Is the Market Tiring of Banks?

“Now we’re hearing a lot about a whisper number at the moment that needs to be beaten and Goldman suffered on the back of that recently. Now, Deutsche Bank is the latest German bank. The shares over in Germany are down 4% and that’s despite them putting out a surprise statement which blew away expectations. They have tripled the net profit in the third quarter.” — CNBC’s Squawk Box 10/21/2009

Despite solid quarterly results out of two of the largest banks in the world, both Deutsche Bank (DB) and Wells Fargo (WFC) are selling off in midday trading. We wrote about a similar instance with Goldman Sachs (GS) (An Enlightening Day for Goldman) last week, where the investment bank reported a great quarter that topped earnings estimates by 25% and yet the stock fell victim to the rumor mill calling for a higher number. In each situation the banks have handily beaten analysts’ projections and in the case of Wells Fargo they broke a record for third quarter profit, yet the market is not satisfied. This sort of behavior seems to suggest that these stocks are overvalued thanks to overly exuberant expectations.

Wells Fargo had an outstanding quarter reporting EPS of $.56 cents, which beat analysts’ expectations by about 50%. The press release touted a record breaking third quarter profit as well as record year to date profits of $1.69 per share. Revenue was also solid as it was flat from the record breaking second quarter results. The performance was driven by mortgage underwriting and servicing income, a business shrouded in doubt as mortgage applications are down in the absence of available homebuyer tax credits.

In the case of Wells Fargo, probably the most distressing portion of the results is the increase in net charge-offs to $5.1 billion or 2.5% of average loans (up from 2.11% sequentially). The worst of the non-performing loans were in the consumer loans, and were not related to commercial real estate. This may continue to worsen as joblessness is a thorn in the side of this recovery, nowhere is this more true that Wells Fargo’s base California. Furthermore, the statement from WFC suggested that the peak in charge offs would likely come in the first half of 2010 and decline through the rest of the year.

For Deutsche Bank, the quarter was solid but not earth shattering, as they brought them to market more than a week ahead of schedule. The company reported pretax profit of EUR1.3 billion, which was slightly ahead of analysts’ expectations of EUR1.2 billion. The bank failed to offer much detail on the breakdown of the results, and its shares fell because some whispers had called for a more impressive quarter. In addition, there is a contingent that believes Germany’s largest lender may need to raise additional capital which would likely dilute shareholders.

It seems that for many banks these days, simply beating the analysts’ estimates will not cut the mustard. The underlying concerns that have weighed on our valuations of major banks for some time are starting to pervade the psyche of the market. A shift in risk tolerance seems to have taken place to some degree and will be something we will continue to monitor. Our valuations went negative on most of these banks prematurely in June based on bad loans still cluttering the balance sheet and questionable earnings power going forward. We can admit to being early on that call, but that view seems to be more prevalent in this quarter than in the previous two.

Is the Market Tiring of Banks?

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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