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KBW CEO sees legs in bank stock rally if reforms come

?Expected regulatory, corporate tax reforms might be necessary for bank stocks to run higher

?Bank M&A, including larger deals, likely to pick up

?Bank IPO activity poised to rebound

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Tom Michaud,
president and CEO of Keefe Bruyette & Woods.

Source: KBW

Tom Michaud, president and CEO of financial services-focused investment bank Keefe Bruyette & Woods Inc., called the bottom in bank stocks last year at the Stifel Financial Corp. unit's Winter Financial Services Symposium. This year at the event, following a three-month run-up in bank stocks, Michaud discussed his outlook for investing in the group as well as for M&A and IPO activity.

The following is an edited transcript of the interview.

S&P Global Market Intelligence: Bank stocks have rallied nearly 25% since the U.S. presidential election, while earnings estimates have only risen 8%. Is there any concern that we're not appropriately discounting anything?

Tom Michaud: The market is following what we've been calling our "blue sky" estimates. We have our real estimates and then blue sky estimates, which incorporate corporate tax reform and greater regulatory reform. Those estimates for the global systemically important banks could be 25% to 30% higher than before the election.

The stocks are up 25% since the election so the market has adjusted for the blue sky estimates. To really get the group moving again robustly, you're actually going to have to see the changes being made. We're actually going to have to start seeing Dodd-Frank amendments and a corporate tax reform policy. I think the first leg up has happened and now the focus has to turn to Washington to actually see it being implemented before I think you get another leg up.

[KBW expects bank margins likely will begin rising this year and then enjoy a sustained period of improvement. The firm's bank earnings estimates bake in four Fed rate hikes over 2017 and 2018 and modest regulatory cost improvement. They include lower mortgage originations due to higher rates but not corporate tax reform.]

If you take these blue sky estimates, you'll see the median U.S. bank ROE go from 12% to 14.5%, their ROA will go from below 1% to 1.15%. That kind of return on equity is back to a precrisis level.

And that means banks would clearly be earning their cost of capital, putting that discussion to bed.

And when you're talking about capital, it's at a 70-year high. If that happens, the industry will be on a really good footing. It will have regained its profitability from the crisis, we'll have revenue growth because margins will have inflected and banks will be earning their return on the highest amount of capital in 70 years. That's the bull case. That's why if you actually start to see the pieces come into place, you could see this being a good environment for several years. That's why I'm not ready to say the rally is done but I do think in talking to investors and then looking at the math, we need to see the pieces fall into place.

You had a number of banks come to market late last year with common equity raises. Do you think we'll see more of that? Do you expect the IPO market to heat up?

Absolutely. I think higher stock prices become a catalyst for more to happen. We're in an area, at least in my 30-year career, where bank stocks are being valued where they're not often valued. I think management teams are going to use that opportunistically. We've done 16 deals since the election. We raised more capital for banks after the election than we did before the election and most of that capital is growth capital. I also think that higher stock prices will lead to more IPOs.

The M&A outlook clearly has gotten better as well. Even if the exchange ratio is the same, the optics just look better. Does that provide a nice tailwind for M&A?

M&A activity is going to go up in my opinion. Absolutely. The market is rewarding certain buyers, and certain companies trade at extraordinary valuations. There are some management teams that investors feel very comfortable having them do acquisitions. I think there is also pent-up demand on the part of sellers. We went back in history and found a year where Norwest bought something like 16 banks in a year. Now the prolific acquirers will do two. There's almost a queuing for some of these active acquirers. Your best buyer may be busy doing another deal which means as a potential seller, you may need to wait. I think at the end of the day, there are more sellers than buyers. There are a couple of banks that a lot of banks would like to sell to.

At the Acquire or be Acquired conference, you said you expected bigger deals this year. What is driving that?

I think some banks are becoming regional champions. Some of it is the law of numbers. As a bank approaches $15 billion in assets, they tend to get less interested in half a billion dollars and tend to think a little bit bigger. I think one of the best examples of that is Pinnacle Financial Partners Inc. [Nashville, Tenn.-based Pinnacle ($11.19 billion in assets) recently announced plans to acquire High Point, N.C.-based BNC Bancorp ($7.40 billion in assets) for $1.76 billion.]

You have these regional champions evolving. Banks have become more comfortable crossing $10 billion in assets. When these barriers came up, the banks, regulators and investors had to figure it out. Now that we've had it for a few years, even though I hope it changes, management teams are more comfortable crossing $10 billion. We haven't done that with the $50 billion asset threshold.