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U.S. Banks Initiation
INITIATION
The Tide Is Turning
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Attractive valuations counterbalance credit uncertainty. Our expectations for
improved earnings in 2008, a recent retreat in valuations, and potential nearterm
relief from the Fed position the sector weighting at Market Weight.
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Risk/reward appears fairly balanced. The bank group currently trades at a
discount to historical averages, but valuations remain above lows. Downside
risk estimated at 14-17% based on similar periods of market turmoil, while
our price targets imply 11-14% potential upside.
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Earnings growth—some optimism, but not without risks. We project
earnings growth for the industry to be about 8% in 2008, up from 4% in 2007.
However, expected growth rate is about 400 basis points slower than the
market. Rising credit costs, slowing capital markets, and a decline in
mortgage banking revenues present the biggest earnings headwinds.
Stabilizing margins and a steeper yield curve are the earnings offset.
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Credit is the focal point, but deterioration should remain manageable. Credit
measures are expected to normalize in 2008, but it should be a manageable
event for most companies. Low reserve levels remain a primary risk. Our
expectations for higher provision costs shave about 4% off our expected
earnings growth rate for our coverage universe in 2008.
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Large caps are the safe haven, but mid caps offer best risk/reward. Large
caps are a dividend play, but potential price appreciation is limited, in our
view. We are most cautious on small-cap regional banks. Mid caps with
discounted valuations, stabilizing margins, and proven risk management
offer best risk/reward, particularly with relief from the Fed.
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Best risk/reward—BBT, ZION and CNB. Best defensive play—USB. Most
Cautious—CYN, UB, and WAL.
Industry Overview
Sector Weighing: Market Weight
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It has been a rough ride for bank stock investors so far in 2007, as historically high
valuations, together with a fairly steady stream of downward earnings revisions, have
weighed heavily on the group’s price performance. Earnings remain pressured by
challenging fundamentals, including normalizing credit measures and persistent
margin compression. And while investor optimism for a soft landing and consolidation
activity have benefited valuations for the better part of the year, investors have
received a cruel reminder of late as to how perceived credit concerns can undermine
bank valuations. At this stage, the Credit Suisse Bank Index is down 11% since the
summer credit meltdown in early June and down 15% since the most recent peak in
February 2007. While valuations have become more attractive in recent weeks, the
uncertainty on the credit front and the Fed’s willingness to bailout the excess market
leverage are still risks, in our view. And, while it is tough to get too excited on the
sector with credit metrics still hovering near historical lows, the recent retreat in
valuations and strong balance sheet position of the industry are enough to warrant a
Market Weight for the sector.
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Despite the underperformance to date and expectations for a Fed rate cut in the short
term, the historically low credit metrics keep us from being more aggressive on the
group. Credit/liquidity worries have surfaced throughout the global economy,
exacerbating investor fears and challenging the Fed. Loan loss reserves are at
historical low levels and the scope of potential credit problems is still unclear at this
time. And, while we think that banks have the capital strength to handle any looming
credit quality issues, it is still too early determine how severe or long the potential
credit downturn will last. To be sure, credit measures will continue to normalize off of
historically low levels and the subprime flu will further pressure the sector as the
tremendous backlog of mortgage resets continues to roll off. Moreover, we remind
investors that every credit cycle tends to turn out differently (i.e., emerging markets in
the 1980s, commercial real estate in the early 1990s, and large corporate credit in
2002). At this time, however, mortgage-related loss levels remain exceptionally low for
most traditional commercial banking companies (mostly prime lenders) and
commercial real estate losses remain nominal and well below the historical long-term
averages. And, only time will tell how the LBO financing frenzy turns out. In short, we
are not overly optimistic about the sector’s prospects in 2008, but the recent valuation
retreat, combined with expectations for some near-term relief from the Fed, is enough
for us to recommend a Market Weight position on the sector.
Table of Contents
Industry Overview 4
BB&T Corp. (BBT) 55
City National Corp. (CYN) 65
Colonial BancGroup Inc. (CNB) 74
Community Bancorp (CBON) 85
CVB Financial Corp (CVBF) 95
First Community Bancorp (FCBP) 105
M&T Bank Corporation (MTB) 114
Regions Financial Corporation (RF) 122
Synovus Financial (SNV) 132
TCF Financial (TCB) 142
UnionBanCal (UB) 151
Umpqua Holdings Corp (UMPQ) 160
U.S. Bancorp (USB) 169
Wells Fargo & Company (WFC) 179
Western Alliance Bancorp (WAL) 190
Zions Bancorporation (ZION) 200
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