I think the bank stocks look cheap, as I highlighted with a few in a recent post. But there are issues with lending right now — and I am not even including the wave of defaults & impairments people expect or forbearance.
In the article in the WSJ titled, The Day Coronavirus Nearly Broke the Financial Markets, there is this scoop on what was going on in the market. Essentially, banks held interest rate hedges on it books and when rates went down, the hedges swung in the banks favor and out of companies favor who decided to hedge.
What is funny is that this was seemingly good thing for banks — they had a gain on their books — but actually restricted their ability to deploy capital:
So when Mr. Rao called senior executives for an explanation on why they wouldn’t trade, they had the same refrain: There was no room to buy bonds and other assets and still remain in compliance with tougher guidelines imposed by regulators after the previous financial crisis. In other words, capital rules intended to make the financial system safer were, at least in this instance, draining liquidity from the markets.
One senior bank executive leveled with him: “We can’t bid on anything that adds to the balance sheet right now.
The Fed stepped in and said that, temporarily, they would ease these restrictions through March 2021:
Liquidity conditions in Treasury markets have deteriorated rapidly, and financial institutions are receiving significant inflows of customer deposits along with increased reserve levels. The regulatory restrictions that accompany this balance sheet growth may constrain the firms’ ability to continue to serve as financial intermediaries and to provide credit to households and businesses. The change to the supplementary leverage ratio will mitigate the effects of those restrictions and better enable firms to support the economy.
This is good and as I showed in my last post on banks, the amount of capital banks hold now is insane compared to what they had going into the Great Financial Crisis. The Fed agrees:
Financial institutions have more than doubled their capital and liquidity levels over the past decade and are encouraged to use that strength to support households and businesses. The Board is providing the temporary exclusion in the interim final rule to allow banking organizations to expand their balance sheets as appropriate to continue to serve as financial intermediaries, rather than to allow banking organizations to increase capital distributions, and will administer the interim final rule accordingly
Why did we tell banks after the GFC that they needed to increase their reserve requirements? So that they would be able to provide support in a crisis, not be a source of weakness. That is what is happening now.
I think we need to go a step further and actually lower the capital requirements for the foreseeable future. When you crimp credit, you crimp the economy. Lowering reserve requirements for some time would unleash significant amounts of capital into the system. So far the Fed has just said certain assets won’t count against the risk-weighted assets. With the rule expiring in 2021, it doesn’t really help banks feel super confident.
Here is the chart again of what banks capital levels look like – exiting 2019 with a median level of 12.8%.
Tier 1 Capital represents core equity capital to risk weighted assets and essentially represents the capital not committed to meeting the banks liabilities. The reason you have excess capital is to prepare for unforeseen events, which is why regulators require a minimum of 4%, but higher (6%) for large banks. Investors typically want to see 150% above the minimum. That foots to 6% and 9% respectively… And the big banks were near 13%. The excess capital allowed banks to invest, conduct share buybacks or dividends.
But its clear to me that banks learned their lesson from the last crisis – they did not want to buy the cause again so they carried significant amounts of capital.
I think the Fed / Govt should lower the reserve requirement to unleash more capital into the system from banks, not just central banks. They clearly have excess capital, they just need to be encouraged to deploy it. Imagine how much capital would be deployed if banks went from 12% or 10% to 6%? We then could say they have to get back to 9% in 5 years.
I’ve been thinking about Google recently… especially as concerns arose around COVID-19 and what it would do to the new era advertising giants. Everyone knows “search” is such a powerful business in advertising and benefits from the scale / platform benefits of everyone “googling” what they need. Though I can’t help but think that Google’s assets are underappreciated.
I think Google should take a page from IAC. For those of you unfamiliar with IAC, they essentially are a publicly traded venture capital firm. However, unlike VC the business is “home grown” and once it matures, they tend to spin-it out and maintain a stake or take a dividend from the business (like they have recently done with Match Group, the owner of Tinder and other dating apps).
IAC’s track record is impeccable. Recognize any of these names?
The point is, IAC understands that sometimes a company is worth more operating outside of a large corporate umbrella and with its own balance sheet, making its own strategic decisions, and having its own separate shareholders.
They also understand that a company may need to have a shareholder early on with a long-term view. I think Google’s assets could benefit from this treatment as many of them are mature at this point.
Imagine Google does the following spin-offs:
Google Nest, Google Home – Hardware play
Google Maps – logistics tolling play in the long run
Waymo – Driverless Cars
Google Cloud Business
Android, Chromebooks, other hardware etc.
Search, YouTube, & G-suite (Google Sheets, Gmail, Google Drive, Google Pay) is the “RemainCo” as the assets really do benefit from being combined.
Do you think the assets of the company are worth more than what Google currently trades at? I do.
I think YouTube and Google probably are worth where Google trades right now.
Facebook has roughly 50% EBITDA margins on its advertising-driven business. Let’s say Google’s is in a similar ballpark. The company disclosed in 2019 that Google and YouTube generated around $135BN in revenue, so applying a 50% EBITDA margin to that implies $67.4BN in EBITDA. At the time of writing, Google’s entire Enterprise Value is $837BN, so that foots to ~12.5x EBITDA for a company that is a secular grower. That doesn’t seem excessive to me.
Next, lets look at Google Cloud, which is growing like a weed and competes with AWS.
Back when AWS was around this size in revenues, it had low 50% EBITDA margins.
Therefore, I can assume again around 50% EBITDA margins for the Google Cloud business, which foots to $4.5BN of EBITDA. This too is a secular grower, an oligopoly business between the tech giants, and likely going to double earnings in a couple years. Therefore, I do not think its is unreasonable to say this is worth $75BN (frankly, if earnings do double in 2 years, that’s only an 8-9x forward multiple).
The point is though that that one segment could add a lot of shareholder value if it operated outside of Google. We haven’t even touched “other bets” Google has, which seems to be a lot of cookey stuff like barges for some reason.
There are so many things within Google that I bet we don’t even know about. This list of acquisitions by Alphabet is insane and as a layperson, I don’t know what many of them do. Its also hard for me to actually see what value they bring to Google or to me as a shareholder — but if Google separated out its businesses, maybe that wouldn’t be the case!
This makes sense. If I were to boil it down in one sentence its “banks do not do well in recessions.”
Borrowers may default on loans and banks use leverage so those defaults add up quickly. In good times, banks also tend to reserve less and take less provisions for loan losses (i.e. losses they generally expect on their portfolios in the future) because its hard for them to see a recession on the horizon – and it also juices net income in the short term.
Then… a recession hits. Banks need to take further provisions and people realizes they may not be invested in a bank that can fully weather a business cycle like they thought.
That’s somewhat true today, but different in a lot of ways as well. Yes, banks so far have taken huge loan losses, major ones detailed below:
They took these provisions because we just so happen to be entering the worst economic crunch anyone reading this has ever seen. I mean, the global economy just ground to a halt. Unemployment has surged. And no one knows how long consumers’ trepidation of traveling, splurging, and so on will last.
At the same time, banks’ balance sheets were essentially forced to be in the strongest position we’ve seen for some time. The last crisis in 2008-2009 was a financial crisis. In response, governments attempted to impose “never again” policies to shore up our financial institutions (arguably, this lowered lending and caused our recovery to be much slower, longer and more painful than it otherwise would have been) and bank stocks were put into the penalty bin.
As you can see below, banks tier 1 capital ratios going into this recession far exceed what they were going into the last recession. While this is a health crisis and not a financial crisis, they still face pain, but should be able to withstand the impacts better.
I think this has created an opportunity in the bank stocks. We can now buy leading franchises below book value and collect meaningful dividends along the way.
Here is a list of banks and financials I am looking at:
You can read my comments for each one above, but I want to very briefly focus on some names I think are worth taking a deeper dive on (frankly, I think the banks in general look cheap and it was very hard to find 4 just to drill into – I think a basket of the above makes a lot of sense, excluding any you don’t want exposure to of course).
This bank is absolutely in the penalty box right now. I mean literally – its in a penalty box. The “fake account” scandal resulted in a freeze on the banks assets as punishment so they could get a handle on what was going on in the firm and improve governance. They are a bank, which requires a lot of trust, and Wells Fargo broke that trust.
How quickly tides turn, though. I remember when Wells Fargo was what JP Morgan is today. The “good” bank. Led by a trustworthy team that wasn’t like those other greedy Wall Street banks. And for that, Wells used to trade at 0.5x-1.0x premium to the group (much like JP Morgan does now). You can clearly see a “changing of the guard” going on here. If you didn’t know when the scandal happened, I am sure you can now pick it out.
But Wells has a new CEO and if you have a long time horizon, I am sure they will figure it out. The CEO, Charles Scharf, has a very interesting pedigree.
CEO of Visa from November 2012 to December 2016
CEO of JP Morgan’s Retail Financial Services for 9 years (2004-2012)
Managing director at One Equity Partners, JPM’s private equity arm
CEO & CFO at Bank One in 2000-2002
CFO of Corporate and Investment bank at Citigroup (1999-2000)
1995-1999 he was the CFO at Salomon Smith Barney
This guy gets banking. And he’s led some very large firms and divisions.
I understand why Wells Fargo trades at a discount to JPM. It can’t grow. Its brand may be irreparably harmed.
But I doubt that lasts forever. Just like Domino’s improving its pizza brand, a bank can improve too. Recall Soloman Brothers and Bank of America were once hated entities that came back considerably in terms of sentiment and trust.
Time heals all wounds as they say. We just need Wells to survive. Can they do it? Well, again, their capital structure is in healthy shape:
Wells does have exposure to high risk industries, like Oil & Gas and Retail that will be under pressure this year, but it is still very diversified. Also note, when they say retail, that breaks down to other exposures. For example, department stores are only 18% of their total retail exposure, so less than 1.5% of total commercial and industrial loans.
I like Wells Fargo here. I think the dividend is probably maintained so I’m collecting 8% per year to wait. Even if its cut in half, it still would be a 4% dividend (clearly, if they did that things would not be going swimmingly, but over the long run it should even out).
It’s difficult to actually compare Discover to a name like Wells Fargo. Discover is mainly a credit card business (80% of loans), private student loans (~10% of loans) and personal loans (~10%). So if I were to sum up what makes Discover different than the other bank stocks, its that it is more of a bet on the consumer. And these are generally unsecured consumer loans, so they carry risk.
In Q1’2020, Discover increased its reserve ratio for its credit card portfolio to 7.2% (up from 5.9% at the end of 2019) and this is actually somewhat light compared to peers (Synchrony reserved 11%, Capital One reserved 9%, American Express reserved 7%). So there is a risk they need to have additional reserves in 2020. I would say that is the bulk of what people expect and that has people concerned.
On the call, management called out a few things to assuage reserve fears:
To give you a sense for how our card portfolio compares today, with how it looked at the end of 2007, our contingent liability, meaning the total open to buy for our card products has been reduced from roughly 5.7 times loans to around 2.7 times. And the percentage of the portfolio below a FICO score of 660 has gone from 26% at that time, down to 19% at the end of 2019. So, while we are not immune from the impacts of deterioration in the economy our portfolio is significantly better positioned than it was ahead of the last financial crisis.
So the open-to-buy has reduced by about $54 billion from the last recession to this recession. Average FICO scores in the portfolio have increased between 500 and 600 basis points, which is a material change. Our underwriting, frankly, is far more sophisticated than it was 10 years ago. And frankly, the actions that this business undertook when the pandemic started to actually drive some real difficult employment numbers was drastic and very, very quick.
Open-to-buy risk is when a consumer is under financial duress so they draw down on their credit cards. So one, they sap liquidity available and two, they increase the risk because the card lenders’ exposure to riskier credits grows. It seems as though Discover is in a stronger position today.
Again, if you have a long time horizon, you’re buying a financials that earns a 22%+ ROE for only 1.5x TBV. That seems too cheap to me.
And now, for something different again. I actually looked up BNP Paribas, the french bank that is one of the largest in Europe, to see how negative rates would impact the US stocks. Clearly ROAs go down, but BNP’s 5-year average ROE isn’t that bad (the shape of the yield curve matters).
Look, a 8% ROE is not that great. But that is 8% return on book equity… and I can buy BNP right now for 0.4x that book value, so return on MY equity should be much higher in the long run.
Let me show a summary example. Assume a bank has $100 of beginning book value, earns 8% on equity and pays out 40% of its income. In year 10, I sell the bank to 0.4x book value, so I get no benefit from multiple expansion or ROEs improving.
The return on my equity is much more attractive.
Look BNP is like any other bank – it will have issues this year. But BNP is a highly diversified bank and I really like how thorough their management team is – their Q1’2020 investor deck was 84 pages!
BNP right now is planning to pay out 50% of its earnings as a dividend, which will be somewhere between a 9-10% yield on the stock. However, the ECB has told European banks that they need to shore up liquidity to support the economy and to cancel dividends for the time being. Even with the dividend, BNP expects to have a 12% CET1 ratio (about 300bps above the Basel III minimums) so I think that would be a huge boon to be able to pay out its earnings.
Last one I am looking at is a small, southeast US bank called Synovus. As shown in the table at the beginning of this post, it trades around 0.7x book and has OK, but not great capital buffers. The banks CET1 ratio is 8.7% compared to their goal of 9%. However, new bank accounting standards result in taking higher losses upfront (called CECL), so the management team relayed that CECL reduced CET1 ratios earlier in the cycle.
As for the downturn, Synovus used to be heavily exposed to commercial real estate, land and 1-4 Family units, but since the crisis has been working to reduce that exposure and get more diversified.
As the company noted, because the loss rates of those sectors was so high, this significantly de-risked the company in a stressed scenario.
We have significantly reduced our exposure to 1-4 family residential, land and investment properties as well as CRE in aggregate. By simply utilizing historical loss rates, the remix of our portfolio alone would result in a 50% reduction in losses. Combined with the improvements in underwriting and portfolio management, we would expect losses to decline even further when evaluating the impact of the severely adverse scenario
Part of the diversification was driven by the banks merger with Florida Community Bank back in 2018. Its funny to look at where Synovus trades now (0.7x BV) compared to when the deal was struck.
But while merging with a Florida bank diversified the company away from being a mainly Georgian bank, Florida isn’t a great spot to be right now. Tourism drives their economy (Disney World!) and COVID-19 will surely wreak havoc. SNV noted 13% of loans were in deferment, which is pretty high compared to peers and the company noted it was in mostly at risk sectors, probably lining up with this slide:
The good news is that the company said “a lot came in, in the first week or 2. We’ve seen it trail off considerably to the point now where we’re really not adding many deferments to that book. And just want to make sure that we’re clear on it. It’s really just a 90-day program.” So seems like the worst is behind us and hopefully back up in running at quarter end (timing well with a re-opening, I would suspect).
Commercial & Industrial loans make up $17.7BN (or 47% of total exposure):
Within C&I, the specialty divisions such as senior housing and premium finance comprise about 14% of total loans and have been a significant contributor to our growth story while also possessing some of the best credit metrics over the last several years. The overall portfolio is well diversified by industry and geography and is extremely granular with almost 35,000 loans with an average original loan balance of approximately $770,000
So clearly the bank is exposed to a bunch of smaller sized loans.
Clearly, SNV is a riskier story, and I would size a position in a portfolio as such, but I think owning Synovus makes sense to buy for a few reasons:
Dividend: Mgmt team seemed committed to the dividend, so we pocket ~7% to wait
The bar is already set low – company used to trade above 1.5x book value. I think BV by YE2021 could be ~$30/share, so trading at 1x would be nearly 60% upside plus a HSD dividend
Take-out candidate: Any bank that wants to increase its southeastern presence or market share could look to acquire SNV. Float a take-out for 1x TBV and I’m sure the synergies would be large and very accretive for the acquirer (branch consolidation, back office savings, etc).
All that said, would I buy more Synovus or Wells Fargo or BNP? I’d probably choose the latter two.
Why did oil prices turn negative? How is that even possible? Typically, instead of paying someone to take a product away from you, you would just stop making that product and wait for another day so you can make a profit. Well, it is very difficult to just stop oil production and wait. It’s very costly to shut-in production and then restart.
What led to this issue? Supply is greater than demand right now. Given the impacts of COVID-19 means the largest consumers of oil have halted (jets and cars). At the same time, we’ve been building supply in Cushing, OK which is America’s key storage and delivery point.
Negative prices may seem attractive when you’re getting paid to take product, but aren’t so great when you realize if you were to take delivery (i.e. receive physical oil) you’d have to pay high prices to store it, which could eliminate all your profits.
Why didn’t the energy ETF sell-off more? If you look at Exxon or Shell or any of the majors on April 20th, their stocks were down maybe 3-4%. In fact, if you looked at Brent futures, the benchmark for Europe, it was selling for $25 / barrel. WTI contract for June delivery was $20 / barrel. Huh?
It all has to do with the futures market. Matt Levine also has a great post on this. In essence, if you want exposure to oil, but didn’t want to actually take barrels of oil, you could buy a futures contract that gives you paper exposure to the commodity until it expires at which point you can either roll the contract (maintain paper exposure) or take physical delivery. If you go to the CME website, you’ll see you can buy oil in 1,000 barrel increments and it is settled “physically” – not financially – so you’d actually have to find a place to store it if you didn’t roll the contract.
When the June oil futures contract price is higher than May, that means the market is in contango. The June cost being higher than May partially reflects “the cost of carry” or storage costs for you to pay someone to hold the oil for you until the contract is settled. In this case, oil went into super contango because the cost of carry went to extreme levels.
This is also why energy companies didn’t sell off more. The “real” price of oil wasn’t actually negative. It was a panic to not settle physically. In fact, if energy companies hedge, they were likely the ones selling futures contracts before this point…
So this caused oil to turn negative? Yes. As traders looked at their May contracts, they realized they couldn’t take physical delivery without paying huge prices. Also, panic probably settled in.
Could it happen again? Yes. And it might given investors decided to buy $USO, the oil ETF, to gain exposure. $1.5BN flooded into the ETF. The problem is that investors bought this fund, which had to create shares and buying underlying, front-end futures contracts. So what did they buy? They forced it to buy June expiry contracts. So now they have exposure to the June contract in a vehicle that cannot take physical delivery and has no choice but to roll contracts. That may very well lead to this issue happening again in a month.
It’s not every day that you hear “recurring business model”, “razor / razor blade”, “route density will drive margins higher” story associated with an industrial company, but here we are. Otis stock has officially spun out of United Technologies so here’s my initial read. In other words, a starting point to see if there should be more work done. I like to take quick looks at topical names (and spin-outs can get interesting) so more of these will likely follow.
Things I like:
Service Drives Profitability:
New equipment sales were 43% of sales, but just 20% of operating profit. That means service revenue, while 57% of sales, makes up 80% of operating profit
This is positive, as it means revenue is much more recurring. Represents a “razor / razorblade” model too in that once the new equipment is installed, the customer needs to come back to Otis for service
The model is pretty simple: Otis sells new equipment and operates under warranty for a couple years. After that, Otis sells long-term service agreements that typically last ~4 years.
According to the company, an elevator will generate 2.5x its original purchase price in aftermarket service
In fact, service is contractual. And I like that the company reports “Remaining Performance Obligations” because it gives a sense of what sales will be in the next 2 years.
Generates a lot of unlevered FCF:
I was somewhat surprised at the low capital intensity of the business. I would say that this level of capex spend based on my experience is top quartile and that checks a box for Otis stock
Further, working capital is really low relative to total assets & sales
This means the company likely can use a lot of cash for dividends (looking at 40% payout ratio) and buybacks plus possible M&A of other service providers as the company says the space is fragmented.
Consistent business model – life threatening to “skimp” on the service:
I like how this business really hasn’t changed in 100 years. It tells me that the next 10 years will probably look similar to the last. That’s something you can’t say about every business so perhaps this deserves a “consistency premium”
If I was a firm deciding which elevator to choose, I’m not sure I’d take the lowest offer. I think a firm with a solid track record actually matters here. Elevators not only get people to work
Failure here might be unlikely, but the cost is so huge it makes no sense to change. For me, I sense that being true on both new sales and maintenance.
In fact, the company says it has a 93% retention rate following end of the warranty period – not bad!
Things I don’t like
Operating Margins have been declining
At first glance, I thought this might be due to new equipment sales becoming a larger portion of the mix. However, that’s not the case. It has been relatively consistent.
It seems to be China sales are the issue. The company has called out this “mix” effect, but also Otis doesn’t not have leading share there. In this business, density matters. So it will take time for the company to build density and improve margins.
Quote from prior call on Otis on the importance of route density:
“So today, if you look at us versus our peer competitors, we have a 200- to 300 point — basis point premium margin. We believe with our scale and density that will continue through the future. Add that to, again, this drop-through of productivity enhancements. But scale and density matters in this industry. You go to any city, whether it’s this building, anywhere else, if you’ve already got mechanics, if they’re already out on a route and you can add new customers, you get, obviously, a little additional incremental cost, but you get to add to the portfolio significantly.”
Mitigant: Company is targeting supply chain savings (3% of gross spend per year) and thinks it can reduce SG&A from 13.6% of sales to ~12.25% over the medium term, but somewhat of a “show-me story”
China is the growth story
China’s construction growth worries me. The talk of “ghost cities” being built to support GDP makes me concerned that a reckoning is eventually coming. And the problem is that many of these buildings may be unoccupied and therefore you don’t need to service them.
China is the largest elevator market – 60% of global volume. It’s also more competitive it seems.
Mitigant: China is getting more focused on building maintenance code, which should support global players like Otis. It should allow more sales to the big players as well as larger service contracts. Real estate developers in China are also consolidating, so it likely means they will want to work with one supplier.
Otis Stock Valuation:
I would say the valuation here is reasonable. Not super compelling in the COVID world, but at least it should be a long-term compounder.
Thysennkrupp’s elevator business was acquired by private equity for $18.7BN, or roughly 17x forward EBITDA. That would point to Otis stock being very cheap on that basis… Given it’s stability and strong cash flow, I can see why P/E would buy out a player. Otis stock is actually a mid-cap, but not too big for someone in Omaha…