Noted bank analyst Mike Mayo of CLSA distributed a note to clients on Wednesday that upgraded shares of SunTrust Banks (NYSE:STI) from a hold to a buy. His decision was based principally on five factors.
First, SunTrust Banks oversees an attractive franchise that's trading for a discount to its historical average price-to-book-value ratio. As Mayo notes, SunTrust is the 10th largest bank in the United States, but the fourth largest in the Southeast. It also has a diversity of business lines serving consumer, commercial, and wholesale clients. Despite its market presence, however, its shares trade for 11.5 times book value, which is a discount to its 10-year historical average of 13 times book value.
Second, SunTrust Banks has a lot of room to improve. Mayo focuses specifically on its efficiency ratio, which measures the percentage of a bank's net revenue that's consumed by operating expenses. Most banks strive for a ratio below 60%. But in the most recent quarter, SunTrust's came in at 64%.
"Getting to an average efficiency ratio can make a difference," wrote Mayo. "If SunTrust reaches its long-term target and gets back to its pre-crisis (1990-2007) efficiency ratio of 59%, its [return on assets] would improve to 1-1.1%." For context, a 1% return on assets has long been the industry's primary benchmark for well-run banks.
Third, SunTrust Banks is less dependent on rising rates than most of its competitors. The main storyline right now among bank stocks concerns the impact that a rise in short-term interest rates will have on their bottom lines. Most lenders expect a substantial boost to earnings, but SunTrust's earnings aren't as dependent on higher rates -- which may or may not come to fruition later this year.
"SunTrust benefits by only half as much [from] higher interest rates than the median large bank," says Mayo. He then predicted that a 100-basis-point increase in rates (one percentage point) would see net income rise at the median big bank by 4% versus a 2% increase at SunTrust.
Fourth, SunTrust Banks' management is heavily incentivized to generate high profitability. This year, for instance, its executives will receive substantial one-time bonuses if the company's return on assets exceeds 1% for the 2015 fiscal year. "We do not think that [Suntrust] is blinded by this payment, and recognize that this is one of several incentive programs," wrote Mayo. "Nevertheless, we like when management interests are aligned with those of shareholders, and pay more attention to this, especially since it impacts at least the top 12 executives."
Finally, Mayo sees a big opportunity for SunTrust to boost its stock valuation by returning more capital to shareholders. As he noted, in 2013, it returned 30% of its earnings to shareholders via dividends and buybacks. This figure increased to 50% in 2014. And it's estimated to be 70% this year. Not only does a higher dividend attract more investors, but buying back more stock should theoretically reduce the bank's outstanding share count and thus increase its earnings per share.
None of this is to say that Mayo believes SunTrust is flawless. As he noted, it's underperformed during the past few decades based largely on a bloated expense base. That aside, he's convinced that its current management is intent on "better optimizing what it has." Consequently, even if it falls short of its efficiency and profitability goals, the ultimate outcome "seems very likely to remain positive."
John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.