A Pair of Bankable Prospects

 | Jun 28, 2013 | 1:00 PM EDT
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Financial stocks, and banks in particular, have increasingly been attracting investor attention. This primarily reflects a growing economy and rising interest rates, which should greatly improve bank fundamentals, since loan growth and net interest margin spreads had been disappointing in recent years.

We have discussed and recommended a number of them (that we continue to like) over the past year. They include BB&T (BBT), JPMorgan (JPM), State Street (STT) and Wells Fargo (WFC).

Two additional high-quality institutions that we find attractive are U.S. Bancorp (USB) and PNC Financial (PNC). While USB has lagged the market and its peer group, year-to-date, with a 13.6% stock market return, PNC has performed well with a year-to-date gain of 26.75%. Both are poised to continue moving higher in a better economy and a higher interest rate environment.

USB came through the 2008-09 recession as a much stronger bank. Its assets have risen by more than 40% since 2008 because the company gained significant market share vs. its peers through new account wins and mid-sized acquisition deals. The bank has emerged as one of the best managed and customer oriented banks.

Nevertheless, earnings have lagged the rise in asset growth due to elevated credit losses, one-time legal settlements, and new regulatory rulings that limited profitability. Furthermore, a compression of the net interest margin arising from the Federal Reserve's quantitative easing programs has significantly constrained the bank's earnings. Fortunately, these headwinds should abate over the next two to three years.

Thanks to USB's favorable market share gains in recent years and expected widening net-interest margins, revenues and earnings growth should dramatically outperform the rest of the banking group. While USB is currently trading at 11.9x 2013's EPS estimate of $3.04 per share, many believe that it should be able to earn more than $4.00 per share in the upcoming years.

USB also has a favorable 2.5% dividend yield, which we expect to increase at a rapid clip as earnings growth picks up. USB is very likely to reward patient, long-term shareholders.

PNC also performed spectacularly through the 2008-09 recession and picked up significant market share. PNC's share gains came from accretive acquisitions of National City Bank and the Royal Bank of Canada's U.S. banking operations. Since 2008, the company's assets have risen from $138 billion to $330 billion or about 140%.

Even though PNC's earnings are up more than 50% since 2008 to $6.80 per share vs. $4.35 in 2007, it is still significantly under-earning relative to its asset base. PNC is still earning a sub 1.1% return on assets (ROA) vs. a pre-crisis historical number of higher than 1.5% ROA. PNC expects to narrow this ROA gap once the economy and interest rates pick up.

Furthermore, PNC should also benefit from continued asset improvement trends and declining one-time legal charges. The company should be able to earn $8 to $9 per share in the upcoming years (compared with its current $6.80 level). The stock is reasonably priced and trading at 11x current earnings. The shares also have a current yield of 2.4%, which will also likely grow as earnings improve.

Both USB and PNC should make attractive portfolio additions for investors who are looking for increased financial sector exposure from quality, durable franchises.

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