Bank of America: A Beast Heading for Profits (NYSE: BAC)
Bank of America (NYSE: BAC) is expected to report results tomorrow, October 17. The stakes couldn’t be higher. Last week, American banks like JPMorgan Chase (JPM) and Wells Fargo (WFC) published earningsmost exceed expectations. But while their results exceeded expectations, the profits always refusedprimarily due to higher provisions for credit losses (“PCL”) and weakness in investment banking.
Of the major US banks, BAC probably has the best chance of generating positive growth in pre-provisioning net income (i.e. net income excluding loan loss reserves). All major banks have experienced significant reserve builds and are unlikely to see positive growth in reported earnings. However, some banks have seen positive adjusted earnings growth this year; for example, Toronto-Dominion Bank (TD)(TD:CA) adjusted earnings increased 5.1% in the last quarter. Bank of America will most likely report negative earnings growth under GAAP, but could report an increase in “pre-tax and pre-provision” earnings, a sort of measure of adjusted earnings. In its most recent quarter, BAC’s pre-tax, pre-provision earnings grew 15%, so we may see the strength of this metric again this quarter.
Why is this important?
Because if this happens, it confirms that BAC’s core business is healthy. PCL construction is a classic “on paper” cost. This is money set aside to cover potential non-performing loans, not loans that are already in default. When the economy becomes more risky (for example, enters a recession), banks generally increase their PCLs, but if the risks decrease, they reduce them later, which leads to a rapid increase in profits. All major banks are already posting higher net interest income (“NOI”) due to Fed interest rate hikes; if the economy does not go into too deep a recession, they will eventually be able to reverse their PCLs and report higher incomes.
Bank of America is extremely well positioned here, as the overwhelming majority of its income comes from interest. Bank of America generated $22 billion in revenue last quarter, of which only $1.1 billion was in investment banking fees. BAC generated the third-largest amount of online banking fees of any U.S. bank during the period, but its exposure to investment banking as a percentage of revenue was well below that of Goldman Sachs (GS) or Morgan Stanley (MRS). Thus, BAC has a much faster recovery path than these banks.
In this article, I will argue that Bank of America is extremely well positioned ahead of tomorrow’s earnings release. Based on prior quarter earnings as well as some third quarter earnings estimates, I will argue that the release will be strong. But first, I need to take a look at how BAC stands today.
Bank of America – Competitive Advantages
Bank of America has a number of competitive advantages in US financial services. These include:
A strong brand. Bank of America is one of the best-known US banks and its brand is the most valuable of its peer group (it has been valued at $36.7 billion).
Operational diversification. Bank of America operates in retail banking, commercial banking, wealth management, and investment banking. This mix of activities allows BAC to better position itself in the current environment compared to pure-play investment banks.
High market share in national filings.
The point on investment banking deserves a little explanation. Of all the financial subsectors, investment banking is the worst performer this year. Due to the tech stock market crash, companies are choosing not to go public. As a result, technical revenues are down. Bank of America is no different from other banks in this regard: its investment banking fees have fallen 47% in the last quarter. However, investment banking represents only 5% of BAC’s total revenue, so it is better positioned than Morgan Stanley, Goldman Sachs and other pure-play investment banks.
Bank of America’s Most Recent Earnings
Speaking of Bank of America’s earnings, we can now turn to its second quarter results. By understanding what happened in the second term of BAC, we can have an idea of what it has in store for us in the third.
In the second quarter, Bank of America delivered:
$22.7 billion in revenue, up 5.5%.
Net interest income of $12.4 billion, up 22%.
$523 million in PCL, up $2.1 billion.
$7.4 billion in pre-tax and pre-provision revenue, up 15%.
$2 trillion in deposits, up 7%.
$1.1 billion in investment banking fees, down 47%.
A CET1 ratio of 10.5%, well ahead of regulatory requirements.
A tangible return on ROE of 14.1%.
$6.2 billion in net profit, down 32.6%.
$0.73 diluted EPS, down 29%.
As you can see, revenue has increased, net interest income and income before provision have increased. Why, then, the decline in net profits?
It boils down to two things:
PCLs have increased. PCL is not technically a “loss”, but it is a charge taken from net income. An increase in this metric can result in lower net income even when operating income increases.
Investment banking fees have fallen. A $1 billion drop in investment banking fees made up the lion’s share of BAC’s profit decline in the second quarter, outside of PCL construction.
So, we can see that of the $3 billion decline in BAC’s earnings, only $1 billion was due to a poorly performing segment. The PCL construction is only a precaution. This reduces net income, but does not reflect actual defaults. In 2020, all major banks increased their PCLs, but later reversed the accumulation when the COVID lockdowns ended. We could see a similar situation in 2022. The last two quarters have seen GDP decline, but only modestly. The economy continues to create jobs. Retail sales continue to increase. Employers are struggling to fill positions. Simply put, the economy is still strong in many ways.
It’s not exactly the kind of environment in which banks struggle to make money. Many people worry about the possible recession we find ourselves in, but ignore the fact that, if it is a recession, it is very mild. The economy does not exist in two states, one where we are in recession and everything is bad, the other where we are not and everything is fine. There are degrees of recessions; the second quarter economic contraction was only 0.6%, a far cry from 2008 or even 2020 levels. So there is reason to think the economy will rebound. If this is the case, LAC will be able to cancel its PCLs and start reporting a higher net income.
what to expect tomorrow
After reviewing BAC’s second quarter results, we can now move on to tomorrow’s release. We can never say for sure how a business will perform over a given period, but there are certain indicators that we can learn from.
First, BAC’s competitors exceeded expectations when they released their results last week. JPMorgan beat on revenue and earnings, Wells Fargo beat on adjusted earnings but not on GAAP earnings. Thus, companies similar to BAC are doing well.
Second, expectations are not high. In the past 90 days, only 2 analysts have revised their BAC revenue estimates up, 9 have revised them down. So, expectations are low and easy to beat.
Third and finally, there are statements from company insiders that point to the strength. Recently, Bank of America CEO Brian Moynihan said the American consumer is strong. Most likely, this statement was informed by Moynihan’s knowledge of his own business, so it could portend a decent income.
Now, a negative: BAC recently agreed to settle a $1.84 billion lawsuit. The settlement was a win because the Bank was able to reduce the amount by $3 billion, but it will result in a pretax expense of $354 million in the third quarter, or $0.03 per share. Markets expect earnings of $0.78 per share, up $0.05 from the prior quarter. The settlement isn’t huge, but it could be enough to cause a shortfall. Given the other signs I reviewed above, I would expect BAC to meet or exceed revenue expectations, but perhaps not PSE.
The only big risk to watch out for
As I’ve shown in this article, Bank of America’s third quarter earnings are expected to be very strong. Earnings might be a little behind estimates, but not by much. All in all, we’ll probably see a decent release.
However, there is a long-term risk that investors should be aware of:
Deterioration in consumer credit. Bank of America makes a lot of money lending to ordinary Americans; if rising interest rates make life more difficult for the Bank’s customers, they could eventually start to see defaults. Most recently, LAC launched a pilot program where it offered no down payment mortgages to members of underserved communities. The plan had ambitious goals, but it ultimately involved lending money to people with little or no credit history or assets. It sounds suspiciously like the subprime lending that took place before the mortgage crisis of 2008. It ended up creating problems.
When interest rates rise, consumers must pay higher rates on variable rate mortgages. Risky loans become even riskier when interest rates rise, and Bank of America is now experimenting with some very risky loans. Overall, BAC’s business is strong, but investors will want to keep an eye on consumer health, as a weak consumer often leads to poor retail banking results.