Bank Of America: On The Buy Radar

The market didn’t like Bank of America’s (NYSE:BAC) third-quarter results, with the stock falling over 5% on the day. Overall, this analyst found the reaction a little harsh. Investors should put BAC on their radar and start buying if this weakness persists.

Source: Google

What you need to know from the results

Let’s start with the obvious strength. This is a period of economic distress. BAC provisioned heavily over the first half of the year, and the third quarter was a key test to see if the bank had achieved a little respite. This happened. The provisioning charge incurred by BAC fell sharply.

All told, the growth in non-performing loans (NPLs) was pretty well contained in the quarter, with NPLs growing $0.2bn in the quarter and up $1bn year to date. BAC’s provisioning for this development far exceeds the loss experienced so far.

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Source: Company data (3Q presentation).

This balance of NPLs is less than half of one percent of gross loans at BAC.

The result of this has been a lower cost of credit in the third quarter. In all, $11.3bn has been set aside to absorb losses so far this year.

41885436 1602736495557273

Source: Company data (3Q results).

BAC didn’t generate bottom-line losses, which means the capital ratios of the bank – always important but more so during periods of economic pain – remained fine. Indeed, CET1 capital adequacy improved in the quarter.

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Source: Company data (3Q presentation).

Remember the 2008 crisis when some very large banks couldn’t raise financing on normally liquid funding markets? Here is CEO Brian Moynihan on the results call yesterday:

Our capital levels and liquidity are at historically high levels as I stated before, and liquidity stands at over $860 billion.

BAC is weathering the storm well, which means it is positioned to do well in a more normal economy in the future.

So what’s not to like?

The obvious area of revenue weakness was in net interest income (typically a little over half of operating revenues), which was down on the quarter.

The second area of weakness was in market-making income.

One of the sources of relief for bank investors over the first half of the year was the perky performance in capital market revenues (both brokerage and product sales fees and market-making income). While generally difficult to forecast and lumpy in nature, these revenues were valuable when interest margins came down due to rate cuts and provisioning charges cranked up to prepare for credit distress. In 3Q, these revenues returned to more normal levels at BAC.

41885436 16027368833810563

Source: Company data (3Q results).

While capital markets revenues are welcome at any time, and this time even more so, the fact is that the net interest margin weakness is of greater concern. It’s a bigger item in the BAC income statement and is generally more predictable than the capital markets business.

Here’s the story for net interest income in terms of net interest yield.

41885436 16027334110030677

Source: Company data (3Q presentation).

There is little a bank like BAC can do to offset this, because a sizeable portion of its deposits – the main source of asset funding – are zero cost anyway, so when its assets roll over and reprice to lower interest rates, the margin squeezes.

41885436 16027334110030677

Source: Company data (3Q presentation).

Of course, on the way up for rates, the same asymmetry is supportive of interest margins, though this isn’t the world we are in right now.

The breakdown of drivers for lower interest margins is given in this slide:

41885436 16027385164597852

Source: Company data (3Q presentation).

CFO Paul Donofrio offered a breakdown of the net interest margin pressures on the results call:

… we believe Q3 will likely be the bottom for an NII and we are optimistic it will move higher in 2021. Let me provide a few thoughts on why we feel good about NII moving forward. First, commercial loan utilization rates are at historically low levels. And with the economy expected to slowly grind forward, we are optimistic that over the next quarter or two, you could see C&I loan demand start picking up.

… we also had seen spending on credit cards slowly picking up. So with stable customer repayment rates, we could see a seasonal lift in card balances as well. At the very least, we are not expecting the continued large declines seen over the past two quarters in outstanding commercial or card loans.

The good news then is that the bank sees this relatively strong interest margin pressure abating, absent further major Covid-related setbacks for the economy, which might see the Fed ease monetary conditions further.

Expenses: Holding in OK but not a source of operating leverage

BAC was able to make progress by holding operating expenses steady while it enjoyed interest margin expansion as rates increased from end-2015. Though headcount reduced by 3,000 in the third quarter, expenses were $1bn higher over the second quarter, and with revenue essentially flat, we saw lower operating profits before provisions.

Here’s Paul Donofrio:

First, about $600 million of the increase is from elevated litigation expense. The remaining increase is split between higher COVID costs and merchant processing expenses, which are not higher, but just accounted for differently this quarter following the JV dissolution. The elevation in our net COVID expense was driven by cost associated with processing unprecedented levels of claims for unemployment insurance, through our commercial card product, and continued costs of supporting PPP loans. Both of these activities have revenue benefits, which helped offset some of the costs.

With respect to expense in Q4, we don’t expect to have a similar amount of litigation expense, and we don’t expect a repeat of the Q3 activity with respect to processing unemployment insurance claims. Therefore, we believe absent other unexpected changes, our Q4 expense number should be in the neighborhood of around $13. 7 billion

BAC has a good track record of delivering on cost targets, and I would trust this outlook, though Covid can always impose unexpected burdens. However, as I have written previously, BAC’s operating leverage story is out of juice for now.

In summary, the income statement wasn’t great, but profitability improved due to lower provisioning charges, and the outlook is relatively positive for key line items relative to the pressures of this quarter.

Valuation

My guess is that sell-side analysts will reduce interest margin forecasts and provision charges for the fourth quarter, and this will not have a great net impact on EPS forecasts further out. Currently, the PE ratios of BAC and its three large-cap peers are as follows:

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Source: Nasdaq EPS forecasts, Author Excel

BAC now looks somewhat cheaper than JPMorgan (NYSE:JPM) out on 2022, which is a more “normalized” forecast year and the one I would use here as a guide.

Under normal economic conditions, these banks try to turn all or nearly all of their net attributable income into buybacks and dividends, with buybacks having been the favored use of funds in recent years. Currently, there are strong curbs on dividends and buybacks are suspended. BAC’s dividend remains well covered and the yield is 3%. The suspension of buybacks may frustrate some investors, but it also speaks to the potential for a lower risk premium for this sector once it is through the pandemic economy.

The only “problem” with BAC from a valuation perspective is that it is less obviously cheap than Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC). WFC faces fairly deep operational challenges to improve its governance and cost efficiency, while C faces a management handover and recently faced a reprimand from the Fed for its slow progress on upgrading its currency risk systems. Both these banks offer greater upside potential than BAC, with risks recognized in the lower PE ratios.

Conclusion

I remain neutral on BAC.

Positives: The balance sheet and capital positions are sound, the P&L evolution in 3Q improved due to lower provisioning charges, even if the active income lines were underwhelming. The journey from the current 2022 PE valuation to a more typical 12-14x EPS would give an investor decent upside.

But: You get the above strengths with C, and if WFC can deliver on its management and operational objectives, these stocks will be the places to be among the large banks.

I am watching BAC’s currently weak performance with interest. If it gets cheap enough to buy, I will let you know.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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