Category: Security Analysis

4 Bank Stocks Worth Considering $WFC $DFS $BNPQY $SNV

Bank stocks have gotten hammered this year. In fact, they only trail energy in terms of worst-performing asset classes.

(thanks Callum Thomas for this chart)

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).


Wells Fargo:

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).


Discover:

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.


BNP Paribas

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.


Synovus

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. 

Otis Stock Spin-out from United Technologies – Quick Thoughts $OTIS

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…

Will Exxon Need to Cut its Dividend? $XOM

Saudi Arabia and Russia are in a price war — increasing the supply of crude oil at a time when we are seeing an unprecedented collapse in demand due to the coronavirus (COVID-19). Exxon has gotten crushed this year, down 45% YTD with a 9% dividend yield. They’ve consistently paid, and grown, the dividend over the past 37 years. Exxon’s dividend offers a juicy proposition for a company that is rated investment grade and at a time when the 10 yr treasury yield is <70bps.

But let’s do some quick math to see if the dividend is covered, first by looking at 2019 figures. As shown below, Exxon did $1.5BN in FCF.

This is not good. The Exxon dividend cost $14.6BN in 2019.

One thing we could do is look at what bare-bones capex is. In other words, what did the company spend in 2015/2016 when the oil outlook was also bleak? Cutting capex down to those levels would help preserve cash:

So now we have ~$10.5BN of FCF, but that still doesn’t cover the Exxon dividend. The other problem is that cutting capex is not what the company wants / intends to do. As stated in their March 5, 2020 investor day, they will actually be spending more than 2019:

On April 8, Exxon said it would cut this figure by 30%

Even so, cutting capex back doesn’t help. And the bigger problem is that oil was roughly 100%-200% higher in 2019 than it is right now.

What other ways could the Exxon dividend be maintained?

  • They could sell assets, but what price would they get in a time like this?
  • They could issue a bond to help cover it – but do you want an increase its debt load? Is jeopardizing the company for the dividend worth it?

I think its a matter of when, not if. Besides, I personally don’t think the oil industry is dead – there must be good long-term investment opportunities out there for them now that so many players are distressed.

Should you buy Homebuilder stocks?

Given the market selloff, I’ve seen a lot of doom and gloom articles on buyers’ appetites for homebuilding. Will buyers still show up to buy a home with COVID-19 going around? What will the impact on interest rates have?? All of this makes me wonder if Homebuilder stocks have reached attractive levels…

I personally like to buy when people are fearful…

Check out these headlines:

All these headlines essentially result in one thing… Agh! Panic!

Panic

Since most people hold a majority of their net worth in a home, these headlines draw eyeballs.

But let’s think about this for a moment. Yes, the coronavirus may impact my willingness to go out to eat. To ride the subway. To cheer on my favorite team at a sports bar (looking at you March Madness).

But is it going to cause me to stop buying a house? Especially when credit is readily available and interest rates just hit all time lows for a mortgage?

I personally have trouble seeing it. And so far, we aren’t in quarantine and the data has been supportive:

  • Redfin noted in early March, “Demand is still growing at surprisingly healthy levels. And growth in the number of people submitting offers is much higher.”
  • Even at ground zero for coronavirus in the US, Seattle, they noted, “Now coronavirus fears have spread from Seattle to other parts of the country, but we haven’t seen a big impact on home-buying demand yet.”
  • Hovnian, a national builder, had a lot of positive things on its results call:
    • Talking about reported results:

“Some may say that the strong increase was against an easy comparison last year. I’m pleased to say we were also up 33% compared to the first quarter of 2018. Additionally, our sales pace was the highest level of contracts per community for any first quarter since 2005. It’s clear that the housing market is rebounding and demand for our homes continues to gain momentum.”

    • Regarding the virus impact specifically:  “Sales feel particularly and perhaps surprisingly steady and solid”

It makes sense. The 30 year mortgage rate has made it super compelling to buy a home. This will obviously help the homebuilder stocks.
30 Year Mortgage Rate Chart

30 Year Mortgage Rate data by YCharts

At the very least, those that own a home can refinance and keep some more cash in their pocket each month.

At the same time, we’ve been underbuilding in this country since the downturn. While we overbuilt in the last downturn, we’ve been growing as a country (creating new households) but new starts haven’t kept up. We were just now getting to mid-cycle levels before coronavirus caused a drop off.

I think this will lead to pent up demand when we come out of this which will support Homebuilder stocks

I personally am looking at the homebuilder equities. Toll brothers and Lennar are trading just above 1.1x BV. These are companies that have cleaned up their balance sheets and are generating ~13% ROEs. That seems cheap to me. Toll has also been buying back stock like its nobody’s business. This could even be a shot to buy NVR, a great blue-chip.

Could we see a pause? Sure. But I think the longer-term fundamentals are strong and that this virus won’t impact their intrinsic value.

Is it Time to Buy Cruise Stocks? Intrinsic Value Impact from Coronavirus

People are saying that no one will ever take a cruise again. It’s over. Done. Pack those cruise ships up and send them home… But do people actually not remember the PR disaster Carnival dealt with in 2013? Here’s a great headline from that time:

Stranded cruise ship on which ‘sewage ran down the walls’ and ‘savages’ fought over food finally docks amid jubilant scenes“.

This came not too long after Costa Concordia wrecked and the Captain jumped ship (literally). 32 people died.

Beware of anecdotal evidence!


I bet you can imagine what happened to Carnival’s sales in 2013 then?

Oh, that’s right – they were up. In 2014 they were up… they’ve basically been on an uninterrupted pace for a long time. In fact, many of these cruise lines have been public for so long that you can see how they performed after SARS, 9/11, 2008, Zika, Ebola – they pretty much kept on humming. Apparently nothing will stop college kids and boomers from taking a cruise. So is that an opportunity to buy cruise stocks?

I’m not saying you should buy them today, but they’ve historically traded at 10-13x EBITDA and are now trading at 5x. The market is currently pricing in death. I can confidently say that because they now are trading below the book value of cruise ships as well.


Now, one problem with cruise stocks is liquidity.

Cruise companies do have ship deliveries, which is something to monitor. This could crimp liquidity as they also take a demand hit in the next year.  But they also likely have tools to pushback on shipbuilders during times of stress. These are the shipbuilders main customers, so not like they want their customers to go into bankruptcy either.

However, some names like Royal Carribean are investment grade and “December 31, 2019, we had liquidity of $1.5 billion, consisting of $243.7 million in cash and cash equivalents and $1.3 billion available under our unsecured credit facilities, net of our outstanding commercial paper notes”. Norwegian just announced at $675MM revolver with JPM priced at L+80bps.

I think the liquidity situation is fine to support a year of weakness, though admittedly, I’m not sure they could survive a whole year of lost revenue. Plus, the ships must be very expensive to dock and that is an ongoing fixed cost….


Lets just try to understand if this virus or 1 year impact should have that much of an impact on cruises (people will fight me on this, but I don’t think cruises are dead… people will still take cruises) but this is relevant for all businesses right now, not just cruise stocks.

Here is a company that is expected to earn $10 in EPS in year 1 and grow ~2% a year. I discount these earnings, and the terminal value, back at 10% to arrive at ~$120 in value, which foots to a 12x P/E. P/E is just short hand for a DCF and that is what I am trying to show here so you can think about if a multiple compression actually makes sense.

*Note: terminal value is the value of a the future cash flows of a business beyond the forecast period, assuming a constant growth rate, in this case 2%.

Now lets say year 1 earnings are toast – they get cut in half. But year 2+ are the same because demand comes back. As you can see below, this had a ~4% impact on the intrinsic value of the business… not 50%! People may say, “well investors only look at earnings over the next year or two, so applying a 12x multiple to $5 in EPS is why the stock gets crushed.” Thanks – I realize that, but the math says that is wrong and an opportunity to make money.

Buying cruise lines is risky right now and up to you. Sorry for the headline, but hopefully you use this as a tool to find other companies who have not had their intrinsic value meaningfully impacted.