Last week, I posited that Bank of America (BAC) is on the road to 100% upside from current levels based on its historical return on average asset numbers and some drivers of that metric. I won't rehash that article here but this article is part two in BAC's path to doubling the share price.
The company's Project New BAC has received a tremendous amount of coverage since being announced several quarters ago. In essence, the project aims to reduce operating expenditures by $8 billion annually by eliminating redundant or otherwise unnecessary expenditures. Part of this is, of course, labor costs and the way that banks compute this cost is through an efficiency ratio. The efficiency ratio also contains other costs but the bulk of this ratio is always going to be labor so it is a decent proxy for a company's ability to wring revenue from its employee base.
While there are slight variations in the definition of efficiency ratio, for this exercise, I'm using the definition the company uses in its SEC filings. That definition is the costs BAC expends in order to generate a dollar of net revenue. In other words, the efficiency ratio computes what percentage of each dollar of net revenue, excluding interest expense, is used up in generating that dollar from whatever source. And of course, the lower the efficiency ratio the better because this can be thought of as a sort of reverse gross margin figure for a retailer; the higher the efficiency ratio the lower the company's "margin" is on each dollar of revenue. BAC's results for the past 10 years are below.
The trend here is obvious but before we address the 800 pound gorilla in the chart, let's take a look at the "normal" period before the financial crisis. In the years leading up to the crisis, particularly pre-2007, we see BAC's efficiency ratio hovering around the 50% mark. Some years it's higher and some it's lower but as an average, around 50% is close enough. That means that for every $1 in net revenue the company generated it only paid about 50 cents to do so. For a bank, the average during that same period was markedly higher than that (around 58%) so BAC was actually quite good at producing low cost revenue.
During the financial crisis we see the ratio tick up roughly 500 basis points but it was still within what would be considered a low range and once again, lower than the average for banks in the US. However, starting in 2010 and persisting through today, we see the ratio spike 3,000 basis points (!) to one of the worst ratios in the country, according to the data I cited above. So what happened?
We all know Countrywide and Merrill Lynch were acquired at the end of 2008 and beginning of 2009, respectively, but we don't see the efficiency ratio spike until the next full year, 2010. Why is that? Prior to 2010, BAC saw a revenue spike commensurate with the non-interest expense spikes it recognized with the acquisitions. Thus, the ratio was largely held intact. However, in 2010, net revenue began to dive without the same magnitude of expense reductions, sending the efficiency ratio through the proverbial roof.
In 2008, BAC saw consolidated net revenues of about $73 billion. After the acquisitions, 2009 saw the same figure skyrocket to $119 billion. Subsequently, 2010 saw net revenues dip to $110 billion and the following year, BAC produced just $93 billion and this year, it is expected to come in at $89 billion. It isn't difficult to understand how these drops in revenue would drive the efficiency ratio up because even small decreases in revenue can have outsized adverse effects on the efficiency ratio. When the decreases are in the tens of billions, it doesn't take long for the ratio to spike to unprecedented levels.
In terms of what this means for shareholders, Project New BAC is intended to remove $8 billion per year of expenditures from BAC's income statement. As of the most recent quarter, $1.5 billion of the $2 billion quarterly savings goal had been achieved. That means that BAC is still on track to remove a further $2 billion of annual expenses from its income statement from New BAC. On BAC's $89 billion in expected revenue next year, $2 billion in further expense reductions will reduce the efficiency ratio by just over 200 basis points, further bolstering profits.
However, that is not the biggest potential positive we can infer from BAC's efficiency ratio history. The long term implication of the data we've examined is that BAC has built-in capacity to expand revenue greatly without incurring much in the way of incremental costs. This is akin to a retailer building out its distribution network before the stores are in place. In other words, BAC is getting its house in order before expanding its revenue base. In the short term, this depresses profits but the long term payoff could be huge.
Consider the following table based on different efficiency ratios and revenue bases; if I'm right that BAC is building capacity to eventually raise its revenue base without having to add much in the way of incremental expenditures, its earnings leverage could be enormous. The three columns to the right of the chart depict the margin implied by the respective revenue base and efficiency ratios in the table. For reference, the 75%/$90B margin number of $22.5 billion is the approximate baseline that BAC is achieving right now.
$90B Rev ($B)
$100B Rev ($B)
$110B Rev ($B)
Under these hypothetical scenarios, BAC could be producing double the amount of margin it produces today under still-conservative scenarios over the medium term. Even if BAC can't increase its revenue base, which seems a long shot given that the company possesses a world class wealth management firm and a huge, growing deposit base coupled with interest rates that are at historic lows, it could still increase the amount of margin it produces from its revenue by a factor of 50% simply by continuing to cut expenses from the budget.
The point is that under most any plausible scenario, BAC earnings are still in a trough. They have certainly come a long way since coming in negative in the wake of the financial crisis but BAC is currently producing nowhere near its peak earnings capacity. Given the tremendous, ahead-of-schedule progress of Project New BAC and the revenue drivers I discussed, BAC should be a great hold for the medium to long terms. Short term volatility should be ignored for long term holders of the stock as the fundamentals for this bank are quite strong indeed.