BOFI Axos Finl (delisted)

U.S. Banks are on track to regain their footing in terms of earnings despite strict regulatory requirements. But the industry’s growth momentum slowed down in the third quarter with lesser mortgage activity and a few mega-players being muted by legal settlements.   

However, financial institutions that depend less on risky activities and resort to other profit-making ways seem to have a brighter future thanks to their fundamental strength.

Overall, expense control, sound balance sheets and lesser credit loss provisions should continue to remain the key earnings drivers in the upcoming quarters. Moreover, a favorable equity and asset market backdrop, falling unemployment, a progressive housing sector and flexible monetary policy are making the road to growth even smoother.

Yet uncertainty related to top-line growth looms due to lack of significant loan growth (primarily the home equity lines of credit), pressure on net interest margins from the sustained low rate environment and less flexible business models owing to stringent risk-weighted capital requirements (Basel III standards). However, banks have been gradually easing their lending standards and trending toward higher fees to dodge the pressure on the top line.

Now that the interest rate environment is reversing, net interest margins are likely to improve and support the top line significantly. But revenues from mortgage fees will lessen as the boom in mortgage refinancing fizzles out. Whether the loss of fee revenues will be compensated by gains from interest rate spreads can however be said only in the course of time.

We don’t see this issue-ridden sector returning to its pre-recession peak anytime soon. What encourages us though is that the U.S. banks are taking legal and regulatory pressure in their stride, indicating their ability to encounter challenges.

Overall, structural changes in the sector will continue to impair business expansion and investor confidence. Several dampening factors -- asset-quality troubles, mortgage liabilities and tighter regulations -- will decide the fate of the U.S. banks in the quarters ahead. But the new capital regime will ensure long-term stability and security for the industry.

Zacks Industry Rank

Within the Zacks Industry classification, U.S. banks are broadly grouped in the Finance sector (one of 16 Zacks sectors) and are further sub-divided into six industries at the expanded level: Banks-Major Regional, Banks-Midwest, Banks-West, Banks-Northeast, Banks-Southeast and Banks-Southwest. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank. http://www.zacks.com/zrank/about_ind_rank.php

As a guideline, the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Banks-West is #14, Banks-Midwest is #24, Banks-Northeast is #47, Banks-Southwest is #68, Banks-Southeast is #73 and Banks-Major Regional is #101. Considering the Zacks Industry Rank of the six banking industries, one could safely say that the near-term outlook for the group is leaning toward 'Positive.'

Earnings Trend of the Broad Sector

The broader Finance sector, of which U.S. banks are part, is in good shape with respect to earnings so far this year. But the third quarter was somewhat downbeat compared to the prior two quarters.

Total Finance sector earnings increased 9.9% on 0.6% higher revenues, with 59.0% companies beating earnings and 46.2% coming ahead of revenue expectations. This compares unfavorably with a substantially higher earnings improvement of 32.5% on 7.9% growth in revenues in the second quarter of 2013 when 76.9% companies beat on earnings and 61.5% surpassed revenue estimates.  

Importantly, excluding the huge contribution from Bank of America Corporation (BAC), the sector’s performance was just average, with only 3.3% earnings growth.

Yet, the sector is heading in the right direction to regain its leadership in earnings contribution in the S&P 500 this year. It contributed 19.2% to the Index earnings so far this year, the highest among all sectors. However, the sector is yet to achieve its record 27% share of the Index earnings in 2007.    

Earnings Preview: Q4 Estimates Show Potency

The consensus earnings expectations for the fourth quarter and full year 2013, however, depict a fairly strong trend. Earnings growth is expected to move up to 20.3% despite an expected revenue decline of 7.8% in the quarter. For the full year, the sector is expected to witness 13.9% earnings growth despite a 10.2% decline in revenues.

However, with continued expense management by sector participants, margin is expected to show improvement. Net margin is likely to increase 370 basis points (bps) year over year to 15.7% in the fourth quarter. The full year is also likely to see a 340 bps margin improvement.

What Do Lower Q3 Earnings at FDIC-Insured Banks Signal?

For the first time since the second quarter of 2009, Federal Deposit Insurance Corporation (FDIC) insured commercial banks and savings institutions witnessed a year-over-year decline in earnings in the third quarter of 2013. Net income came in at $36.0 billion, lagging the year-ago earnings of $37.5 billion by 3.9%.

However, this does not signal trouble in the industry, as a $4 billion increase in litigation expenses in one institution was primarily responsible for dragging the results down. “Had it not been for that, the upward trend in earnings would have continued for the industry,” said FDIC Chairman Martin J. Gruenberg.

On the fundamental side, reduction in mortgage lending activity was the biggest dampener. Mortgage originations are less likely to show any favorable trend in the quarters ahead given the increase in lending rates that will lessen the demand for mortgage re-financings.           

In addition to contraction in provisions for credit losses and cost containment, continued recovery in the bond and equity markets, and the consequent growth in noninterest income should keep boosting earnings. Moreover, prolonged improvement is expected from the settlement of major legal issues that weighed on the mega players.

Fewer Bank Failures and Problem Institutions

During the third quarter of 2013, failure of the FDIC-insured banks lessened to just 6 from 12 in the year-ago quarter. In total, 23 banks failed in the first nine months of the year compared with 50 in the same period a year-ago. Moreover, as of Sep 30, 2013, the number of banks on the FDIC's "Problem List" declined to 515 from 553.

The slower pace of bank failures and decline in problem banks indicates continued improvement in the sector. Though there will be fewer bank failures in 2013 compared to 2012, the industry is still to see an average failure of just four or five banks annually, which would indicate maximum strength in the industry.     

Growing Faster Will Not Be Easy

As the gap between loss provisions and charge-offs is gradually narrowing, reduction in provisions is not likely to remain a significant earnings driver in the upcoming quarters. So banks are trying to look at other areas -- primarily non-interest income and operating costs. But opportunities will be curbed by regulatory restrictions and a still shaky economic recovery.

Efforts to cut interest expenses and take additional risks to improve net interest margins could be marred by a still-flat yield curve. Further, shifting assets to longer maturities for strengthening net interest margin could backfire with the expected increase in interest rates in the near term.

Conversely, increasing revenues through non-interest sources -- charges on deposits, prepaid cards, new fees and higher minimum balance requirement on deposit accounts -- could be hampered by regulatory actions and soaring overhead. However, with a rebound in capital market activity, the propensity to invest in the market has increased, which may lead to more non-interest revenue sources.

Eventually, banks will have to take resort to cost containment through job cuts and reduced operational size. But any cost-cutting measure will act as a defense. The industry witnessed more than half a million layoffs over the last five years just to stay afloat, and the story will continue.

Balance Sheet Recovery on Track   

Steady deposit growth from lack of low-risk investment opportunities is quite possible, but high charge-offs and delinquency rates plus weak demand could keep loan growth under pressure in the near to mid term. Though banks are easing lending standards to accelerate loan growth, credit quality concerns are likely to mar the effort.

Moreover, though growth in gross domestic product (GDP) and reducing unemployment will help banks strengthen their balance sheets, expected unrealized losses on underlying securities due to rising interest rates will act as dampeners.

However, banks are trying to reorganize risk management practices to address potential solvency issues from rising interest rates. Efforts are also being given to address asset-quality troubles by divesting nonperforming assets. Yet, we don't expect balance-sheet strength to return to pre-recession peak anytime soon.

OPPORTUNITIES

Though improved performances by banks seem already priced in and significant concerns remain, the sector is unlikely to disappoint investors in the upcoming quarters.

Specific banks that we like with a Zacks Rank #1 (Strong Buy) include BofI Holding, Inc. (BOFI), TriCo Bancshares (TCBK), First Interstate Bancsystem Inc. (FIBK), Mainsource Financial Group (MSFGTM), Arrow Financial Corporation (AEOW), Center Bancorp, Inc. (CNBC), Southside Bancshares Inc. (SBSI) and American National Bankshares Inc. (AMNB).

Stocks in the U.S. banking universe with a Zacks Rank #2 (Buy) currently include KeyCorp (KEY), Bank of Hawaii Corporation (BOH), City National Corporation (CYN), Associated Banc-Corp (ASBC), Chemical Financial Corporation (CHFC), First Commonwealth Financial Corp. (FCF), The Community Financial Corp. (TCFC), BancFirst Corporation (BANF) and Bank of the Ozarks, Inc. (OZRK).

WEAKNESSES

Difficulty in liquidity management due to regulatory restrictions will restrict top-line growth of banks in the quarters ahead.

Specific banks that we don't like with a Zacks Rank #5 (Strong Sell) are Banc of California, Inc. (BANC), Farmers Capital Bank Corporation (FFKT). We also don’t recommend a few Zacks Rank #4 (Sell) banks including VantageSouth Bancshares, Inc. (VSB), Tristate Capital Holdings, Inc. (TSC), BOK Financial Corporation (BOKF) and First Horizon National Corporation (FHN).
 
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