Bank Of America - Expense Cuts Are Driving Earnings, But For How Long?

| About: Bank of (BAC)

Shares of Bank of America (BAC) saw a modest jump towards the upside after the bank posted its third quarter results.

Earnings growth was driven by expense control and fewer loan loss provisions. I remain on the sidelines seeing little opportunities for earnings growth after 2014, as the impact of expense reduction will be diminished while the bank is struggling to grow its revenues.

Third Quarter Results

Bank of America generated third quarter revenues of $22.19 billion, excluding debt value adjustments and fair value option adjustments. This was down 1.5% on the year before and down 3.1% on the quarter before.

The bank reported net income of $2.50 billion, or $0.20 per diluted share, which is ahead of consensus estimates of $0.18 per share. This compares to break-even results in the third quarter last year, and second quarter earnings of $0.32 per share.

CEO Brian Moynihan commented on the performance throughout the quarter, "This quarter, we saw good loan growth, improved credit quality and record deposit balances. Our customers and clients continue to do more business with us. The economy and business climate will improve even more quickly as conditions normalize, and we are well positioned to benefit from that."

Looking Into The Results

Net interest income rose by 3.1% on the year before, coming in at nearly $10.5 billion. The increase was mainly driven by net interest margins of 2.44% widening 12 basis points on the year before.

Non-interest income saw a healthy 7.4% increase to $11.3 billion. Note that weak mortgage banking income was offset by lower negative FVO adjustments, income related to the sale of shares in the China Construction Bank and better brokerage income.

Note that DVA and FVO only reduced revenues by $444 million this year, while lowering revenues by $1.87 billion in the third quarter of last year.

Non-interest expenses fell sharply by some 5.6% to $16.4 billion, driven by lower litigation and personal expenses.

The bank cut its provision for credit losses by over 83% to just $296 million, providing a huge boost to earnings. Note that actual charges were much higher than provisions for credit losses, reducing the allowance for credit losses to the tune of $1.4 billion.

And The Performance Across Divisions

The consumer and business banking division reported a solid 3.6% increase in revenues to $7.52 billion. Earnings rose by 31.6% to $1.78 billion on the combination of revenue growth, lower credit losses and lower non-interest expense. Assets kept increasing, notably brokerage assets and deposits.

The shocker within the earnings report, while not surprising, is the consumer real estate service business which generated revenues of just $1.58 billion, down nearly 49% on the year before. Net losses came in at $1.0 billion even though the unit took a $308 million negative provision for credit losses.

Bank of America's global wealth and investment management unit had a solid quarter as well, as revenues advanced by 7.5% to $4.39 billion. The unit reported a healthy 25.9% growth in net earnings to $719 million as the unit saw positive leverage from increasing assets under management and cost control.

The global banking unit reported revenues of $4.01 billion, up 5.8% on the year before. Net income came in roughly unchanged at $1.13 billion as the bank took higher provisions for credit losses.

Global markets reported a loss of $778 million on the back of DVA and UK tax hikes. Otherwise net income totaled $531 million, still down from last year. Notably fixed income, currencies and commodities generated poor revenues in a quiet third quarter on financial markets.

Valuation And Balance Sheet

Bank of America ended the quarter with $142.8 billion in Tier 1 common capital, resulting in a Tier-1 common ratio of 11.08%, for a tangible ratio of 7.08%.

Tangible book value per share came in at $13.62 per share, while normal book value stands at $20.50 per share. Over the past year, the balance has shrunk by some $50 billion to $ 2.12 billion. Trading around $14.50 per share, the bank trades at 1.1 times tangible book value and 0.7 times the normal book value.

Note that on a Basel III basis, the bank has fortified its balance sheet quite a lot, notably through a sizable reduction in its Basel III risk weighted assets.

Revenues for the first nine months of the year came in at $67.5 billion, up 4.3% on the year before. Earnings saw a boost as the bank has been tight on expense control and cut provisions for credit losses. Earnings roughly tripled to $6.9 billion for the first nine months of the year.

At this pace, annual revenues could come in around $90 billion, as earnings could hit the $9 billion mark.

Trading around $14.50 per share, the market values Bank of America at $156 billion. This values the bank at roughly 1.7 times annual revenues and 17 times earnings.

Bank of America pays a dividend of merely a penny a quarter, for an annual dividend yield of 0.3%.

Some Historical Perspective

Over the past decade shares of Bank of America have lost roughly two-thirds of their total value. Shares peaked in their mid-fifties in 2006, after which they fell to lows of $3 during the financial crisis. Ever since, shares have traded in a $5-$15 trading range.

Note that the bank has been aggressively cutting its activities to bolster the balance sheet again. Between in 2010 and 2013, revenues are expected to fall by a cumulative 33% to an expected $90 billion. The company has steadily recovered its profitability in the meantime, cleaning up the mess of the financial crisis in recent years.

Note that shareholder have seen quite a bit of dilution in recent years on top of their capital losses. Between 2009 and today, the outstanding share base increased by roughly 40%.

Investment Thesis

Bank of America has seen some ups and downs in the business over the past quarter. Expense control, lower litigation expenses and lower loan loss provisions were a major boost to earnings. That being said, revenues failed to show growth as the bank saw weakness in the mortgage business and sales and trading activities, notably in fixed income, commodities and currencies.

Moynihan has been focusing on settling the legal problems, and putting those issues behind, while cutting costs. He still failed to grow revenues for now, but the improved pace of cost cuts is already boosting earnings, which could come in as high as $9 billion this year. Fortunately for shareholders most of the legal nightmares following the acquisition of Countrywide Financial seem to have passed.

So far this quarter, Bank of America cut operating expenses, driven by staff cuts and litigation costs to the tune of $1.1 billion. The company still targets $2 billion in quarterly cost savings by next year, in order to save some $8 billion per annum.

During the quarter alone, the bank cut some 9,200 jobs, a quite impressive 3-4% of the total workforce. Besides general cost cuts, the bank also cut staff at its home-lending activities as higher interest rates have reduced mortgage applications.

Back in April of this year, I last looked at Bank of America's prospects. I concluded that the bank creates value for its shareholders through tight expense management. At the time the bank was still busy resolving its legal issues, cutting costs and shrinking its balance sheet. Fortunately the bank has boosted its capital position allowing the bank to repurchase its shares again, and repurchase expensive preferred stock.

With the bank being on target to report annual earnings of around $9 billion this year, earnings could advance to some $13 billion next year as the bank is completing its job cuts and is saving on expenses.

At the time shares were trading around $11.50 per share as I concluded that management has taken its job to create shareholder value seriously. I noted that the current price at the time provided investors with an interesting entry point. Ever since, shares have risen some 25% to $14.50 at the moment.

At these levels I would be much more cautious. I remain on the sidelines, as profitability growth will be limited after 2014 with the impact of expense control slowing down, while the bank still has to demonstrate its ability to grow its revenues.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.