Monday, February 11, 2019

Why SunTrust and BB&T? Why?

I know on the investor conference call, Kelly King of BB&T and Bill Rogers of SunTrust spoke to why. But I may not have been listening well.

I suppose much of the discussion revolved around scale. So, along with my first inclination, my second inclination was also... why?

The Numbers

Here are their slash lines (read: Assets/ROA/ROE/5-Year Annual EPS Growth/Dividend Yield)

BBT: $225B / 1.47% / 10.95% / 9.5% / 3.3%
STI:  $216B / 1.34% / 11.50% / 15.5% / 3.1%

BBT (bank only) had $6.3B in operating expenses in 2018, five percent of which is in the Call Report category "Data Processing Expense", defined as expenses paid for data processing and equipment such as telephones and modems. It does not include employees. STI (bank only) had $5.4B, 10% of which was in Data Processing Expense. I find it difficult to believe they can't find enough money in that pot or outside of the Data Processing pot for technology innovation. It would be a travesty of management. 

Perhaps they would find it difficult to maintain that level of EPS growth, given the law of large numbers. But they chose to solve that problem by becoming larger? BB&T will issue 1.295 shares for each SunTrust share outstanding, increasing their share count from 777 million to 1.4 billion. So to earn one cent per share more, the combined company would have to generate $14 million in additional net income. And at the 1.5% ROA BB&T already achieves, they would have to grow $933 million for each penny of EPS growth. To maintain 10% EPS growth, the combined bank would have to grow about $39 billion per year (42 cents x $933MM).

Perhaps they felt the pressure "to do something", as my BB&T regional business banker friend told me, saying that at their size they were in "no man's land". I don't know what that means. But an investment banker told me today that investors are intolerant of tangible book value per share dilution of more than three years. So if you feel you need to "do something", and can't overly dilute your book value, perhaps a merger of equals (MOE) makes sense.

I have preached MOE virtues for banks that could actually benefit from scale to achieve better efficiency ratios. Statistically, banks between $5B and $10B in total assets are better at it than larger financial institutions. But I digress.

Law of Large Numbers

I have written in the past about financial institutions running into the law of large numbers, leaving only acquisition as its means to meet shareholder expectations. I'm not saying it's impossible, as JPMorgan Chase did it ($2.6T in total assets, 14% EPS CAGR since 2014). But it's difficult. And JPM received a huge boost from tax cuts. 

Financial institutions, in my experience, are not keen on turning themselves into cash cows, maximizing their profitability with slower growth and paying a higher proportion of shareholder returns in dividends. Financial institutions also don't tend to buy and divest lines of business as a means to stoke shareholder returns, as very large industrial firms do (i.e. GE).

So if BB&T and SunTrust have ample operating budgets to invest in technology, and are delivering strong shareholder returns, in good markets.. i.e. almost the same markets... 

I ask: Why merge?

~ Jeff

Want to be notified via e-mail when new posts are up? Follow by e-mail in the upper right column! I haven't spammed anyone yet!

This article relates to my firm's Financial Advisory services. Click on the link to learn more.

Friday, February 01, 2019

Guest Post: Financial Markets and Economic Update by Dorothy Jaworski

A Long, Cold December 

I could just scream!  After a lengthy stretch of strong economic growth and stock market gains, the inevitable correction arrived with force in the fourth quarter, culminating with a December that can only be described as “tres terrible!”   Stocks of all industries sold off relentlessly in volatile trading sessions featuring price changes of 2% to 3%.  US stocks erased all gains in 2018 and ended the year down 4% to 6%.  If it is any consolation, stocks around the world were much worse.  China’s indices, for example, were down by 25% to 30% for the year.

For the month of December, 2018, the major indices were down about 9%, which was the worst December stock performance since 1931.  Three contributing factors caused the correction:  a tipping point of rising interest rates driven by the Federal Reserve, the ongoing trade wars, and the government shutdown.  The worst trading day was actually on Christmas Eve, when stocks reached their lows for the year.  Then, surprisingly, we actually got a Santa Claus rally (for the last week of December and the first two trading days of January averaging +1.4% since 1969, that brought stocks up over 4%.  So we spent Christmas day feeling bad, but for anyone who hung in there, the month at least ended on a good note.

Meanwhile, while stocks were displaying their volatile price swings, US Treasury yields for longer-dated issues were declining by .45% to .53% from their highs in November, on the 2 year and 10 year Treasuries, respectively.   The yield curve continued to flatten from 2 years to 10 years to only .19% at year-end, 2018, down from .52% at the end of 2017.  The spread between 3 month and 10 year Treasuries is not much better, dropping to .23% at the end of 2018, from 1.02% one year earlier.  At one time, former Fed Chairman Greenspan said that a healthy yield curve had .50% between 2 and 10 years.  Fears of the dreaded inverted yield curve rippled through the markets as investors kept seeing a Fed that would raise interest rates forever.

Inverted Yield Curves

An inverted yield curve occurs when the Federal Reserve raises short-term interest rates too much and longer-term rates are lower or falling below the short-term levels.  Currently the yield curve is not inverted, with the 3 month Treasury yield at 2.42% and the 10 year at 2.69%, but the cushion is only .27%; the Fed recently said that a cushion of .40% is more comfortable.  History has shown that inverted yield curves precede recessions by 18 to 24 months on average, as we saw in 1990, 2001, and 2005.  Since 1960, all six recessions have been preceded by inverted yield curves.  Investors are fearful because they see this type of curve hurting economic activity.  Indeed, banks generally pull back on lending if longer-term loan rates are less than their cost of funds, which are generally based on shorter-term rates.

The Fed has repeatedly said that they do not want to increase short-term rates if that would cause a yield curve inversion.  This leads many, including me, to believe that they will stop raising interest rates and will “wait and see.”  It is actually a good strategy.  Fed policy works with a long lag, so letting the effects of earlier rate hikes catch up would be good.  Long- term rates have fallen back and should only reverse and trend higher if inflation becomes an issue.  Inflation is currently stable or falling.

Money supply (M2) growth has slowed dramatically in the past few years, from a 6% to 7% year-over-year pace just two years ago to a pace under 4% today.  I am one of the “old school” advocates of monitoring money supply because it is used in some formulas for determining GDP growth.  M2 growth has slowed because of Fed tightening, which includes both the raising of short-term rates and the reduction of their balance sheet investments by $50 billion per month, draining money from the system.  Rates are too high and the Fed is too tight.

Large Hadron Collider Update

Many of you that have read my newsletters or seen my economic presentations in the past know about the Large Hadron Collider, the world’s most powerful atom smasher located in a 17 mile long tunnel deep under the mountains of Switzerland.  Back in 2008, the LHC started up with a bang and led to all kinds of new physics particle knowledge.  The discovery of the Higgs Boson particle so far is the pinnacle of the research.  But more physics discoveries (and updates from me) will have to wait.  The LHC was shut down in December, 2018 for two years for maintenance and upgrades.  How much faster and harder can they smash particles? 

The Outlook

All indications are that GDP growth is slowing, reverting back to its “new normal” range than has been in place since 2011 of 2.0% to 2.5%.  I believe that GDP will be stuck in this range, mostly due to the effect of high debt levels of consumers, businesses, and especially government.  Most economists and the Federal Reserve expect growth in 2019 will be 2.3% to 2.6% and lower in 2020.  Some are calling for a recession in 2020, but we should be able to avoid it if the stubborn Fed stops raising rates.  The slowdown in GDP was inevitable because of higher interest rates.  A tightening campaign that started in December, 2015 and has totaled 2.25% has basically offset the boost from tax cuts and the tightening also succeeded in flattening the yield curve.  The Fed has made cautious statements in the past few months about not wanting to raise short-term rates high enough to invert the yield curve.  No one wants that, if it will predict a recession in 18 to 24 months.

I believe that the Fed will not raise rates in 2019.  They will switch to fighting inflation that never came (sorry, Phillips curvers!) to supporting the economy and trying to avoid recession.  Supporting this belief is the fact that Fed Funds and Eurodollar futures, which trade on short-term rates, do not contain any rate increases in 2019.  But remember, just because we believe in no rate hikes does not mean that the Fed will always listen.  They will do what they want. 

Despite a very low unemployment rate of 3.9%, inflation and inflationary expectations have been falling and are at or below 2.0%, which is the Fed’s target.  Job growth continues to support the current expansion, which is now 9.5 years old.  And, if GDP expands through July, 2019, which is expected, we will set a new duration record of 121 months for a recovery, albeit the weakest recovery since World War II.  Supporting continued growth will be consumer spending, jobs, and falling oil and gasoline prices.  Hindering growth will be continued huge government deficits and the ongoing shutdown.

The time has come for a Fed pause.  The markets are a force to be reckoned with, as Chairman Powell has now acknowledged, and their volatility of the past several months, a flat yield curve, and slowing economic data have a newly humbled Fed ready to stop their tightening campaign.   Thanks for reading!  

DJ 01/11/19

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.