Tracking Bank Of America Corp's (BAC) "New BAC"
In a previous article we discussed the progress made by Bank Of America Corp (BAC) management against its stated operational cost reduction objectives, specifically, the initiatives known as "New BAC Phase I and II". The present note continues this series with an evaluation of the disclosures made as part of yesterday's earnings release.
In our previous article we estimated that Bank Of America Corp (BAC) was able to reduce core expenses (before Legacy Asset Servicing and Litigation) by approximately $300m compared to the prior period. We also provided the following table to illustrate how further cost reductions against the stated 1.5bn per quarter goal (by end 2013) under New BAC Phase I may evolve:
So how did management do? Fortunately, good progress appears to have been made on all fronts and disclosures in the analyst presentation show a core expense figure of $13.2bn. Simple arithmetic indicates that this is an approximate $100m reduction from Q1 2013 and it is likely that most of this difference can be attributed to New BAC Phase I (this is also consistent with management's comments on the call and in line with our estimate of the potential trajectory above). Whilst a larger reduction would have been preferrable, we are happy to continue to give management the benefit of doubt with respect to its ability to deliver further cost reductions.
Management is clearly well on track to deliver another $200m split across the two remaining quarters and thus to achieve the stated cost reduction target by the end of this year. As we described in the previous note, this is important as the market appears to have assigned a "show me" discount to management's promises over the last years. Yesterday's and today's market reaction indicates that the progress has been received positively, as we had predicted.
What is it worth to shareholders?
The reduction in core operational expenditure of $100m is worth only about 3.5c per share in annual earnings, which may not appear that important. However, considering the market's common practice of punishing or rewarding earnings misses or "beats" even when they are only 1c/share, it is well worthwhile keeping track of the operational improvements management is implementing.
Secondly, the aforementioned "show me" discount will only diminish if management continues to deliver as promised. We therefore will be looking for at least another $100m reduction in core expenses in the next quarter, ending September 30th 2013. On a like-for-like basis, we would therefore expect quarterly earnings to increase from the current 32c/share to approximately 33c/share in Q3 2013, a 3% increase quarter over quarter. By the end of this year, we would expect like-for-like earnings to top 34c/share not accounting for further boosts to EPS through further management actions (such as the optimisation of Bank Of America Corp's (BAC) liability structure as discussed in this article).
An additional positive this quarter was the continued reduction in litigation expenses following the major settlements earlier in the year and the reduction of Legacy Asset Service expenses, which are running ahead of schedule and which will be the subject of a future article (see table below for a brief overview):
LAS Expense (excl. Litigation)
Bank Of America Corp (BAC) is trading at approximately $14.70 at the time of writing and we continue to believe that the stock has upside to at least $20.00 per share over the next 1.5 years, based on our assessment of the potential earnings power driven by continued cost reductions and an improving economic climate in the US. We base this assessment on modeled annual earnings of $1.5 - $2.0 by 2015, which would represent an attractive return on tangible book value of more than 11%, justifying a multiple in excess of 10x. Under these assumptions, the stock offers upside of 36% over this time period.
It is possible that Bank Of America Corp (BAC) will give up some of the recent gains in the remaining summer months as the only near term catalyst would be a potentially favourable outcome in the outstanding $8.5bn BNY settlement case for which the court timeline for a decision (and the outcome itself) remain uncertain. We view these price declines as good entry points and plan to add to our position should they occur.
Additional disclosure: Long position consists of common stock, options and class-A warrants.