Bank of America (BAC) traded down near 5% on Wednesday ostensibly because of "disappointing" Q1 earnings. Here is what the Financial Times had to say: "BAC suffered a setback on its road to recovery as revenue in key divisions declined and earnings missed expectations".
This is inaccurate. Revenue at BAC was $23.7bn, which beat analyst estimates of $23.4bn. EPS was 20 cents, 2 cents shy of analyst estimates because of $900 million in litigation expenses (typically not included in analyst models because of their inherent unpredictability) and $900 million in "retirement-eligible stock-based compensation awards" which BAC typically has in the first quarter but some analysts had apparently forgotten to include in their models. Between them, these two items represent 1.2 cents/share accounting to within a penny for the EPS "miss".
Road to Recovery
In fact, the quarter demonstrated how far along the road to recovery BAC has come. Most importantly (as announced on 3/14 and anticipated in our article of 1/16), BAC will buyback $5.5 billion of preferred stock (which will not be replaced so that the ~$500mm/year of dividends will flow to common stockholders and lift EPS by ~5 cents/share) and $5 billion of common stock.
For as long as the stock price is below tangible book value/share of $13.46, we expect BAC to continue buying back common stock as aggressively as it can and in preference to paying a dividend. The bank has plenty of firepower given that its Tier 1 capital ratio under BASL III is 9.42%; in other words, the bank has already substantially met the maximum likely capital requirement of 9.5% (comprising a base of 7% and a SIFI buffer at the high end of the 1-2.5% range) well ahead of the 2019 deadline.
This means that, as of now, any excess capital generated by BAC is available for distribution to shareholders. Analyst estimates call for BAC to generate EPS of over $2 between now and year-end 2014 representing ~$23 billion of capital available for stock buyback. (In practice, the available capital will exceed this amount because BAC is becoming more capital efficient in its business as, for example, the legacy mortgage, structured credit, and private equity portfolios run off; this is referred to as risk-weighted assets or RWA mitigation).
Can We Be Confident of Earnings?
With the stock price now at $11.7 and tangible book value of $13.46/share, BAC's buyback allows it to buy a dollar for 85 cents. Of course, the analysis fails if BAC does not generate the capital, through earnings and/or balance sheet actions, to fund the purchase.
But it likely will. Analysts are concerned about key earnings drivers such as the pressure on net interest margins because of low rates and a flat yield curve, the impact on non-interest income of a possible decline in mortgage revenues and variable trading results, and tougher compares on credit costs. Management agrees these are risks and responded on the earnings call as follows:
Net Interest Income: In the current rate environment, management expect this to track at $10.5 billion (ex trading-related impacts) versus $10.6 billion in the March quarter. An important driver (and offset to adverse changes in the yield curve) is loan growth, and the bank is growing its loan book: commercial loans and leases grew 17% year-on-year. (Consumer loans and leases fell 10% because of the run-off from the legacy mortgage portfolio).
Trading Revenue: The business is configured to make a satisfactory return with revenue at $3 billion and a strong return with revenue at $5 billion. This quarter, the trading revenue (excluding the debit valuation adjustment) was $4.4 billion versus $2.5 billion in the December quarter and $5.2 billion a year ago. BAC seems to run a conservative book and so will likely "disappoint" versus competitors on trading revenue in up-quarters.
Credit Costs: Declining provision expense (because of reserve release which amounted to ~$800 million or 5 cents/share in the March quarter). Management appeared to guide to a net charge-off ratio of 1.8% which is a bit higher than the 1.5% reported for the March quarter. In other words, credit costs move from a meaningful tailwind to a slight headwind.
Management's joker is expense-saves. There are two sources: one is efficiency (branded as "Project New BAC") generating run-rate saves of $900 million in Q4 2102 and expected to increase by $600 million to $1.5 billion in Q4 2013; and the second is the expenses to serve the legacy mortgage portfolio which ran at $2.6 billion in Q1 2013 and are expected to fall to $2.1 billion by Q4 2013.
If you buy BAC at $11.70, you are paying ~85 cents on the dollar for tangible book value/share of $13.46. Of course, BAC has traded at a substantially wider discount to tangible book value but this time there is a difference: BAC itself is buying back shares and has the willingness and ability to be aggressive particularly when the price is below tangible book value.