My grandfather used to say, though never to me directly, that "banking is like sex. When it's good, it's great. And when it's bad, it's still pretty good."
While the financial crisis may have led the average investor to question this -- 454 banks have been seized by regulators since the beginning of 2008 -- the industry is back on its feet and growing again -- albeit at a less frenetic pace than before. In its most recent quarterly banking profile, for instance, the FDIC noted that the industry's first-quarter aggregate net income of $35.3 billion is the highest it's been since the second quarter of 2007.
Yet many banks are still trading for fractions of book value. While the average savings and loan institution is selling for an 11% discount, megamoney center banks like Bank of America and Citigroup are trading for less than half of their book values respectively. In this environment, it's become exceedingly important for investors in financial stocks to be able to weed out the winners from the losers. And to do this appropriately, one must look under the proverbial hood.
In this series, I examine six of the most important metrics to assess the quality of a bank's operations. The bank under the microscope below is First Niagara Financial Group
First Niagara Financial
|Tier 1 risk-based capital ratio||9.4%||approximately 8%|
|Net interest rate margin||3.26%||>= 3.5%|
|Provision for loan losses (as a % of net interest income)||10.85%||<= 5%|
|Net noninterest expense (as a % of net interest income)||96.0%||<= 33%|
|Allowance for loan loss/nonperforming loans||107.0%||approximately 100%|
|Return on equity (TTM)||3.73%||>= 15%|
|Price-to-book ratio||0.63||approximately 1.0|
Source: First Niagara Financial Group's Q2 2012 10-Q and Yahoo! Finance.
At first glance, First Niagara's performance with respect to these pivotal targets appears underwhelming.
To start with, the lender appears to struggle with the nuances of capital allocation. The most obvious indication of this is its 3.26% net interest rate margin in the most recent quarter, which comes in below both the stated target and the industry average of 3.52%. While First Niagara has a $17.7 billion loan portfolio yielding a respectable 4.59%, this figure is diluted by roughly $11 billion in mortgage-backed securities that yield only 2.62%. And on top of this, the bank's borrowing costs are needlessly high due to an overreliance on non-deposit-based funds, which account for 28% of its interest-bearing liabilities.
First Niagara's income statement further confirms the appearance of operational challenges. As you can see, its provision for loan losses consumes nearly 11% of its already unimpressive net interest income -- although it could be argued that the bank is simply being conservative here, as its allowance for loan losses laudably exceeds its nonperforming loans -- and the rest is negated by net noninterest expenses such as salaries and rent, among other things.
The bank's one saving grace is that it just wrapped up two relatively large acquisitions. The first, completed in April of last year, consisted of $5.3 billion in deposits and $5.1 billion in loans, and gave First Niagara an entry into the New England market. The second, completed in May of this year, included $9.9 billion in deposits as well as a cash-heavy basket of assets. In addition, costs associated the acquisitions are one of the primary explanations for the bank's inordinate noninterest expenses, more than a third of which are marked as "merger and acquisition integration expenses."
While these additional deposits have helped to bring down the bank's cost of funding, they've come at a price, as the associated premium for goodwill dramatically decreased First Niagara's tangible book value per share from around $8 in the first quarter of 2011 to just over $5.20 today. Indeed, this is the reason why organic growth is so much more economical compared to growth through acquisition. Whether the latter will work in this case remains to be seen.
My take on First Niagara Financial Group
Because of the massive acquisitions, this is not a cut-and-dried case. On the one hand, it's hard not to focus on First Niagara's failure to organically grow its deposit base, the core of any high-quality bank. But on the other, it may also be difficult for investors to dismiss its 40% discount to book value as well as the potential synergies of its recent purchases. When all is said and done, however, the former shows a fatal misapprehension of prudent and profitable banking, which could easily be aggravated as opposed to mitigated by the recent inorganic growth.
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Fool contributor John Maxfield owns shares of Bank of America. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days