Description

Bank of America is cheap. This is a quality bank trading at 9x earnings. There are two ways to win here:

Bank keeps chugging along. Shareholders will receive +10% in capital per year (buybacks & dividends). On top of that, earnings will grow due to continued improvement in efficiency and modest loan growth. BAC is currently over-capitalized so we can expect capital returns to grow in the future.

OR

The bank quickly rerates to a more reasonable multiple of 12x, which should take the stock close to $35. I believe this is an above average business managed for the long-run by a great CEO.

Why this opportunity exists?

Bank of America has been statistically cheap for a long time. This is widely known.

I believe current fears are: 1) markets believe the US economy might fall into a recession in 2019 2) for years, US banks have traded with the steepness of the yield curve. Many investors believe banks are dead in a flat yield curve environment as the spread in borrowing short and lending long tightens. The curve has flattened in the past few months and financials have “lagged”.

Let´s address these 2 major concerns:

1. Recession: If the US gets into a nasty recession then banks will not trade well. My bet here is that the economy might grow at a slower pace and that is fine. It might sound obvious, but if I thought we were about to fall off a cliff I would not be putting my money in BAC equity.

In case of a slowdown, I believe BAC won´t suffer great losses as the consumer is in good shape, the GFC helped clean many of the financial industry excesses and the bank is run in a conservative way.

If you think a nasty recession is coming in 2019 don´t buy BAC. In a mild downturn, I think BAC will do ok and returns should be satisfactory. If the bank does well in the next downturn, probably investors would be willing to apply a higher multiple to the stock as earnings are proven to be more predictable.

2. Yield Curve: Investors have traded US banks with the steepness of the yield curve. This makes some sense since banks “borrow short, lend long”. BAC has often said that a 1% rise in rates through the curve would yield $3bn in additional income. So as the probability of a parallel rise in rates diminishes, bank equities sell off. The problem with that is investors don´t consider two things:

• Effect of hikes/short term rates: BAC benefits significantly from an increase in the short part of the curve. They have mentioned that the short-end represents 75% of the benefit from a parallel move in rates. Since the crisis, the bank has built significant liquidity and reserves. These funds earn more as rates go up. For these assets the positive impact is immediate. As you can see, ~20% of the balance sheet has benefited significantly from the rise in the fed funds. In 2018, the FED hiked 4 times and most of that benefit will show in 2019 results.

• Valuation at current profitability is undemanding. I think the bank can keep earning ~15% ROTE even if rates stay as they are. This is because the bank has significant competitive advantages in scale, cost of funds, etc.

BAC trades at 1.5x TBV (not a very relevant metric imo) and 9x earnings. In the past 2 decades, BAC has on average traded at 2.3x TBV and 10.5x earnings.

In the decade prior to the GFC, BAC traded above 3x TBV. Since then, valuations have compressed as banks are less profitable, regulation is tighter and there are many scars from ´08. I don´t think the industry will or should return to the days of +20% ROEs. It is better for the system and shareholders to have large financial institutions earning adequate, yet not extraordinary returns. What I think the market has yet to acknowledge is that current earnings are sustainable, and lasting. For this reason, I believe the discount to the overall market might be unwarranted.

Having said that, what about the business?

BAC, as we know it today, was built through a series of acquisitions that transformed the bank into a global colossus that offers various financial services.

Bank of America is a good business because of its deposit franchise. BAC has roughly $1.3tn in low-cost deposits. Out of those deposits, 35% are non-interest bearing and these have been rising even as rates have moved up. The rest are interest bearing and the rate that is paid for the US deposits is less than 20bps. The total cost of deposits, including rates and service expense, was ~150bps. This large and cheap deposit base is a great asset.

Deposits have been growing at ~4% per year, which is solid given the size. Also, more than half of this deposit base is from consumers. BAC and JPM are the leaders in US deposits with more than 11% share each. Followed closely by WFC.

Depositors care more about convenience and safety, than getting a higher rate from their deposits. There are exceptions as large retail clients and corporations do care, but most of the deposit base go to BAC for other reasons (not rates).

BAC has 5 divisions: Consumer, Wealth and Investment Management, Global Banking, Global Markets and Other.

Consumer Banking: 45% of total earnings and 32% of assets

Crown Jewel of BAC. This is the traditional bank that collects deposits in the US and lends to consumers. The CB segment loans are composed primarily of mortgages, credit card and auto.

Earnings have grown at elevated rates in past few years as loans have expanded, rates have risen, and expenses have decreased. The bank has made big investments in its digital transformation which have helped make the division more efficient. A large portion of customers now transact digitally, reducing the need for headcount and branches. In the past 5 years, revenue has grown by almost 20% while non-interest expenses are basically flat. This has made the CB segment much more efficient and Moynihan can be credited with some of this success. He has constantly stated how improving efficiency was one of his priorities.

It is also important to note that the CB segment has been gaining share in the US consumer market. Deposits in the past few years have grown at a CAGR of 7%, which is better than the market. These are valuable clients as they transact often, are sticky and don´t require high rates on their deposits.

The bank should continue to earn good returns on assets, given their scale, low-cost funding and low risk business model. As a stand-alone, I believe this business would be considered extraordinary.

Global Wealth and Investment Management: 17% of total earnings and 12% of assets

This segment is the wealth management operation. During the GFC, BAC acquired Merrill Lynch in a disastrous transaction that almost destroyed the combined company and a ton of shareholder value. Having said that, Merrill Lynch is, and for a long time has been, a good franchise that took the wrong path at the wrong time.

In the years prior to the GFC, they aggressively entered the mortgage securitization market. Once the housing bubble popped, the assets Merrill Lynch held in its balance sheet were worth far less than expected. These losses coupled with high leverage and dependence on the capital markets almost killed the institution. If it were not for the BAC transaction, probably ML would have not made it.

Ten years later, the business is managed in a more conservative way. As it always should have been. This is a business where the money is made by charging fees from AUM. This makes it a low risk business and high ROC segment.

ML has a large network of HNW clients that trust BAC with their wealth. This sticky and highly valuable customer base is a great asset.

In the last decade, there has been some pressure on commissions from passive investment. This has pressured fee growth and overall revenue. Going forward, this should be a good business that grows, but at modest rates. A decline in equity markets might impact results in the short term as the AUM base declines.

Global Banking: 38% of total earnings and 18% of assets

This segment holds the corporate, commercial and investment banking businesses. BAC provides services to large corporations including underwriting, treasury solutions, commercial loans, trade finance, etc.

As many of the clients in the segment are large corporations, these are asking for higher rates on their deposits. This increase in rates has diminished the benefit of the “hikes”. This is normal and expected as these are large, sophisticated clients that do care about what they are earning on their liquidity.

This segment might be pressured as market volatility has impacted equity and debt underwriting. Fees from these services might decline as the markets are less attractive for issuers.

Over the past few years, the segment has shown good results as efficiency has improved, large corporations have had strong results and the market has been open for transactions. At the same time, BAC has lost market share in some IB segments such as leveraged loans. Management has stated that their plan is to maintain a decent share of these businesses.

Global Markets: 18% of total earnings and 28% of assets

This segment offers market-making solutions, research and certain capital raising transactions. Over the past few years, the segment has been pressured as spreads have compressed. This has resulted in sub-par profitability, which can be seen in the low ROA/ROE. The segment is also volatile as market movements can affect earnings.

Going Forward

I expect BAC to continue performing well by following its playbook since the crisis. This is growing modestly and improving efficiencies by maintaining expenses in check.

Management has “guided” to modest net revenue growth (GDP like) and flat non-interest expenses for the following years. Expenses will receive a tailwind from lower FDIC payments and branch footprint, while headwinds include technology investments and general wage inflation. I believe this flat expense guide is “achievable” given what they have done in the past decade. Non-Interest expense has declined from $71bn in 2010 (excluding Goodwill impairment) to current levels of $53bn. This while making significant technology investments and gaining share. Remarkable.

On provisions, current run-rate might be below average given how strong credit has performed. Assuming a rise in provisions might be prudent.

On these assumptions, the company should be able to grow earnings at a nice rate. On top of that there should be ~6% share shrink as the bank puts 70% of NI into repurchases. BAC expects to distribute all of its earnings in the coming years given current capital levels.

Conclusion

This is an above average business that currently trades at an attractive price. If the stock remains at current levels, the underlying performance of the business and repurchases should yield good results over the medium to long term. Another positive scenario would be if the market finally applies a more favorable multiple to BAC´s earnings and a quick gain is made.

Risks

If we enter a recession, BAC stock will not perform well. These names are sold off in these environments.

Rates, liquidity and competition have an impact on NIM over the long-term. I believe BAC is one of the low-cost operators in the industry and that serves as a mechanism of defense but it is something to look out for.

Regulation. This is a known unknown since it is difficult to handicap what politicians might do in the future. My stance is that regulation might benefit the incumbents and I don´t have an issue with capital requirements since that makes the system safer. That makes the industry more stable, etc.

Catalyst

No Catalyst