This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, it's regional banks making the headlines again with a series of downgrades for SunTrust
Last week, we looked first at how one analyst (Bernstein) called a halt to the outperformance of regional banking firms Huntington Bancshares
Today, everything slightly old is new again as we begin the trading week with yet another series of downgrades. Regions Financial and SunTrust both got downgraded to "hold" this morning by analysts at Compass Point. Meanwhile, the analyst took aim at First Horizon with a downgrade to "sell." Let's look at this last one first.
Take this mortgage -- please!
According to Compass Point, what initially attracted its attention to the regional banking sector was the intense run-up in valuations here over the past year. So far, investors in SunTrust have seen their stock rise 55% in value over the past 52 weeks. Regions has more than doubled, while the weakest performer has been First Horizon, with "only" a 51% gain.
Yet even this gain, notes StreetInsider.com, is too strong a rise to justify -- according to Compass Point. Calling the stock "priced to near perfection," Compass warns that investors are giving no consideration to the risk that bad mortgages that First Horizon originated during the housing boom might be "put back" to the bank by their buyers. As the analyst notes, a "6-year statute of limitations (on '06 deals) leads us to believe litigation will likely increase in the next 6-12 months," with burned buyers demanding that First Horizon buy back their mortgage securities.
Investors may also be putting too much faith in First Horizon's plans to buy back shares. Compass points out that "should Basel III be implemented under the current NPR, FHN's buyback potential could be curtailed."
Add to all these risks the fact that First Horizon is -- let's face it -- unprofitable at current day, and priced at more than 11 times next year's hoped-for earnings (with a single-digit growth rate), and Compass sees little reason to want to own the stock, and every reason to head for the exits.
Compass' comments on the other two banks it's downgrading are less severe, but still not terribly encouraging. Regarding Regions, Compass observes that lower reserves against losses, and the ability to pay less interest on CD offerings as they reprice to lower rates, will both "provide a tailwind to earnings." Still, the analyst cites the stock's severe run-up but limited growth prospects (just 7% annualized profits growth expected over the next five years) as too high, and too low, respectively, for a bank that's just as unprofitable as First Horizon.
According to the analyst, "loan growth would need to exceed our forecast or Basel III would need to be softened" (loosening capital requirements and giving Regions more flexibility to issue loans and buy back stock) in order to Regions to be worth the 9.4x forward earnings multiple its shares currently fetch.
Similarly with SunTrust, Compass starts out with optimistic language, hypothesizing how lower reserves against mortgage putbacks, plus potential new business from mortgage refinancing, will boost earnings in the near term. (It's also worth pointing out that among the three banks downgraded today, SunTrust is the only one currently reporting net profits for the past year.) Regardless, the analyst worries that SunTrust will have to "stretch" to outperform expectations of 17% earnings growth over the next five years, and won't be worth buying unless it can stretch far enough.
17% earnings growth and a 19 P/E valuation on its stock make SunTrust arguably the best deal of the three stocks that Compass Point axed today. In fact, once you add in the bank's modest 0.7% dividend yield, the stock almost starts to look fairly priced. Even so, a fair-priced stock is by definition not a bargain-priced stock, and probably not worth much more than a neutral rating.
Which is exactly what Compass Point gave SunTrust today.
Fool contributor Rich Smith holds no position in any company mentioned. The Motley Fool owns shares of Huntington Bancshares. 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.