Monday, January 22, 2007

2007's Top Picks: Financial Services

News Analysis
January 22, 2007

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2007's Top Picks: Financial Services

Top Wall Street pros offer their thoughts and predictions on companies in the financial-services industry

Neither an inverted yield curve, rising interest rates, nor a weakening U.S. dollar could keep financial services stocks from solid gains in 2006. The industry also weathered security concerns and outsourcing talk, and still share prices emerged undaunted (see, 12/19/06, "Financial Services '06: Dash of the Unusual"). In fact, the financial services sector rose 15.8% last year, according to Standard & Poor's (MHP), compared with a 13.6% advance for the broader S&P 500 index.

There's no guarantee the good times will continue, however. Slowing economic growth, the yield curve's ongoing inversion, and deteriorating credit quality could put a damper on earnings growth in 2007, some analysts say. In 2006, S&P estimates the financial sector logged a 16.6% uptick in earnings, while the S&P 500 posted an average 14.6% increase. This year, however, S&P expects the sector's profit growth to slow to 6.4%, vs. 9.9% for the broader benchmark.

Greener Pastures

Despite this gloomier backdrop, Wall Street's soothsayers still see pockets of green in the money business. From banks to brokerages and beyond, asked top analysts for their picks in the financial sector as the year gets underway.

Deal activity could be a boon for one regional bank, according to David George, a senior analyst at A.G. Edwards (AGE). Bank of New York (BK) should get a boost from the recent swap of its retail banking unit with JPMorgan Chase (JPM) and its pending $16.5 billion merger with Mellon Financial (MEL). "The combined company has a platform capable of generating double-digit growth for the next three to five years," George says. The banks expect to cut pre-tax costs by roughly $700 million annually as a result of the deal (see, 12/4/06, "The Man Behind the Mellon Merger").

In the traditional banking sector, George also likes Wells Fargo (WFC) and U.S. Bancorp (USB). He expects 10% earnings growth from these companies in 2007, about twice the anticipated rate for their peers. Wells Fargo should continue to generate strong profits despite a challenging macro-environment, George says. He adds that a high percentage of revenue from fees out of nonbank businesses such as payment services, payment processing, and corporate trusts will likely insulate U.S. Bancorp's earnings from the inverted yield curve. (A.G. Edwards has had business relationships with Bank of New York, Wells Fargo, and U.S. Bancorp.)

UBS analyst Matt O'Connor's top pick among large-cap banks, Wachovia (WB), might be another stock poised to gain after recent M&A action. The company's $25.5 billion purchase of Golden West Financial may have sparked some concerns on Wall Street about the mortgage lender's earnings prospects in a slowing housing market, but overall results should come in line with expectations, O'Connor says. "Combine that with an attractive valuation and what I would view as an attractive franchise," he says, citing the company's southeastern U.S. geographic base and diverse business mix. "I think it could be a very good place to make some money."

Meanwhile, SunTrust Banks (STI) might be a smart play for two different reasons. On one hand, a new cost-savings plan could help the company get expenses under control, paving the way for above-average earnings growth against the industry, O'Connor says. If costs don't come down, he sees an increasing probability that the company will be sold, likely at a premium.

In a somewhat contrarian call, O'Connor expects improved earnings growth from BB&T (BBT). The analyst says the bank is just beginning to see the benefits of its investment in organic growth—such as opening new branches and hiring sales staff— and may enjoy improved operating leverage going forward. The company has also made changes to its balance sheet that could improve its position for a prolonged flat yield curve, he says. (UBS has had business relationships with Wachovia, SunTrust Banks, and BB&T.)

Elsewhere, Bank of America (BAC) analyst Michael Hecht favors Lazard (LAZ). Hecht says the boutique advisory group, his top small- and mid-cap pick in the sector, stands to gain from booming M&A activity and a growing asset-management practice. The company's valuation of 16 times its estimated 2007 earnings is also cheap compared with its peers, he writes in a recent research report. (Bank of America beneficially owns at least 1% of securities of Lazard and has received investment banking fees from the company.)

Within large-cap stocks, discount stockbroker Charles Schwab (SCHW) may be a bargain. Hecht says the stock looks undervalued based on the 23% compound annual growth rate he projects for earnings over the next five years. Ongoing cost discipline and decreased reliance on transaction-based revenue could also bode well for Schwab, Hecht notes in the report. (Bank of America makes a market in the securities of Schwab and has received investment banking fees from the company.)

Schwab is a favorite of Citigroup (C) analyst Prashant Bhatia as well. "We continue to see significant upside for [Schwab]," Bhatia writes in a recent research report, citing faster organic growth and per-share earnings increases of 20% or more over the next two to three years. "In our view, the marketplace continues to underappreciate the long-term earnings power and the growth prospects of the Schwab franchise."

In life insurance, Citigroup analysts' top picks are Aon (AOC) and Lincoln National (LNC). Aon may be positioned to grow revenues, margins, and earnings at the same time, analyst Keith Walsh notes in the Citigroup report. As for Lincoln, fellow Citigroup analyst Colin Devine says the Street has yet to fully recognize the stock's attractive valuation and above-average dividend yield. (Citigroup makes a market in the securities of Schwab, Aon, and Lincoln National, and had business relationships with the companies.)

As the financial sector faces a tougher environment, analysts believe a few well-positioned financial companies could still be poised for growth in 2007.

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