The Midwest remains an important banking market, but only for the banking companies that are actually based there, according to analysts at the quarterly American Banker roundtable, which took place Nov. 9. Midwestern banks have done well despite the economic challenges, but not enough to attract much attention from potential acquirers. The roundtable’s participants were Denis Laplante, the director of U.S. bank research at Keefe, Bruyette & Woods Inc., and analysts Terry J. McEvoy with Oppenheimer & Co Inc., David J. Long with Robert W. Baird & Co., and Mark W. Batty with PNC Financial Services Group Inc.’s PNC Advisors.
Economic growth has been slower in the Midwest than in many other parts of the nation. What does that mean for it as a banking market?
DENIS LAPLANTE: Even though organic growth is likely to be slower in the Midwest, you can still make money investing in the region. There are a lot of good companies there, including U.S. Bancorp, Fifth Third, and National City, to name a few.
In terms of fundamentals, the region’s dependence on the industrial sector probably means the banks will get some extra benefit from a recovery in commercial loan demand.
MARK BATTY: While the Midwest is a slower-growth market, many banks are efficiently utilizing capital. I think U.S. Bancorp is a good example. In the most recent quarter, 94% of earnings were paid back to shareholders in the form of stock buybacks or dividends. As long as you have banks that are efficiently utilizing capital, the Midwest is a fine place to operate.
Given the lack of growth, you are likely to see more consolidation over time. While commercial and industrial loan growth has been anemic, the most recent data from the Federal Reserve indicate that for the first time since July of 2001, we have seen an increase year over year in C&I loan growth. While it is only one data point, it may be the makings of positive things to come.
Over all, the valuations of Midwest banks are reasonable.
DAVID LONG: You don’t have the same population growth in the Midwest that you have in the Southeast or the West. However, the banks that are there know their markets, and they know what they can and can’t do.
The dollar has been declining, which helps some of the manufacturing companies in the Midwest perform a little better. I believe the commercial lending environment has definitely started to improve, and there are several banks that are more levered to that than others, Marshall & Ilsley and U.S. Bancorp, to name a couple.
TERRY McEVOY: With a third of the employment base in the Midwest tied one way or another to manufacturing, it’s no surprise that given the slowdown in that sector, banks in the Midwest region have had the lowest loan growth, deposit growth, net income growth and earnings growth relative to banks in other parts of the country for the past three years. This has translated into weaker stock price performance for those banks when compared to banks outside of that region.
We expect the Midwest economy to improve in 2005 as the manufacturing sector continues to show signs of expansion. As this occurs, hopefully the fundamental performance of those banks that operate in the Midwest will begin to generate better returns for shareholders.
Midwest banks today are trading at a discount to their peers in the Southeast, Southwest, and Pacific Northwest. We would expect the multiple discrepancies to compress, going forward, should the economic recovery in the Midwest follow through.
Is it a mistake to look at the Midwest only as a commercial market?
McEVOY: Up until early this summer, commercial loan volumes were down for over two and a half years. While this had negative implications for the banking industry, it was intensified in the Midwest, given the industrial concentration in that region. So what has occurred in many cases is that banks whose core business was lending money to commercial customers needed to find an alternative source of revenue.
As such, we have seen many banks aggressively open up branches and in general invest a lot of time, energy, and resources into growing and improving the profitability of their retail platform in hopes of offsetting the decline in the commercial business. At this point, it’s so competitive for new customers and their deposits that we are concerned that certain banks may have overinvested in their retail platform and may have trouble supporting the higher cost structure.
BATTY: The Midwest is an attractive consumer market as well, although it remains to be seen to what extent banks may have overbuilt in terms of their retail branch infrastructure. We may not know for a couple of years to what extent branch overbuilding may have occurred. Over all, I think it is important to have a balanced business model.
LONG: The baton is in the process of being passed. I don’t think it’s fully out of the consumer’s hand and into the commercial customer’s yet, but we are starting to see some signs that it is going to pass.
The uncertainty of the election has passed, and I believe we are starting to see an increase in investment over the last few weeks. There is a good chance the improvement in commercial and industrial lending could snowball over the next few quarters.
If you look back 10 years, when commercial and industrial loan demand started to pick up, C&I loans outstanding increased almost 20% over the first 18 months. I don’t think it will be quite as robust this time around, but if we can get to 10% growth, that will be fantastic. Several of the Midwest banks would surely benefit from that type of improvement.
How large a share of the economic recovery do you think the Midwest could get?
LAPLANTE: Although investors have complained about the lack of commercial loan growth, the last couple of quarters have provided some positive surprises.
The second quarter proved to be a far better quarter for C&I loan growth than our expectations going into the quarter. And although our discussions with commercial bankers lowered our expectations for growth going into the third quarter, C&I performance was not all negative. There were some haves and have-nots.
The haves that flourished in the summer slump included KeyCorp, M&I, Fifth Third, TCF, and Associated Banc Corp. The have-nots included Comerica, National City, and U.S. Bancorp.
Who do you think will be the major beneficiary of that? Is it the companies that we have seen put on loan growth mainly through market-share gains?
McEVOY: As the demand for C&I loans accelerates, we feel every Midwest bank will benefit, as it will reduce the competitive environment across the board. Unfortunately, what demand we are seeing today is being sought after by everyone. So banks that are winning that business may be sacrificing on the pricing or terms of the loans. We are cautious today on some of the commercial loan growth we’re seeing at some institutions.
Over the next year we believe the growth in C&I loans will be broad-based and have a positive impact, on the large regionals right down to the one-branch community banks.
LAPLANTE: One thing to keep in perspective is that C&I is less important as a percent of the loan portfolios today than it was 10 years ago, so a rebound in this business alone is not going to make 2005. I would be thrilled with 7% C&I loan growth next year. It will help boost profit growth next year, but I don’t think it’s going to help the banks go from 9% to 10% earnings per share growth to 15% or more.
BATTY: Yes, I would agree with that. Many large companies are obviously accessing the capital markets, which may impede a recovery in large corporate loans. I would note that small and middle-market lending will benefit most of the banks within the Midwest as this region recovers. The Midwest may benefit to a greater extent than other pockets of the country.
Capacity utilization may be a number to keep an eye on. Capacity utilization is showing signs of improvement and is approximately 77.4%. As we see this improve, it is usually a sign of an expanding industrial economy and should benefit the economy and loan growth in the Midwest.
What about Bank of America Corp. and Wachovia Corp.? If you want to be a truly national bank, is the Midwest an area you can just leave out?
LAPLANTE: First of all, B of A really can’t do more deals unless Congress sees fit to change the national deposit cap. At the moment, we do not see a lot of support for a change in the law.
Second, their franchise is already the envy of a lot of bankers, given their presence in the Southeast, the Southwest, and all along the West Coast. I think that moving into the Midwest would likely slow down B of A’s long-term growth rate.
Of course, what do I know? Management struck a deal to move into New England, which I also believe will slow the company’s long-term growth rate. The good news: Investors do not have to worry about B of A doing banking deals right now.
BATTY: I do not know if B of A would want to be there or not, but it really takes a possible seller to strike up some interest.
I would suspect that once the cycle turns and the economy picks up in the Midwest, then you may see an interested seller. At that point I am sure there would be many interested buyers.
McEVOY: The Midwest might be one of the last areas of the country where the major regionals that you mentioned start to grow aggressively through acquisitions. At some point they will begin to become interested in that region, but only because they have saturated every other market.
Unfortunately, until this begins to occur, the limited amount of large-scale M&A activity may keep the valuations of Midwest banks on the low side.
How crucial is it for midwestern banks to expand out of the Midwest?
LAPLANTE: We have seen several of them expand into the Sun Belt, and we suspect we will see more activity. Fifth Third could do more deals in the Southeast. National City is another company that appears willing to expand outside of the region; I think they would consider deals in Tennessee, and reportedly they looked at Riggs.
However, I think we will continue to see Fifth Third, KeyCorp, and National City seek opportunities in the Midwest as well. I just hope that Nat City doesn’t overpay like they did for Wayne Bancorp in northeast Ohio.
Do Huntington’s current issues make it a target?
McEVOY: The problems at hand today are not enough to drive management and the board of directors to sell out, in our view. If they intensify, maybe that’s another story. It seems like the issues are resolvable and management will work through them and move forward as a stand-alone company.
What do you think about U.S. Bancorp?
BATTY: Their multiple remains in the penalty box because many investors suspect that they will make another large acquisition. But having said that, I think that they have done a great job in terms of efficiently redeploying excess capital. By returning capital to shareholders via dividends and stock buybacks, they have been very shareholder-oriented, and I view that as a positive.
LONG: They really do run a good bank. The second quarter of this year was the first time we saw a really solid clean quarter [for U.S. Bancorp] for some time, and I expect more of that going forward.
LAPLANTE: I think U.S. Bancorp is a good company, but let me play devil’s advocate. A high return on equity, one of the best efficiency ratios in the industry, and slower-than-average revenue growth might suggest that they are not reinvesting enough in their core businesses.
We’re seeing a pickup in growth in their processing businesses, but not much in their retail and wholesale businesses. Given the fundamentals, we think our “market perform” rating is appropriate.
McEVOY: When I ask the smaller banks on my coverage list in the Midwest who are their best competitors in the retail banking area, U.S. Bancorp very rarely comes up.
Who does come up?
McEVOY: Fifth Third is a name that is almost always mentioned first, with most saying that they are consistently a great competitor and are very aggressive with the pricing of their products. And National City is normally a distant second.
How do you all view KeyCorp’s strategy?
McEVOY: The company is making a big push to improve the growth and profitability of their consumer banking division through both acquisitions and the hiring of seasoned bankers. For the last three years the consumer business has been the real cash cow for the banking industry, and for them to be making the investments today might prove to be too late.
As I look at their franchise, one that stretches from Maine all the way up to Alaska, we feel there is a limited appeal from a potential buyer today, because of their lack of concentration. So they’re making acquisitions in higher-growth markets. I wish they were maybe growing it in a more concentrated area, which might increase the takeover value within that stock price.
What about Comerica?
LONG: Comerica is obviously the pure play in pickup in commercial and industrial lending. That said, the Detroit market, and the Michigan market in general, has become very competitive.
[ABN Amro’s] Standard Federal and some others have really thrown a lot of resources at middle-market lending up there. Comerica is the 800-pound gorilla … in Michigan, so it’s going to be difficult for them to really grow their market share. They’ll rise with the rest of the group once we see a more robust pickup in C&I lending, but as far as outpacing the competition, that’s going to be difficult.
LAPLANTE: Actually, I like their focused strategy on commercial customers, and I think they can improve profitability from current levels.
Three trends are helping fundamentals. One, credit trends have already improved. Two, higher rates will help boost net interest margins. And three, C&I loan growth will eventually be a tailwind rather than a headwind.
The bad news is that it looks like most of the improvement in fundamentals is already reflected in the share price.
McEVOY: I was a little surprised to not see the growth in the C&I portfolio in the third quarter, given the growth we were seeing at many of its peers, which tells me either people were aggressively going after their customers or they were just being extremely disciplined on pricing and the type of growth that they wanted to put on the books that quarter.
But there is a ton of leverage from rising rates, improving demand for C&I loans. They also don’t have that big hurdle to get over which is the mortgage business, like Nat City and many others do.
What is your outlook for the next year in the Midwest? How much growth do you see in the banking sector? What’s earnings quality going to be?
McEVOY: For the 20 Midwest banks that we cover, according to our models we feel earnings in 2005 will be up 10%-11% relative to 2004. This is down a bit from the earnings growth reported over the past three years, due to the dramatic decline in mortgage banking profits. Expected earnings [growth] for the S&P 500 right now is approximately 8%.
While the growth in 2005 appears quite healthy for the group, we are somewhat concerned with the quality of earnings. Investors have not been critical of banks that have been eating into loan-loss reserves or simply allowing chargeoffs to be greater than the provision. At these valuations, we worry that certain banks could be penalized over the next few quarters for growing earnings through underreserving.
LAPLANTE: We’re looking for the Midwest banks to grow earnings by about 9%-10% next year, including the small-cap companies.
One factor in this optimism is that we expect short rates will continue to rise by, say, 25 basis points per quarter. Under that scenario, we’re betting that margins will expand next year. We also see some pickup in C&I loan growth, and moderating but still healthy growth in home equity portfolios. We also have higher provision costs baked into our numbers, simply because we don’t think it is prudent to assume that commercial credit costs will remain as low as they have been.
LONG: Well, just looking at margins, I may not be as optimistic. The yield curve has begun to flatten out a little bit. The interest you’re paying on deposit is moving higher as the mix shifts towards time deposits from demand deposits. Also, you are losing a lot of the easy mortgage warehouse income that you used to get.
My earnings growth expectation for the regional banks next year is 8.5% to 9%. That number is dependent on how quickly we see C&I loan growth pick up. That obviously will impact the margins as well. So if we get a more robust pickup, I would be a little more optimistic in regard to margins, and I could slightly raise my earnings expectations.
What stocks would you sell?
McEVOY: Over all it’s been a great four years for bank stock investors, and at this point we are extremely selective on what bank stocks are on our recommendation list. We recently lowered our investment rating on KeyCorp to “sell,” given our outlook for low earnings quality. Other “sell”-rated stocks under coverage for us are PrivateBancorp and Independent Bank Corp. [of Ionia, Mich.].
LONG: Of the 16 banks and thrifts on my list, I’m neutral on 12 and “outperform” on four. I don’t have any “underperform” ratings. That said, the banks that I would say that you need to be careful of are those with large mortgage concentrations, particularly National City.
Looking at my numbers for 2005, I expect EPS to decline by almost 10% for National City. So that is a name where you have a decline in the denominator of the PE ratio, making its forward multiple expand even if the stock is flat.
LAPLANTE: We have “underperform” ratings on PNC and KeyCorp.
BATTY: One stock we do not own in our core portfolio is KeyCorp, and this is primarily due to valuation at current levels and the fact that its profitability levels are below peers’.
