Monday, October 17, 2011

Invest in Wells Fargo, Pause on Citigroup

Banking has not exactly been a great investment -- especially since September 2008 when Lehman Brothers kicked the bucket. In 2011, bank stocks have declined an average of 27%. As rumors of 100,000 Wall Street layoffs surface, Wells Fargo (NYSE: WFC) -- it's trying out a $3 a month debit card fee to boost revenue -- and Citigroup (NYSE: C) just reported earnings for the third quarter. But should you invest in either bank?

Prior to their scheduled reporting time of 8 AM Monday, the two banks were expected to report double digit earnings growth compared to the year before thanks largely to lower charges for bad loans. Analysts expected Wells Fargo to report an 18% rise in net income to $3.9 billion while analysts saw Citigroup as poised to report a 15% rise to $2.5 billion, according to Bloomberg.

In fact, both banks reported better than expected numbers. Thanks to improvements in its lending and deposit division and its absence from the volatile investment banking business, Wells Fargo earned a $200-million-higher-than-expected $4.1 billion profit in the third quarter profit. Its EPS of 72 cents a -share matched analysts’ estimates according to DealBook.

These numbers reflect the benefits to the banks of combining so-called commercial and investment banking. Commercial banking is the business of taking insured deposits and lending them to businesses and consumers. Investment banking uses overnight loans from other banks to finance corporate issuance of debt and equity and pay advisors who help companies with mergers.

Citigroup also beat expectations. Its 74% rise in net income, to $3.8 billion, was much better than expected. Moreover, its $1.23 EPS for the third quarter was 36% higher than the 81 cents a share analysts’ consensus, according to DealBook.  But there may be less here than meets the eye – after all, about a third of Citigroup’s pre-tax operating profit came from a $2 billion paper gain – that weirdly reflects “a sharp increase in the perceived riskiness of its debt.” And that gain helped offset weak trading results and big mortgage losses.

In 2011, the investment banking business -- Citigroup is a big player here -- has been relatively quiet thanks to turbulence in the financial markets. By contrast, commercial banking has been growing, albeit slowly. For example, International Strategy & Investment Group reported that in the third quarter, loan growth inched up 1.2% among the top 25 U.S. banks due to a rise in commercial and residential loans while the deposits to fuel those loans climbed 6.8%.

Does this mean that you should avoid Citigroup and invest in Wells Fargo stock instead?
  • Wells Fargo: Shrinking, but still fairly profitable; very cheap stock. Revenues for Wells Fargo have dropped 6.2% in the last 12 months to $51 billion while net income has jumped 46% to $13.7 billion --- earning a fairly large 17.8% net profit margin. In addition, its price/earnings to growth ratio of 0.58 (where a PEG of 1.0 is considered fairly priced) is very cheap on a P/E of 10.34 and expected earnings growth of 17.8% to $3.30 in 2012.
  • Citigroup: Decent growth, profitable, and a cheap stock to boot. Citigroup's revenues are up 3.8% in the last 12 months to $74.9 billion while net income jumped 220% to $9.8 billion --- yielding a net profit margin of 13%. Its PEG is a very cheap 0.43 on a P/E of 8.79 and expected earnings growth of 20.4% to $4.61 in 2012.
Banking stocks are widely hated by investors. But if these earnings forecasts prove accurate, both stocks look like bargains. I’d favor Wells Fargo over Citigroup because I am not optimistic about a recovery in investment banking. But if you see such a recovery around the corner, both stocks look good.


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