Friday Five: Banks Jump Over a Low Bar

Christine Benz: Hi, I'm Christine Benz for Morningstar.com and welcome to The Friday Five. Joining me to discuss the top business and market news from the past week is Morningstar markets editor Jeremy Glaser.

Jeremy, thank you for being here.

Jeremy Glaser: You're welcome, Christine.

Benz: Jeremy, let's start with bank earnings in the news this week. Results were a little better than expected.

Glaser: The expectations for the big banks--and really for the market as a whole and companies as a whole--for this earnings season are pretty low. There's just a lot of concerns about growth, about energy, about a lot of different things. As you said, the results were a bit better than expected; they weren't terrible, which I think the market was pretty happy to see.

First, on the bad news was that volatile markets did in fact take a toll on trading revenue. This is something we know going in for a lot of these organizations: That's always going to be volatile. It's the nature of that game. So, no big surprises there.

Energy did weight on credit losses a little bit. We saw some higher charge-offs. We saw some concerns about that, but it wasn't anything terribly alarming yet. Jim Sinegal, who covers a lot of these banks for us, thinks that overall credit quality remains pretty good, and we saw that particularly on the consumer portfolios through the banks in this quarter.

On the plus side, consumer demand for loans seems to be pretty healthy, and we saw that across a couple of different banks, which is a sign that maybe the consumer is out there looking to take out those loans right now, taking advantage of these low rates. That's something that's potentially positive for the banks over time.

But that being said, it's still not going to be a banner year for bank earnings. Beyond just the market, they are dealing with some of these energy issues and dealing with regulatory costs. We wouldn't expect a great year, but we think that they can muddle through it, and they are [implementing] some cost-cutting initiatives to help them muddle through it, and we do see some value in some of these names. Bank of America and Wells Fargo, for example, are trading in 4-star territory, so we do think that investors are a little bit too pessimistic on some of these names.

Benz: You mentioned, Jeremy, some of the regulatory pressures that we think could be a headwind for this sector. What's going on there?

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Glaser: We did get another sign this week that that is very much going to be a problem for the banks, when we heard about the outcome of the review of these so-called "living wills" that big financial organizations have to put together.

These were part of the Dodd–Frank financial reform. The idea is that the banks are supposed to come up with a way that they could potentially go bankrupt and not cost the taxpayers any money--not to need a bailout if they were to see some kind of bankruptcy event.

And five firms--Bank of America, JPMorgan, Wells Fargo, State Street and Bank of New York--all were told that their plans were not sufficient. This isn't something that we're particularly alarmed about right now. Jim Sinegal, again, looked at this for us, and he says this is very reminiscent of when the CCAR results first started coming out. This was the process to determine if capital levels make sense. There was a lot of miscommunication and misunderstanding of what the regulators really want, and it took a couple of iterations of it to get it right. He sees something very similar happening again here.

The fact that Citigroup's plan did pass--and they have some very complicated derivatives positions and other things that would be difficult to wind down in bankruptcy--the fact that they could come up with something workable shows that there probably are workable plans here, but they are going to have to spend more money to get there. They are probably going to have to make some changes in terms of entity structures in order to satisfy the regulators.

But if you look at the fact that communication between the regulators and the banks still seems to not be maybe as robust as it should be, and that these processes seem to keep coming, elevated regulatory costs are going to be something that the banks are living with for quite some time.

Benz: Another name in the news this week was Berkshire Hathaway. Everyone for the past decade or so has been closely what leadership changes at the level below Warren Buffett could mean. Let's talk about what's going on there.

Glaser: One of the open questions for Berkshire Hathaway is who will succeed Warren Buffett as the CEO. We already know that his son will step into the Chairman of the Board role. We know that some of the investment selection already has been outsourced to new lieutenants. But that CEO role has been the open question.

This week we found that Gen Re's CEO, Tad Montross, is going to retire at the end of the year and that Ajit Jain, who previously was the head of Berkshire Hathaway Reinsurance, is going to take over that business as well. They are going to combine those business units. These have been run separately for two decades now, and they are bringing them together under Jain.

Gregg Warren, who is our Berkshire analyst, thinks this makes a lot of sense--that we're in an environment where reinsurance pricing doesn't look great. So they really need to think about cost-cutting, think about what their cost structure looks like, and combining them could really help it.

But what he thinks even more interesting is what this probably says about what's going to happen to the CEO role. It might be tempting to say, Jain is getting all of this new responsibility. He had been talked about as a potential successor; maybe he is the guy who is going to get it. But Gregg thinks that it actually makes more sense for Greg Abel, who is the CEO of Berkshire Hathaway Energy, to move into that role after this move has been made. Greg Abel has a lot of M&A experience, he has more operations experiences, and Gregg thinks he can come in and be that caretaker CEO, allow the other managers to do what they were hired to do and to run those businesses, and that Jain really is the insurance genius, so let him run insurance, let him continue to produce good results there, and then let Greg Abel take that role.

So, we won't know for sure. It's unlikely that when we're in Omaha in a few weeks this is going to be announced, but it certainly adds some more intrigue into what those next steps could be.

Benz: Over to the metals sector--aluminum. Alcoa reported results that were not so hot. Kind of mixed.

Glaser: Alcoa traditionally kicks off earnings season. It gets looked at maybe a little bit more than you would expect. They did have very mixed results. This comes at a time for the company where they are preparing to split into two. They are going to have the upstream business, which is the more commodity-exposed business, and then another business that's more of the engineered products, the value-added products, where they think that they have more pricing power.

Andrew Lane, who is our Alcoa analyst, thinks that the transformation toward this has been very gradual, and the way that we are seeing the business evolve really seems like very gradual progress.

What we saw this quarter was that the upstream business was under a lot of pressure, as pricing was very weak, and we think this is something that could continue for some time. Generally, we think that China's demand, particularly for aluminum, is going to be much lower than Alcoa or the market expects--and that's going to weigh on that business for some time. That was very clear in the results this quarter.

We think the shares are overvalued right now. They are trading in 2-star territory. So we think split or no split between these businesses, investors are probably better off looking elsewhere.

Benz: Over to the consumer sector, Nestle had lackluster results during the quarter.

Glaser: Nestle is seeing some deceleration in sales growth. Organic sales, which excludes currency impacts and divestitures and acquisitions for Nestle, were up 3.9% in the quarter, which isn't bad, but it's a decline from 4.2% last year. Weak pricing and some loss of market share in markets like Europe is really weighing on the packaged food giant.

But Erin Lash, who covers the company for us, thinks that their wide economic moat is still very much intact. We think they are going to be able to overcome some of these short-term headwinds from the deflationary-type environments in a lot of places around the world, and if price levels start to rise again and they get higher pricing, they are going to be well-positioned to take advantage of that. She thinks the shares are undervalued where they are trading today.

Benz: Jeremy, it was a busy week on the earnings front. Thank you for being here to recap the headlines for us.

Glaser: You're welcome, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.