Bank of America (BAC) reported disappointing earnings on Wednesday, sending the stock down about 6%. Of course, it was an ugly day for being long just about anything so I'm certain that didn't help. The banking giant reported net income of $2.6 billion, or $0.20 per share, on expectations of $0.22 per share in earnings. In addition, the investing community is now worried about BAC's ability to generate revenue growth in the future. While this is a generic concern for any large bank, I think the consternation regarding BAC's prospects may be overblown and as a result, the huge decline in shares is likely a great buying opportunity.
First, let's take a look at the business highlights of the announcement. Deposit balances were up 5%, indicating that the bank is still attracting new checking/savings customers. This is key because these customers are most likely to do other business with the bank. Next, the bank pointed out that consumer credit loss rates are at lows not seen since before the financial crisis took full effect. Non-interest expenditures were decreased by about $1.0 billion on the back of restructuring efforts as a result of Project New BAC. Finally, the company reported that its efforts to improve its legacy assets are paying off, with mortgages delinquent for more than 60 days down 39%. These are all great metrics and evidence that BAC is in full-on turnaround mode.
Management also said the bank's capital position continued to improve. The highlights include:
· Capital plan approved by the Federal Reserve to begin this quarter; $5.5 billion in preferred securities redemptions and $5 billion in common stock buybacks
· Long-term debt down another $75 billion from last year
· Basel 1 Tier 1 Common Capital Ratio improved 20 basis points to 10.58%
· Basel 3 Tier 1 Common Capital Ratio improved 17 basis points to 9.42%
CEO Moynihan went on to say:
"Our strategy of connecting our customers to all we can do for them is working. Solid increases in loan growth to small businesses and middle-market companies, four straight quarters of steady growth in mortgage originations, record earnings in wealth management, and another quarter near the top in investment banking fees show we are balanced, focused and moving forward."
Now, all of this good news is terrific as it means that BAC's turnaround efforts appear to be working. If we examine the things that are really important, such as adequate capital cushions, non-interest expenses, deposit growth (customer acquisition and retention), and returning capital to shareholders, BAC deserves high marks. Indeed, shareholders should be quite pleased with the progress the bank has made in the past 12 months.
However, the idea of a lack of revenue growth catalysts sent the stock tumbling and it is important to try and understand these concerns and assess the risk of this going forward to BAC's earnings.
BAC breaks down its results into categories for us and in this way we can ascertain BAC's strongest and weakest lines of business and look for clues as to the future profitability of the bank.
First up, the Consumer and Business Banking segment produced net income of $1.382 billion. While this amount is down slightly from last year's 1Q, it represents the highest nominal profit of any segment in the bank. The bright spots here other than it being the most profitable segment in nominal terms is that it produced that profit while lowering the loan-to-deposit ratio a full 446 basis points. This means the segment is operating more profitably on less risk, all else equal, as loan balances have declined in relation to deposits at the unit. Additionally, as loan balances have moderated, return on sales (net of interest expense) remains very strong at 19.2%. Shareholders should be very excited about the results of CBB and its prospects for the future once the legacy asset issues are fully resolved.
Next up, Global Markets was a real bright spot for the company, posting net income of $1.358 billion. This represents a 64% increase in earnings from the Global Markets division. Total assets were up $93 billion for the division but return on sales fell 297 basis points. Despite the decrease, return on sales was still an eye-popping 26.65%! While the division has become less profitable on a percentage basis, the fact that it's growing is terrific news while still returning nearly 27% return on net sales.
Global Banking came in with $1.338 billion of net income in the quarter, a 15% decrease from 2012 1Q. The segment produced a lot of profit, good for third in the company, but it was on increased deposits and loans. The loan-to-deposit ratio for this quarter was 127% versus 126% last year and return on net sales fell a whopping 547 basis points to a still very respectable 31.47%. While a sizable decline in return on sales is never desirable, the division is still producing an enormous amount of profit for the capital invested there. This division produced the highest profit margin and is a real gem within the organization.
Global Wealth and Investment Management produced $720 million of net income in the quarter, a 31% increase over last year. Loan-to-deposits is up marginally to 42% and return on sales accelerated 302 basis points to 16.29%. This is perhaps the best performing division overall within the company, growing return on sales substantially while producing a huge increase in net income. Unfortunately for BAC, the sheer lack of size in the segment is not enough to make up for the losers of the bunch.
Speaking of the losers, Consumer Real Estate Services continues to hemorrhage money, losing over $1.3 billion in the quarter. The bright spots are few and far between for this division, but the main positive to take away is that the loans and leases the segment owns declined 16%. With the way the segment is losing money, any decline in its assets is a positive thing. There isn't much to say about this division other than it appears the efforts to wind down legacy assets is in full swing with such a huge decline in loan/lease balances.
The last segment of BAC's business is just labeled "Other" and it was also a money-loser in the quarter. Again, this is nothing new for the "Other" business but the $867 million loss was a vast improvement over last year's $2.605 billion loss. Average loans declined 9.4% to $245 billion which, again, is a plus considering the bank is losing money every day with these assets. This is another instance where it is a positive that the business is shrinking because it is unprofitable to the bank. I will look for an ever smaller loan balance next quarter as BAC should continue to wind down these legacy assets. If this doesn't happen, it will be a red flag.
One comment that has me a bit worried is that management stated 91% of the mortgages it funded in the quarter were refinances and the other 9% were new purchases. Given that the refinance boom that the industry has enjoyed for the past year or so is widely believed to be coming to an end in the near to medium term, I have to wonder if BAC is working on a way to increase its purchase originations. I fear relying on refinances in 2014 and beyond will prove to be problematic.
Despite these fears, since BAC pointed this metric out, they are fully aware and I'm sure management knows it will not end well if it doesn't improve. Moynihan has been adamant about cross-selling efforts since he came on board as CEO and the purchase/refinance origination mix leaves an enormous amount of room for growth and change. Wells Fargo (WFC) is the undisputed mortgage king and has been taking share from BAC on that front; it is time BAC takes some of it back. I believe this particular piece of BAC's business will define it in the medium to longer term as it has lost significant market share and by extension, revenue and profit to WFC and others. If BAC can't find a way to turn things around, it will be disastrous. If it can, new highs in the stock are on their way for a long time.
The bottom line is that BAC's core businesses performed very well during the quarter with the main exception being the Consumer Real Estate Services business. The legacy assets on this division's books are continuing to cause headaches and losses for the company. However, the bank is busy winding the division down and we are seeing progress as management noted 60+ day delinquencies are falling like a rock. In addition, the bank is shrinking its unprofitable businesses in an effort to slow the bleeding of earnings. Once BAC works out the CRES mess, earnings should be ready to take off. The Global businesses are functioning very well and producing growth and profitability for the bank; they are truly the bright spots of the company right now. Project New BAC's efforts to control costs and restructure the bank's business lines are working and once the Countrywide mess is sorted out, BAC will once again be an elite bank. If you wait until that happens to get your shares, however, it will be too late.