I have written a number of bullish pieces in recent months regarding Bank of America's (BAC) turnaround efforts, capital return plans and prospects for the future. I believe the bank is set up with a great CEO who is exactly what the company needs for its gargantuan turnaround effort that is already well under way. However, expenses are climbing quite rapidly at the bank as a percentage of revenue and I am a bit concerned in light of declining net interest margins and the regulatory environment that BAC might be spending too much to run its business.
The data for these graphs were pulled from BAC's 10-Ks filed with the SEC.
This graph shows the relationship of BAC's revenues and operating expenses since 1999.
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What we see is that BAC's revenue and expenses were largely stagnant from 1999 - 2003 when we saw both begin to increase quite rapidly. The good news is revenues grew much more quickly than operating expenses; that is, until 2007. Following the well-publicized Countrywide and Merrill Lynch acquisitions, BAC's revenues and expenses exploded in the latter part of the last decade. Unfortunately for shareholders, we see the revenue line decrease from a peak of $121 billion to just $83 billion last year. As a result, we see a massive convergence of the two lines, indicating that a larger percentage of BAC's revenues are being used up to pay operating expenses. Obviously, this is negative for net income as less and less money is available to cover variable expenses and to provide a profit.
Below, we can see the same data but depicted as the company's efficiency ratio. Basically, this is just the company's noninterest expenses divided by revenue, net of interest expenses. The efficiency ratio is a way to determine a company's operating leverage, or the amount of its revenue that is being used to cover fixed costs before being allocated to variable expenses and, eventually, profit.
Please note, there are several variations of the efficiency ratio and this is my take on it. I am fully aware it can be computed different ways but this is the way I find it to be most effective and useful.
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What we see in this graph is the very reason why I'm a bit concerned about BAC's spending. After hovering in the 50% to 60% range prior to the financial crisis, BAC's efficiency ratio has skyrocketed to 87%! You can see the inflection point in the data and it involves the Countrywide and Merrill Lynch acquisitions. I can understand these acquisitions would cause BAC to incur incremental operating expenses as it was trying to absorb two entities that were already huge in their own rights. However, one would expect commensurate increases in revenue to accompany those expenditures. We have seen, though, that this has not played out for BAC. I am not suggesting those acquisitions won't eventually pay dividends for BAC shareholders, but we can clearly see the thus-far disastrous results.
The brokerage world is not the same as it was before Merrill Lynch was acquired for a ridiculous sum of money during the financial crisis and Countrywide has provided nothing but massive losses, enormous litigation expenses and headaches for BAC. However, Countrywide's mortgage business will eventually become a strong source of profitability for BAC. In fact, this is a primary reason why BAC is my favorite money center bank. I believe BAC is best positioned to take advantage of a growing, appreciating housing market. At some point, the litigation and asset write downs will cease for Countrywide legacy portfolios. At that point, BAC will begin to reap huge rewards from the business.
I still think BAC shares are undervalued here and are a great place to park long-term cash. However, management must find a way to curtail expenditures resulting from Merrill Lynch and Countrywide. I believe this effort is under way and is succeeding but management has a long way to go, as we saw earlier.
Of course, there are two ways for BAC to improve its efficiency ratio, and thus, profitability. It can either arrest the decline in revenues or it can accelerate the decline in operating expenditures. Ideally, both would occur, resulting in the maximum profitability gain. I believe this will occur in the medium term due to CEO Moynihan's desire to "right size" the bank for the new banking environment we have seen arise since the financial crisis. Just for an idea of what an efficiency ratio of 70% would mean for BAC, at last year's revenue of $84B, expenses would clock in at roughly $59 billion. Contrast this with the actual result of $72 billion and you'll see there could have potentially been an additional $13 billion available for profit. Obviously, this is easier said than done but it highlights the massive earnings potential BAC has if it can monetize its investments in Merrill Lynch and Countrywide. According to what I see, those two entities have been virtually nothing but cost centers for Bank of America, but once costs are under control and revenue begins to increase, look out above.
Disclosure: I am long BAC.
