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"The horse I bet on was so slow, the jockey kept a diary of the trip."
For decades, BB&T(NYSE: BBT), a regional bank headquartered in Winston-Salem, NC, was the master of its own destiny. Having formed a taste for acquisitions in the early 1960s, it benefited from a sharp management team that focused on external as well as organic growth. It purchased smaller deposit institutions in contiguous states in the Southeastern U.S. As the company's earnings and stock price rose steadily, and it continued its string of dividend checks unbroken since 1903, investors were content to wager on this horse, whose slow speed was a virtue.
The credit crisis and recession during 2008 and 2009 likely shook BB&T's faith in its formula. To be fair, few banks of any meaningful size have exited the last five years unscathed. BB&T fell victim to market risk; the risk that the movement of an entire asset or liability class will create losses in your portfolio. BB&T has traditionally been heavily vested in commercial real estate lending in the Southeast, and this lending concentration deflated the bank's profits during the recession.
Residential mortgage lending also pressured the bank's bottom line. Net income plummeted more than 50%, from $1.5 billion in 2008 to $729 million in 2009. Scroll through the tape to the present and you'll find that profits are finally surging back: through the first three quarters of this year, the bank has recorded $1.41 billion in net income, already outpacing the total of last year's net income of $1.29 billion. In addition, management is tinkering with its business model to insulate against future unforeseen storms. A closer look at their strategy may unearth clues regarding the bank's future performance.
Size Is Necessary, but Problematic All the Same
One of the criteria by which banks have traditionally scored their performance is asset size. BB&T doesn't differ from the crowd on this metric -- the following statement appears verbatim in each of the company's annual reports going back at least seven years:
"BB&T has maintained a long-term focus on a strategy that includes expanding and diversifying the BB&T franchise in terms of revenues, profitability and asset size."
"Expanding and diversifying" revenues and profitability seems an appropriate mission for a steadily growing regional bank. But expanding asset size is a thornier proposition. A bank's assets consist primarily of the loans it issues: mortgage loans, lines of credit, commercial loans, credit card offerings, etc. This class of assets is markedly different from fellow residents of the balance sheet such as cash, equipment, inventory, or even trade accounts receivable. A bank loan is an asset that is based on a promise to pay. When a bank trumpets its total asset size, it's saying, questionably enough in times of economic vulnerability, "We hold more promises to pay than other banks do." This is the great double-edged sword (or ledger sheet, rather) of contemporary banking. Increasing "earning assets" is the most natural method for a bank to book profits. But it's also potentially the most problematic: a bank's operating mojo at any given time is only as strong as the current health of its credit portfolio.
Reining in the Promises
Even before the financial crisis, BB&T was in the process of managing its risk by trimming loans in relation to total assets:
As loans issued decrease in relation to total assets, the potential for adverse effects on the income statement diminishes (if the credit quality of the total loan portfolio remains roughly unchanged). BB&T has trimmed these numbers in a variety of ways. A good example is the bank's recent acquisition of Florida competitor Bank Atlantic: under the original deal terms, BB&T acquired $3.3 billion in deposits, and only $2.1 billion in loans. Circumspect in their dealings and wiser from the industry's recent travails, BB&T simply refused to acquire the worst (non-performing) loans in the Bank Atlantic portfolio. While eventually the excess deposits will be loaned out or otherwise invested for short-term yield, BB&T can do so at its own pace and within the framework of its internal loan criteria.
A Common Problem
BB&T is not alone in grappling with how best to use its assets, and divining what role loans should play in the total earnings picture. The following is a comparison of ROA (Return on Assets: net income divided by total assets) between BB&T and a peer group of regional banks, including PNC(NYSE: PNC), Huntington Bank (NASDAQ: HBAN), Regions Financial(NYSE: RF), and Bank of New York Mellon(NYSE: BK):
As a group, to yield an average earnings of less than one percent on billions of dollars of assets seems meager, doesn't it? Give me just a tenth of those dollars and I promise to earn a more efficient return! It appears that it will be some time before regional banks' ROA improves. Net interest margin -- the difference between the interest a bank pays on deposits and the interest it earns by lending out those deposits -- is currently a victim to a low interest rate environment. The inability to safely lend at a significantly higher rate than interest payable on deposits chips away at a bank's overall earnings power, forcing it to acquire more and more assets for a dwindling payoff.
The true earnings juice for these companies comes from non-traditional, non-lending services, including investment, advisory, insurance, and the like. A bank sensitive to both the risks and the inefficiencies inherent in the net interest margin business model will seek to find dependable, higher margin business offerings to shore up and amplify its returns.
Dealmakers: Leading the Charge to Neutralize Market Risk
BB&T is attempting to achieve this goal and lessen its market risk in commercial lending by activating its M&A prowess. The bank has a dense history of acquiring banks and financial services companies of sundry stripes under fairly strict, earnings-accretive criteria. Since the third quarter of 2011, BB&T Insurance, the company's insurance brokerage, has acquired four insurance companies, the largest of which, Crump Insurance, will add $300 million per year of revenue to the company's ledger. At BB&T's fairly predictable 10% margin on insurance services, this will contribute somewhere between 2 to 3% of the bank's yearly total net income, which is a decent-sized puzzle piece to wedge into its financial statements on a regular basis.
Banks of BB&T's size aren't trying to replace their daily net interest margin bread, or run from lending. The more accomplished are attempting to increase the number of profit centers they can lean on during the periods in which they must turn the lending spigot down. BB&T will likely use its M&A strength to smooth out its earnings and cash flow by increasing its insurance business over the next two to three years. BB&T Insurance has quietly mushroomed into the seventh largest insurance brokerage in the world (there's that pesky problem of size again).
In some ways the bank is gradually trading out portions of one risk-based business for another. Still, one gets the sense that BB&T's management is tired of the marketplace calling its shots, and wants to reassert control again over its own destiny. While it jockeys for position among its peer group, BB&T is taking careful note of what works in its travel diary. Long-term investors should be pleased that the latest entries call for a little earnings insurance.
Finosus has no positions in the stocks mentioned above. The Motley Fool owns shares of Huntington Bancshares and PNC Financial Services. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.