With ‘stress test’ results due out this Thursday many bank stocks are especially volatile ahead of the release. This presents a good chance for putting on buy/write combinations with some of the better quality names that are unlikely to need to raise new equity capital (with its diluting effect).
Custodial Banks look to have much less risk than typical commercial banks due to their high percentage of income from fees rather than interest spreads. Here is a brief description of their genre:
(From Wikipedia)
A custodian bank, or simply custodian, is a financial institution responsible for safeguarding a firm's or individual's financial assets. The role of a custodian in such a case would be the following: to hold in safekeeping assets such as equities and bonds, arrange settlement of any purchases and sales of such securities, collect information on and income from such assets (dividends in the case of equities and interest in the case of bonds), provide information on the underlying companies and their annual general meetings, manage cash transactions, perform foreign exchange transactions where required and provide regular reporting on all their activities to their clients. Custodian banks are often referred to as global custodians if they hold assets for their clients in multiple jurisdictions around the world, using their own local branches or other local custodian banks in each market to hold accounts for their underlying clients. Assets held in such a manner are typically owned by pension funds.
Earnings have been negatively impacted for these banks as many of their fees are based on a percentage of Assets Under Management (AUM). The poor market action of the past 18 months has reduced AUM significantly as have the net redemptions from mutual fund clients.
That said, most custodial bank stocks have already reflected, or even more than reflected these earnings declines. I’m looking at only the best quality names today.
Two of these are Northern Trust [NDQ:NTRS - $52.78]
and Bank of NY Mellon [NYSE:BK - $25.90].
Northern Trust has handled the credit crisis in pretty good style. EPS were $3.47 in 2008 versus $3.24 in 2007 although Q1 this year fell to $0.61 from $1.71. Zacks full year estimate for 2009 and 2010 are now at $3.10 and $3.82 respectively.
That makes Northern Trust’s multiple 17x this year’s and 13.8x next year’s projections. That’s just a moderate discount to its typical 18 – 20 range and a testament to the respect it gets in today’s market.
NTRS has not needed to cut its dividend. At $0.28 quarterly, the current yield is a respectable 2.12% and is well covered at just 36.1% of forward earnings. The yield hasn’t been much better than this since 1996 when the shares were at a (split adjusted) price of $11.50 on their way to $92 over the next four years.
On April 28th Northern Trust sold 15 million new shares @ $50 and issued $500 million in 4.625% 5-year notes @ par. The proceeds are earmarked to retire $1.6 billion in TARP money and to rid the company of government interference. I see that as very positive. Again, the fact that NTRS could sell shares and bonds at decent prices speaks loudly to the perceived strength of Northern Trust.
Here’s my play on NTRS:
_______________________________Cash Out_________Cash In
Buy 1000 @ $52.78 _______________$52,780
Sell 10 Jan. 2011 $55 Calls @12.60 _________________$12,600
Sell 10 Jan. 2011 $55 Puts @ 15.80 _________________$15,800
Net Cash Out-of-Pocket ____________$24,380
On expiration date in January 2011…
If NTRS shares have risen by at least $2.22 or plus 4.3% from today’s quote:
Your $55 calls will be exercised.
You will sell your shares for $55,000.
Your $55 puts will expire worthless (a good thing for you as a seller).
You will have collected $1,960 in dividends.
You will have no further option obligations.
You will hold no shares and $56,960 cash for your original
outlay of $24,380.
That’s a cash-on-cash profit of $32,580 /$24,380 = 133.6%
achieved as long as NTRS has gone up by 4.3% or better.
What’s the risk?
If Northern Trust shares are still below $55 on expiration date in 2011:
Your $55 calls will expire worthless.
Your $55 puts will be exercised.
You will be forced to buy an additional 1000 shares and to
lay out another $55,000 cash.
You will have collected $1,960 in dividends.
You will have no further option obligations.
You will hold 2000 shares of NTRS and $1,960 of cash.
What’s the break-even on the whole trade?
On the first 1000 shares it’s their purchase price of $52.78 less
the $12.60 /share call premium = $40.18 /share.
On the ‘put’ shares it’s the $55 strike price less the
$15.80 /share put premium = $39.20 /share.
Your break-even is the average of $40.18 + $39.20 = $39.69 /share.
Thus, NTRS could drop by as much as $13.09 or (-24.8%) from your starting price
without causing a loss.
Bank of NY Mellon saw a drop in earnings from a record $2.18 /share in 2007 to just $1.20 last year. Zacks is looking for 2009 and 2010 EPS of $2.12 and $2.63 respectively.
With BK shares now at $25.90 that makes their multiple 12.2x this year’s and < 9.9x next year’s projections. Both of those are well under the historical levels on BK since 1994 – 1995. Buyers back then saw huge appreciation in the five subsequent years.
BK cut their quarterly dividend from $0.24 to $0.09 recently to conserve capital. This will save approximately $700 million annually and lessen the possibility that BK will need to issue new shares that would dilute current holders.
Here is my combination play with BK:
_________________________________Cash Out_________Cash In
Buy 1000 @ $25.90_________________$25,900
Sell 10 Jan. 2011 $25 calls @ 8.10______________________$8,100
Sell 10 Jan. 2011 $25 puts @ 7.60______________________$7,600
Net Cash Out-of-Pocket______________$10,200
On expiration date in January 2011:
If BK shares simply remain above $25 (where they are today):
Your $25 calls will be exercised.
You will sell your shares for $25,000.
Your $25 puts will expire worthless.
You will have collected $540 in dividends.
You will have no further option obligations.
You will hold no shares and $25,540 of cash for your original
cash outlay of $10,200.
That’s a best-case scenario profit of $15,340 / $10,200 = 150.4%
achieved as long as BK shares don’t finish below $25 or (-3.4%) from today’s price.
____________________________________________________________
If you are very bearish on even the best of the banks then these plays won’t appeal to you.
If you feel these higher quality names should at least hold their own over the next 21 months, then these combinations have the potential for outsized total returns while offering modest downside protection.
Disclosure: Author is long shares and short options of both NTRS and BK.
Custodial Banks look to have much less risk than typical commercial banks due to their high percentage of income from fees rather than interest spreads. Here is a brief description of their genre:
(From Wikipedia)
A custodian bank, or simply custodian, is a financial institution responsible for safeguarding a firm's or individual's financial assets. The role of a custodian in such a case would be the following: to hold in safekeeping assets such as equities and bonds, arrange settlement of any purchases and sales of such securities, collect information on and income from such assets (dividends in the case of equities and interest in the case of bonds), provide information on the underlying companies and their annual general meetings, manage cash transactions, perform foreign exchange transactions where required and provide regular reporting on all their activities to their clients. Custodian banks are often referred to as global custodians if they hold assets for their clients in multiple jurisdictions around the world, using their own local branches or other local custodian banks in each market to hold accounts for their underlying clients. Assets held in such a manner are typically owned by pension funds.
Earnings have been negatively impacted for these banks as many of their fees are based on a percentage of Assets Under Management (AUM). The poor market action of the past 18 months has reduced AUM significantly as have the net redemptions from mutual fund clients.
That said, most custodial bank stocks have already reflected, or even more than reflected these earnings declines. I’m looking at only the best quality names today.
Two of these are Northern Trust [NDQ:NTRS - $52.78]
and Bank of NY Mellon [NYSE:BK - $25.90].
Northern Trust has handled the credit crisis in pretty good style. EPS were $3.47 in 2008 versus $3.24 in 2007 although Q1 this year fell to $0.61 from $1.71. Zacks full year estimate for 2009 and 2010 are now at $3.10 and $3.82 respectively.
That makes Northern Trust’s multiple 17x this year’s and 13.8x next year’s projections. That’s just a moderate discount to its typical 18 – 20 range and a testament to the respect it gets in today’s market.
NTRS has not needed to cut its dividend. At $0.28 quarterly, the current yield is a respectable 2.12% and is well covered at just 36.1% of forward earnings. The yield hasn’t been much better than this since 1996 when the shares were at a (split adjusted) price of $11.50 on their way to $92 over the next four years.
On April 28th Northern Trust sold 15 million new shares @ $50 and issued $500 million in 4.625% 5-year notes @ par. The proceeds are earmarked to retire $1.6 billion in TARP money and to rid the company of government interference. I see that as very positive. Again, the fact that NTRS could sell shares and bonds at decent prices speaks loudly to the perceived strength of Northern Trust.
Here’s my play on NTRS:
_______________________________Cash Out_________Cash In
Buy 1000 @ $52.78 _______________$52,780
Sell 10 Jan. 2011 $55 Calls @12.60 _________________$12,600
Sell 10 Jan. 2011 $55 Puts @ 15.80 _________________$15,800
Net Cash Out-of-Pocket ____________$24,380
On expiration date in January 2011…
If NTRS shares have risen by at least $2.22 or plus 4.3% from today’s quote:
Your $55 calls will be exercised.
You will sell your shares for $55,000.
Your $55 puts will expire worthless (a good thing for you as a seller).
You will have collected $1,960 in dividends.
You will have no further option obligations.
You will hold no shares and $56,960 cash for your original
outlay of $24,380.
That’s a cash-on-cash profit of $32,580 /$24,380 = 133.6%
achieved as long as NTRS has gone up by 4.3% or better.
What’s the risk?
If Northern Trust shares are still below $55 on expiration date in 2011:
Your $55 calls will expire worthless.
Your $55 puts will be exercised.
You will be forced to buy an additional 1000 shares and to
lay out another $55,000 cash.
You will have collected $1,960 in dividends.
You will have no further option obligations.
You will hold 2000 shares of NTRS and $1,960 of cash.
What’s the break-even on the whole trade?
On the first 1000 shares it’s their purchase price of $52.78 less
the $12.60 /share call premium = $40.18 /share.
On the ‘put’ shares it’s the $55 strike price less the
$15.80 /share put premium = $39.20 /share.
Your break-even is the average of $40.18 + $39.20 = $39.69 /share.
Thus, NTRS could drop by as much as $13.09 or (-24.8%) from your starting price
without causing a loss.
Bank of NY Mellon saw a drop in earnings from a record $2.18 /share in 2007 to just $1.20 last year. Zacks is looking for 2009 and 2010 EPS of $2.12 and $2.63 respectively.
With BK shares now at $25.90 that makes their multiple 12.2x this year’s and < 9.9x next year’s projections. Both of those are well under the historical levels on BK since 1994 – 1995. Buyers back then saw huge appreciation in the five subsequent years.
BK cut their quarterly dividend from $0.24 to $0.09 recently to conserve capital. This will save approximately $700 million annually and lessen the possibility that BK will need to issue new shares that would dilute current holders.
Here is my combination play with BK:
_________________________________Cash Out_________Cash In
Buy 1000 @ $25.90_________________$25,900
Sell 10 Jan. 2011 $25 calls @ 8.10______________________$8,100
Sell 10 Jan. 2011 $25 puts @ 7.60______________________$7,600
Net Cash Out-of-Pocket______________$10,200
On expiration date in January 2011:
If BK shares simply remain above $25 (where they are today):
Your $25 calls will be exercised.
You will sell your shares for $25,000.
Your $25 puts will expire worthless.
You will have collected $540 in dividends.
You will have no further option obligations.
You will hold no shares and $25,540 of cash for your original
cash outlay of $10,200.
That’s a best-case scenario profit of $15,340 / $10,200 = 150.4%
achieved as long as BK shares don’t finish below $25 or (-3.4%) from today’s price.
____________________________________________________________
If you are very bearish on even the best of the banks then these plays won’t appeal to you.
If you feel these higher quality names should at least hold their own over the next 21 months, then these combinations have the potential for outsized total returns while offering modest downside protection.
Disclosure: Author is long shares and short options of both NTRS and BK.
