Tracking Bank of America's (BAC) "New BAC"
Bank of America will announce its earnings this Wednesday, July 17th 2013. A substantial part of the investment case for BAC hinges on management's continued performance against the stated cost reduction goals, specifically their "New BAC" initiatives (Phases 1 and 2).
This short note aims to (a) recap on what has been accomplished to date vs. what has been promised and (b) to evaluate what type of announcement in the forthcoming earnings release should be seen as positive news for the stock.
What we know
New BAC Phases I and II are expected to deliver significant on-going core expense savings of $5bn and $3bn per annum (respectively) for Bank of America, as repeatedly confirmed by management over the last reporting periods. The completion of phase I is targeted for the end of 2013 and, consequently, quarterly benefits should reach $1.5bn by the end of this year. Phase II is supposed to be complete by the end of 2015.
So how is BAC tracking against these objectives? In the last earnings call, Bruce Thompson (CFO) stated the following:
"We've said that at the end of 2012, on a quarterly basis, we had achieved $900 million per quarter of New BAC cost saves in the fourth quarter of 2012. So as you look to adjust your models, we will take that $900 million a quarter that we would have had in the fourth quarter and that will grow to $1.5 billion by the fourth quarter of 2013."
Due to the fact that Phase I and II are running in parallel, it is not straight forward to work out exactly how much of the remaining target of $600m per quarter has been accomplished in Q1 2013. However, management did disclose in the last earnings presentation that out of the total of $13.8bn of core operating expenses (i.e. excluding LAS, annual compensation costs and litigation expenses), approximately $0.8bn related to higher incentive compensation costs. (Incidentally, this cost increase should be seen as a positive as it is, presumably, paid only on the back of increasing business profitability.)
The corresponding core expense figure for the preceding quarter was $13.3bn. Therefore, on a comparable basis, Q1 2013 expenses should have been expected to come in at approximately $13.0bn. Alternatively, including increased incentive compensation and assuming no further benefit from New BAC initiatives should have yielded a core expense figure of $14.1bn, with the difference to the actually achieved costs attributable to cost reductions, presumably related primarily to New BAC.
It is likely that some element of this $300m cost reduction is already related to New BAC Phase II and unfortunately it is not possible to quantify this more accurately from the disclosures made. However, taking a conservative approach and attributing the entire amount to Phase I allows us to estimate how the remaining savings may be realised over the course of this year:
What we would like to see
In this week's earnings call, it would be encouraging to see progress along the lines projected in the above table, i.e. a cost reduction attributable to New BAC of at least $100m. A larger amount would be preferable as not all of the estimated $300m costs savings in Q1 are clearly attributable to New BAC Phase I or II.
The value of demonstrating further progress against these cost reduction targets should not be underestimated for two reasons:
- The total cost reduction target of $8bn would translate into an improvement of approximately 80c of EPS against current levels. This very large part of the potential earnings power of Bank of America is currently masked by legacy legal issues and legacy operational issues stemming from the breakneck acquisition spree of the bank's previous management team.
- The market has not acknowledged this potentially large EPS boost, which may be realised over the next 2.5 years. The stock price remains suppressed vis-à-vis competitors whilst the market is waiting for confirmation that BAC will indeed be able to deliver on the stated objectives. Clearly identifiable progress on this dimension would improve the market's perception of the bank and, in time, could lead to an increase in stock price over the course of the next year as realised and promised EPS gains lead to a revaluation of the stock.
As we have argued in a previous note, Bank of America's earnings power can be estimated at approximately $2.0 per share and it is clear that the planned cost reductions must be a major component of achieving this target. Other steps taken by management, such as the optimization of its funding sources and costs, also have a role to play but are much smaller in comparison to the operational efficiency gains targeted (or the wind-down of Legacy Asset Servicing costs and associated legal expenses).
Earnings of $2 per share would represent a very attractive return on BAC's tangible book value (currently at approximately $13.3 per share) and thus a multiple of 10 - 15x would likely be justified, pegging the potential future stock price at $20 or higher. Demonstrating progress against the stated objective of increasing operational cost efficiency is therefore a "must do" for management in the quarters ahead.
In our view, management has largely delivered on what it has committed to shareholders to date and we therefore believe that the stock is priced attractively at current levels with upside to $20, especially if this week's earnings announcement is indicative of continued strong delivery on the stated objectives. We see the stock as delivering a potential return of over 50% from current levels over the next year and a half.
A future article will track management disclosures and progress against the cost reduction targets as Bank of America completes New BAC Phase I and shifts its focus to Phase II.