

14%
Regulatory
requirement as
per BASEL III

12%

6.0%

10%

5.0%

8%

4.0%

6%

3.0%
2.0%

4%

1.0%

2%

0.0%

0%

WFC

USB

MS

JPM

HSBC

GS

BK

BCS

BAC

WFC

USB

MS

Total Risk-Based Capital Ratio

JPM

HSBC

GS

BK

BCS

BAC

USB

HSBC

Tier 1 Leverage Ratio

12%

25.0%
Regulatory
requirement as
per BASEL III

20.0%

10%
Regulatory
requirement as
per BASEL III

8%

15.0%
6%
10.0%

4%

5.0%

2%

0.0%

0%

WFC

USB

MS

JPM

HSBC

GS

BK

BCS

BAC

JPM

BAC

WFC

GS

MS

BCS

BK

Source: Company filings

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

17

CAMEL analysis of top US banks indicating GS performed better than peers in maintaining high level
of capital adequacy
Capital Adequacy Ratios (2013)

C
WFC
20%

BAC

BAC

10%
BCS

BCS

MS

0%

Capital Ratio
BK

JPM

BK

HSBC

JPM

HSBC

GS

GS

WFC
12%
BAC

WFC
20%
USB

9%

BAC

6%
BCS

USB

15%
10%

MS

3%

Tangible

BCS

MS

5%

Common Equity

0%

Common Equity
Ratio

USB

15%

5%

Total Risk-Based

0%

Capital Ratio

Tangible

10%
MS

5%

Tier 1 Risk-Based

WFC
20%
USB

15%

0%

to Risk-Weighted
BK

JPM

Assets

HSBC
GS

BK

JPM

HSBC
GS

Source: Bloomberg, Aranca Analysis

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

18

BK better placed among peers in terms of asset quality, with low NPL level; HSBC underperforming
with high NPLs and low coverage ratio
Asset Quality Ratios (2013)

WFC
4%
3%

BAC

Loans (NPLs)/

USB

BAC

8%

USB

0%
JPM

0%

Provisions/Net

BCS

JPM

-4%

Revenue

Total Loans
BK

HSBC

BK

HSBC

WFC
250%
BAC

200%

WFC
120
USB

BAC

90

150%

60

100%

30

50%

Coverage Ratio

4%

1%
BCS

WFC
12%

2%

Non-performing

A M

BCS

USB

0
JPM

0%

BK

Cost of Risk (bps)

HSBC
C

BCS

JPM

-30

BK

HSBC
C

Source: Bloomberg, Aranca Analysis

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

19

Increase in headcount of GS in 2013; significant growth in sales and net income per employee
Management Quality Ratios (2013)

WFC
1,600
BAC

BAC

800

Actual Sales Per

BCS

000)

BCS

MS

-12%

Headcount
BK

JPM

BK

HSBC

JPM

HSBC

GS

GS

WFC
250
BAC

WFC
100%
USB

200

BAC

150

USB

80%
60%

100

BCS

MS

40%

BCS

50

MS

20%

Employee
(USD 000)

USB

0%

-8%

YoY growth in

Net Income/

-4%
MS

400

Employee (USD

WFC
4%
USB

1,200

0%

Efficiency Ratio

BK

JPM

HSBC
GS

BK

JPM

HSBC
GS

Source: Bloomberg, Aranca Analysis

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

20

WFC and USB relatively superior in converting assets to earnings; poor performance by BCS
Earnings Ability Ratios (2013)

WFC
20%
BAC

BAC

10%
BCS

USB

1.5%
1.0%

MS

5%

Return on

WFC
2.0%
USB

15%

BCS

Return on

0%

(Average) Equity

MS

0.5%

0.0%

(Average) Assets
BK

JPM

BK

HSBC

JPM

HSBC

GS

GS

WFC
50%
BAC

WFC
50%
USB

40%

BAC

30%

30%

20%

BCS

MS

20%

BCS

10%

MS

10%

0%

Pre-tax Margin

USB

40%

0%

Operating Margin

BK

JPM

HSBC
GS

BK

JPM

HSBC
GS

Source: Bloomberg, Aranca Analysis

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

21

BCS among most aggressive lenders in peer group; BAC and JPM with highest short-term deposits
in their books
Liquidity Ratios (2013)

WFC
120%
BAC

BAC

60%
BCS

0%

Customer

BCS

BK

JPM

Assets

BK

JPM

HSBC

GS

GS

WFC
100%

JPM
35%
HSBC

80%
USB

60%

Deposits

USB

0%

-5%

Deposit Growth

BCS

JPM

HSBC

5%

20%

BK

BAC

25%
15%

40%

Deposits/Total

MS

0%

HSBC

Short-Term

USB

60%

20%

Deposits/Total

Ratio

BAC

40%
MS

30%

Loan-to-Deposit

WFC
80%
USB

90%

BK

WFC

BCS

GS
MS

Source: Bloomberg, Aranca Analysis

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

22

04

Conclusion
Fundamentals ahead of valuations

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

23

Fundamentals ahead of valuations; upside expected

After analyzing the fundamentals and valuations of big banks simultaneously, it can

Sound
Fundamentals

be concluded that US banks have strengthened fundamentally over the last six
years. Loan and deposit growth improved from an almost bottomed-out scenario in
2008; operating metrics such as net interest income, fee income, and operating
income increased, but the NPL level reduced. Although NIM is below the pre-crisis
level, it is expected to improve with the hike in FED rates.

Although the stringent regulatory guidelines impacted the operating maneuverability

Regulatory
Compliance

and limited the trading gains of banks, banks can operate under relatively strict
supervision to avert another crisis. The emphasis on the quality and quantity of
capital requirement is another effort to build relatively more robust banks to face an
economic downturn.

Sector requires
re-rating

In the current scenario, while US banks regained some lost ground, they appear to

Rate Hike, Key

Event to Watch
for

be undervalued and have reasonable upside potential.

Yet, investors would do well to keep a close watch on evolving global economic

scenario, exposure to problematic regions and any rate decision by the FED.

Aranca Views: US Banks Fundamentals Ahead of the Valuations?

January 2015

24

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