Over the next month, banks will be releasing results for the second quarter. In advance of these releases, let's take a moment to review the state of some of these banks as of the end of Q1.
Today, we'll look at Regions Financial Corporation (NYSE:RF), a $117.9 billion bank headquartered in Birmingham, Alabama. Regions is scheduled to release earnings on July 22.
When I evaluate banks, I follow a model made famous by former Wachovia CEO John Medlin: soundness, profitability, and growth. As investors, we then look at valuation and the potential for investment after gaining a better understanding for each bank.
Soundness refers to the bank's asset quality. Generally speaking, this means loans. If a bank makes loans that are never repaid, that bank will fail, and fail quickly. The best banks put risk management first, ensuring that shareholder capital is protected if a portfolio of loans turns sour.
To measure this, we'll look at both non-performing assets and Regions Financial Corp.'s provision for loan and lease losses. A simplified definition of non-performing assets is loans or other assets that have fallen seriously delinquent or are in foreclosure.
The provision for loan and lease losses is a reserve of money that the bank pulls out of its income each quarter to guard against future losses in the loan portfolio. Banks are required by regulation to maintain certain levels of reserves, but within that, management has plenty of wiggle room to over- or under-reserve. Over-reserving increases protection but hurts net income; under-reserving increases risk but keeps net income high.
For the quarter ending on March 31, Regions had 1.1% non-performing assets as a percentage of total assets. The FDIC reports that banks with total assets greater than $10 billion on average had 1.5% non-performing assets as a percentage of total assets. Competitors Fifth Third Bancorp (NASDAQ:FITB) and BB&T (NYSE:BBT) each reported lower levels of problem loans, at 0.73% and 0.53%, respectively.
Regions Financial Corp. reserved $2 million for the first quarter, which represented 1.6% of operating revenue. That compares with 5% for the $10 billion-plus peer group, according to the FDIC.
The lower-than-peer level of new reserves for the quarter indicates that the bank's problem loan portfolio should continue to mend. Regions does trail comparable regional banks in this measure, a concerning reality. That said, Regions doesn't have an excessive level of problem assets; management appears to have this issue under control.
After establishing an understanding of a bank's risk culture and soundness, next we can focus on profitability. Any investment in a business is an investment in that company's future earnings, so profitability is a particularly important consideration for any bank investor.
The first question, perhaps most obviously, is whether the bank generates a profit at all. According to data from the FDIC, 7.3% of U.S. banks failed to generate a profit at all in the first quarter. That's one in every 14 banks!
For Regions Financial, the first calendar quarter of 2014 fortunately wasn't that bad. The company generated total net revenues of $1.3 billion for the quarter -- that is total interest income plus non-interest income minus interest expense.
Over the past 12 months, Regions Financial Corp. has generated $5.0 billion in total net revenue. Of that revenue, 65% was attributable to net interest income, the difference between interest earned on loans and paid out to depositors. The remaining 35% was through fees, trading, or other non-interest revenue sources.
The bank was able to turn a profit margin of 22% on that revenue.
For the first quarter, the company reported return on equity of 7.7%. Of the banks covered in this series of articles, the average return on equity was 8.9%. The FDIC reports that the average ROE for U.S. banks with total assets greater than $10 billion was 9.1%.
For comparison, BB&T produced a profit margin that was essentially equal to Regions, while Fifth Third blew it out of the water at 28%. BB&T's ROE was 10%, and Fifth Third's was 8.7%.
Leverage is a double-edged sword for banks and could easily fit into either the soundness or profitability categories. We'll call it a subset of both and discuss it here.
Leverage is just part of the game with banks, so if you're a conservative investor who really focuses on conservative capital structures, the banking industry may not be the best place for your money. Adding leverage is an easy way to juice return on equity, which is generally speaking a good thing. The bank increases assets and thus earnings, while maintaining a lower capital level.
The result is a higher numerator, a constant denominator, and a larger return-on-equity number. The math does the heavy lifting for you.
On the flip side, too much leverage can put the bank on thin ice if the loan portfolio takes a turn for the worse. A stronger equity base protects the bank from bankruptcy and bailouts, two outcomes that are both politically charged and downright terrible for shareholders.
Banks use all kinds of esoteric and overly complex accounting methods to determine leverage. We'll keep it simple here with an old-fashioned assets-to-equity ratio. The lower the number, the less levered (and more conservative) the bank.
Regions Financial Corp.'s assets-to-equity ratio comes in at 7.3. The average of the 62 banks analyzed in this series of articles was 9.1.
Of the major regional banks, Regions is one of the most conservative when it comes to leverage. Going back over the past 10 years, the bank has consistently limited its use of leverage to well below peer average. In fact, the bank's assets-to-equity ratio is more or less unchanged going back all the way to 2005!
Growth and valuation
Regions Financial Corp. saw its revenues drop by 3.7% over the past 12 months. That compares with the 5.7% average increase of the 62 banks analyzed.
This change in revenue corresponded with a 12% decrease in net income over the same period. The peer set averaged an increase of 14.1%. Fifty-four percent of all U.S. banks saw year-over-year earnings growth in the first quarter.
Moving now to valuation, Regions Financial Corp. traded at a forward price-to-earnings ratio of 12.5, according to data form S&P Capital IQ. That compares with the peer set average of 16.67 times.
Regions Financial Corp.'s market cap is, at the time of this writing, 1.4 times its tangible book value. The peer set average was 1.9.
Many investors use a general rule of thumb of buying a bank stock when the price-to-tangible book value is less than 0.5 and selling when it rises above 2. For me, that method is just way too oversimplified.
It sometimes makes sense to pay a premium for a bank stock that places a high value on credit culture and asset quality. These banks will survive and prosper while others fall by the wayside. That security can be worth a premium. Likewise, a bank that relies heavily on leverage to achieve above-average return on equity may not be worth the price, even if price-to-tangible book value is low. That risk may not justify even a healthy discount in price.
Based on the factors we've discussed here -- soundness, profitability, and growth -- Regions Financial appears undervalued.
From the beginning of this analysis, Regions' financials have consistently trailed both the peer set and its more directly comparable institution. But its performance hasn't been so poor as to justify such a steep discount in terms of price to book value. BB&T trades at over 2 times price to TBV. Fifth Third, which I also think is undervalued, trades at 1.6.
Regions reported earnings per share of $0.21 in the first quarter. Median analyst expectations for Q2 put earnings at $0.21 per share.
Among these three regional players, it is my opinion that BB&T is the strongest bank in terms of management and performance. However, from a purely value investing standpoint, Regions' valuation is unjustifiably low. This bank may not stay in your portfolio for the next 20 years, but it may be a good fit for the next two or three.