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A Recap of Second-Quarter Bank Earnings and More

By Matthew Frankel, CFP® - Aug 4, 2019 at 11:54AM

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Now that earnings season is underway, here’s how the big banks are doing.

We've now heard the latest results from most of the major U.S. banks, so in this episode of Industry Focus: Financials, host Jason Moser and Motley Fool contributor Matt Frankel, CFP, break down what investors need to know. Plus, they dig into the war on cash and how cryptocurrencies could potentially affect some of our favorite payments companies. They also give us their favorite foreign fintech companies to keep an eye on. All of this and more on this week's installment.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 29, 2019.

Jason Moser: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market each day. It's Monday, July 29th. I'm your host, Jason Moser, and we've got a lot to get to today on this show as we recap the latest earnings from the big banks. We're going to get to a couple of listener questions here on payments and crypto. We're going to roll some Ones to Watch into those emails as well. Joining me in the studio, back from his vacation in sunny Key West, and he's a year older, folks, certified financial planner Mr. Matt Frankel. Matt, how's it going?

Matt Frankel: Pretty good! It was good to be back in my old hometown. We lived in Key West for five years. It was good to show the kids were Mom and Dad met and all that good stuff.

Moser: I feel like I jumped the gun and I probably said, "back from sunny Key West," assuming that it was sunny, but I have to believe it was pretty good weather.

Frankel: Oh, it's beautiful! You're from South Carolina. You know how hot the summers can be here.

Moser: Oh, yeah!

Frankel: It was actually cooler down in Key West than it was here. 

Moser: You probably get a nice little breeze off the ocean there.

Frankel: About 88 degrees and island breezes every day. It was really nice.

Moser: Sounds like my kind of place. [laughs] Well, while you were gone, we had a lot of the banks here who have reported earnings. The big banks, at least, got us kicked off here for Earningspalooza. We had reports from Wells Fargo (WFC -0.79%), JPMorgan (JPM -0.82%), Citigroup (C -0.06%), you name it, and Bank of America (BAC -1.71%). We were talking about, leading into this earnings season, a lot of themes centered around share buybacks and this little bit more of a challenging environment with lower interest rates. Wanted to get your take on how these big banks are faring thus far. What did you think about their reports?

Frankel: Well, all in all, it was a pretty good quarter. All four of the big banks beat on earnings. Most beat on revenue. Efficiency was great across the board. Returns are doing well. Tax reform had some boost to that. JPMorgan, for example, ran a 16% return on equity. If you're doing that, you're doing something right. 

But there were some causes for concern. Loan growth was pretty slow across the board, which could be a troubling sign that the economy's slowing down a little bit. JPMorgan's consumer loan portfolio actually declined. Deposit growth slowed down. Most of all, interest margins are contracting. That's somewhat to be expected because long-term interest rates have fallen a little bit in anticipation of the Fed lowering rates. When long-term interest rates fall -- like, say, the bank can't charge as much for an auto loan -- you would expect its profit margin to go down a little bit. The magnitude of the interest margin drop caught investors by surprise. Bank of America completely missed its projections for interest margin. JPMorgan reduced its full-year guidance for interest income. That was a bit of a disappointment. But interest rates will rise and fall over time. You can't do anything about it. 

Banks are doing well from a long-term investor's perspective. Interest rates might squeeze margins a little bit more in the near term.

Moser: I think you're right. Generally it did seem leadership for the most part was bullish on the consumer. They felt like it was a good consumer environment. That comes and goes as well. Just to put a little context around the share buybacks, I was looking through these banks to put some numbers around it, Citigroup spent $3.5 billion in the quarter on buybacks. JPMorgan spent $5 billion on repurchases. Wells was about $5 billion as well. At Bank of America, $6.5 billion in buybacks. I think that goes along with the theme that you were talking about here a couple of weeks ago. Given that these banks all just got the green light to buy back even more stock, not terribly surprising. 

Now, that's always part of thesis with investing in banks -- that they're going to return some value to shareholders in the form of buybacks and dividends. I'd just rather see them raise those dividends a little bit more. Either way, they're going to have an effect on the bottom line pricing that we're getting as shareholders.

Frankel: The banks especially, like you said, they're buying back stock so quickly. Just to name one example, Citigroup grew its earnings 12% year over year, but it reduced its outstanding shares by 10% year over year. In other words, almost all of its earnings growth can be traced back to the buyback itself and not actual growth. Their loans grew by 1%. Deposits grew by 2%. Margins, like I said, actually dropped. It's not like Citi's doing 12% better than they were last year, it's just that they bought back a ton of stock so there's less shares to distribute their profits among.

Moser: Yeah. Also, Citigroup is the one that stood out to me because looking back in history, you go back to 2008, 2009, 2010, where these banks were in a load of trouble, and some listeners may remember, Citibank actually executed a reverse split because their share price was in the tank and they needed to do something in order to attract new investment and stanch the bleeding a little bit. I think that back then, we were all looking at Citigroup as one of the weaker banks, one of the banks in a bit more of a precarious position. It's not to say that, fast forward to today, it's been a great investment. But by the same token, you look at the 10-year chart for Citigroup, I actually have to tip my cap to them for getting this thing back under control. You would have made money owning those shares over the last 10 years.

Frankel: If you look back before the crisis, I think their split adjusted all-time high is something like $600. They're not quite there yet. But no, Citigroup even after the split was a small fraction of where it is today. Not just looking at this stock price, but if you had told me 10 years ago that Citigroup was going to be the most efficient of the big four banks -- which it was this quarter, it was 56% and the rest were 57% or higher. So, it was the most efficient bank, it was running a 10% return on equity -- which isn't great, but it's good. And, buying back 10% of its outstanding shares a year. I would have called you crazy. And look, here we are.

Moser: [laughs] Here we are, indeed. Well, I'm going to put you on the spot. With that in mind, looking out three to five years, as we do when it comes to our investments, if you're looking at these four banks -- Citigroup, JPMorgan, Wells Fargo and Bank of America -- is there one of those four banks that comes out of this earnings season looking a little bit better to you than the other three?

Frankel: Bank of America. I know I'm always on Bank of America's side. I'll tell you why in this case. Bank of America had by far, by far, by far, the best loan and deposit group of all the big four banks.

Moser: I noticed that! Something like 6%, wasn't it?

Frankel: It was 4% loan growth and 6% deposit growth. JPMorgan was second place and they had 2% loan growth. Wells Fargo is obviously not allowed to grow right now. Citigroup, I just mentioned, grew its loans by 1%. So, 4% loan growth in that environment looks pretty good. I love Bank of America's management. I think they've done a fantastic job since the crisis. I think they're the biggest turnaround story. Citigroup has done well since the crisis, but Bank of America -- and, Warren Buffett just bought a ton of it a few years ago and continues to buy more. There's a reason for that. It's because it's probably the best run of the big four banks right now, in my opinion.

Moser: OK, good stuff. Let's move on over to an email we got from a listener. This comes from Stock Advisor member Gary J. Gary says, "Hi from a PayPal, Mastercard and Square investor. I'm both concerned and curious about the possible effects that cryptocurrency could have on the war on cash stalwarts and fellow travelers. Just the perception of a possible disruption in the digital payments space could be enough to send the stocks tumbling even if the perception is wrong and the companies behind the stocks are as robust as ever. Then, there's the possible reality that the perception is real. Can we envision a world where the digital payment companies peacefully and profitably coexist with cryptocurrency? Or is that world unlikely to emerge in the next 10 or 15 years?"

Matt, I wanted to bring this in because we get to talk a lot about crypto and payments on this show, and I like the question because when I think about the payments space, cryptocurrency to me is addressing a different need, a different issue. I can certainly see a world where they peacefully coexist. I don't see a world necessarily where crypto is supplanting these payment companies. That's just my point of view. What's your take?

Frankel: I think it's actually incorrect logic to think of the payments companies and cryptocurrencies as two different things. If you look at Square, Square integrated Bitcoin trading over a year ago, and Jack Dorsey's a big fan of cryptocurrencies. The other ones you mentioned -- Visa, PayPal, MasterCard, I believe all three of those are partnering with Facebook for its new Libra cryptocurrency. These companies know that cryptocurrencies are a real thing. They know that there's some future potential, whether you love the current cryptocurrencies or not. They know there's definitely future potential in digital assets like that. And they're not just sitting on their heels right now. They're actively making investments in blockchain technology, actively looking at ways that cryptocurrencies can be integrated into their existing businesses. So, I don't think of them as two different things, or even things that would have to coexist. I think, if it turns out that cryptocurrencies really start gaining traction, they're going to be a big part of the four companies we just mentioned.

Moser: That's a very good way to look at it. To me, when we look at Facebook Libra, for example, and the intentions there -- and I think it's really important to note that this is not off the ground yet. They're under a lot of scrutiny for this, I'm a little bit skeptical that it even materializes, to be honest with you. But, on the flip side, I don't think there's any downside at all for these companies like PayPal and Visa investing. That's just a nominal investment on their part that, if it doesn't pan out, it doesn't pan out, it won't affect them at all. It's just a rounding error. But the intentions there with Facebook Libra, at least, are to focus more on the unbanked and underbanked and bringing the costs of moving money down. 

Now, that all depends on where you're trying to move that money. In today's day and age, whether it's Square or PayPal or MasterCard or Visa or any of these other payments companies, the cost for moving money around, that cost is coming down considerably and quickly. But to your point, it does seem like all of those companies are at least giving cryptocurrency some attention, thinking that it will be a part of our future in some way.

Frankel: Yeah. I especially think it'll have a lot to do with how we process payments internationally. I don't know if you saw the story about MoneyGram, I think it's Ripple they're partnering with, to pretty much process all their overseas transfers because it's so much cheaper and quicker that way. In that sense, cryptocurrency could actually be a money saver to those companies. Visa can charge their customers less for international transfers and still make a higher profit margin if the transfer is actually being done with a digital asset as opposed to a traditional method like a wire transfer.

Moser: Yeah. I guess the bottom line there for Gary, maybe you and I are thinking the same thing here, is that as cryptocurrency evolves and becomes whatever it becomes, I don't necessarily see it as a threat to these payments companies as much as I see it as being another part of a holistic solution.

Frankel: Yeah, I think that's what we're saying. They're not necessarily two separate entities. Cryptocurrencies could actually help the companies. They could be one in the same.

Moser: Yep, very good. Gary, hope that answers your question. I'm not selling my war on cash investments, big guy, and I'm not too sure that you should worry about yours, either. 

Matt, we're going to dive into our Ones to Watch this week, but we're going to do a little something different. We got another email from a listener out there. It seemed like this fit perfectly into this segment here. The email is from Melissa Brown. Melissa writes, "Hi, Jason and Matt. I'm a huge fan of the show." I'll just leave it right there, Matt. I'm not going to finish the email because that made me feel so good. She's a huge fan of the show. We can just leave it right there, right? [laughs] Nah, I'll finish it. "I'm a huge fan of the show. I really appreciate all of the great help you both provide us investors. I started my own war on cash basket with Square a while back, and then I added PagSeguro and StoneCo at the beginning of the year. I was wondering if maybe you could do an international or South American payments podcast. I know one of the Industry Focus podcasts talked about MercadoLibre and the move they're making in payments. Unfortunately, I missed out on MercadoLibre, but PagSeguro and StoneCo both also appear to be great high-growth companies in the payments space. I would love to hear your thoughts on those three and any others you're interested in."

Thanks, Melissa, for the kind words and for the questions there! I'll go ahead and get in front of MercadoLibre first because we have talked about that one a number of times. We can certainly find some back episodes to support our ongoing belief in that business and the different ways that it makes money. But we are going to focus here on PagSeguro and StoneCo for you. Matt, I'm going to kick it over to you first. Talk a little bit about StoneCo. What are your thoughts on this investment idea?

Frankel: StoneCo is definitely One to Watch over the next few years. You might have heard us mention it on the show before. Late in 2018, Berkshire Hathaway bought an 11% stake in the company. It was one of the other stock pickers, not Buffett, who did it. But we mentioned it in that context. It's a Brazilian fintech company that does payment processing. They provide point of sale terminals to businesses, things like that. It's just growing like a weed. Revenue was up 86% over the past year. Payment volume up 60%. The margins are improving, which they call the take rate. That's the percentage of the transactions that they actually pocket. And it's profitable, unlike some of these foreign fintech companies that you're seeing. They actually had pretty good earnings this past quarter. This is definitely one to watch going forward, not just because it's a Buffett stock, but that should definitely make you take a look at and ask why it was good enough for Berkshire. They're not known for betting on fintech companies. They're known for investing in things that they see real potential in. So, I think this is definitely One to Watch over the next several years.

Moser: Good stuff there. Melissa, I took PagSeguro for you. That ticker is PAGS. PAGS is a payment company for micro merchants and small and medium-sized businesses, primarily in Brazil. I looked through this business and I came up with three things that I like, perhaps one thing you want to keep an eye on. First thing I like: they're profitable and growing. At the end of 2018, they were growing revenue at a compound annual rate of a little better than 80%. It's a big company, $15.5 billion market cap, with a strong balance sheet, close to $650 million in cash and no debt. It is a fairly new IPO. Just got going public a little bit more than a year ago. That's always worth remembering. I also like brand awareness there. It's a very competitive space, for sure. They state in their annual report specifically that PayPal and Mercado Pago are competitors. According to Google Trends in August 2017, for every 100 Google searches for the term PagSeguro, there were 21 for the term Mercado Pago and 23 for the term PayPal. So, it does seem like PagSeguro certainly has some brand awareness there, which I think matters when you're going up against companies like PayPal and MercadoLibre.

The numbers are impressive. Looking through their last conference call, their total payments volume reached 24.4 Brazilian reals. They ended the quarter with 4.4 million active merchants, adding 1.3 million new clients year over year. There's a lot of encouraging data there that tells us the company is growing. We know they're pursuing a big market opportunity in the payments space. 

One thing for investors to keep in mind, it is a bit of a convoluted organizational structure. The entity UOL or Universo Online owns 94% of the voting power of the company. It's not even really to necessarily say that's a bad thing. UOL has a lot of resources at its disposal. But the bottom line is, this is a Brazilian company with an involved ownership structure. Sometimes that can make it difficult to connect the dots when it comes to decision-making and strategy. 

All in all, I think this is a compelling idea. I think it's one where a little bit of exposure can probably go a long way. You want to make sure you position size this one appropriately. Right, Matt?

Frankel: Yeah, I would echo that first StoneCo as well. Berkshire, I mentioned, they put about $300 million, which is like, for me and you, putting 0.2% of our portfolio into it. Invest accordingly. I mentioned it was a profitable company, but that's not to say it's not a high-risk play. Invest accordingly.

Moser: Very good! Melissa, I hope that helps! Matt, we're going to wrap it up here. Before we go, I did want to let people know to tune in next week because Matt's got a fun interview here in the pipeline for us. We can't talk about it much further than that right now. But keep an eye out there for next Monday's episode of Industry Focus: Financials. You're going to get to hear Mr. Frankel talking with an executive at a company that we've covered here before on the show. Matt, anything else you want to add?

Frankel: Nope. My lips are sealed on that one. I was sworn to secrecy.

Moser: I hear you. We'll leave it at that. Matt, thanks so much for joining us this week! Good talking to you again!

Frankel: Always good! Always good to be here!

Moser: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's show was produced by Dan Boyd. For Matt Frankel, I'm Jason Moser. Thanks for listening! And we'll see you next week!

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