Investors in Bank of America (BAC) had a great start of the year with shares advancing over 5% in the first two trading days of the year alone. A big upgrade from analysts at Citibank is the main driver behind these strong returns.
While analysts cite fewer uncertainties and a strong US economy as main reasons to be upbeat about the prospects for the bank, I remain more cautious. Even when factoring in significant improvements, returns on equity fail to match the cost of the equity, warranting a slight discount to the common equity valuation.
Analysts Predict A Good 2014
Last week, Citigroup's (C) analysts upgraded the rating on Bank of America from "Neutral" to "Buy." The price target was hiked by some three dollars to $19 per share. The target suggests another 15% upside from current levels, after shares of the bank have risen some 45% over the past year.
Analyst Keith Horowitz believes that the bank has many built-in earnings drivers, notably on the cost side. Combined with continued improvements in the US economy, shares could be a "play" on the US economy. As I explain further in the article, BAC is already realizing 70% of targeted quarterly cost savings of $2 billion per quarter, limiting the operating leverage going forwards.
The asset sensitive balance sheet and exposure to US consumers makes the bank interesting according to Horowitz. These trends should reduce the beta of the stock, and thereby the cost of equity. Based on a declining beta towards 1.25, cost of equity is seen just below 11%, justifying the higher price target.
While the concept of the capital asset pricing model is useful, I don't believe the use of such a low beta is justified, given the inherent volatility of banks due to the high degree of leverage and operational risks. While credit continues to improve, there is limited potential here as well for the bank. Actual losses have fallen sharply in recent years, but so have loan loss provisions, with loss reserves no longer increasing. As such, any potential good news in terms of delinquencies will not improve earnings going forward anymore.
Despite these expected improvements, the bank is expected to report results for the upcoming fourth quarter results, scheduled to be released on 15th of January, which are in line with consensus estimates.
A Bank In Recovery..
If Citigroup's price target would be achieved it would send shares to the highest levels since 2010. While shares have already more than tripled from lows around $5 in 2011, shares still have a long way to go. Note that shares traded in their mid-fifties in the years before the recession. A return to these levels is not very likely, especially as the outstanding shareholder base has increased by some 40% over the time period.
The bank which has been struggling to report revenue growth has focused on costs and the sale of non-core assets to streamline the operations. Since 2010, the bank has shed $70 billion in assets, while strengthening the balance sheet. Greater capital, a reduction in long term debt and asset divestitures make the bank already compliant to 2018/2019 Basel III capital requirements rules. The Basel III Tier 1 common ratio stands at 9.9% at the moment, exceeding requirements of 8.5%.
While the financial position is stable and solid, which has alleviated concerns of investors in recent years, further progress depends on cost cuttings and finally revenue growth again. Tightening rules in terms of trading, mortgages as well as leverage are not helpful in a still difficult business environment.
The bank continues to operate with the supermarket model, serving all kinds of clients through its operating segments. This includes the consumer and business banking unit, consumer real estate services, global wealth and investment management, global banking and global markets business. Note that revenue generation is roughly split in half between net interest income and non-interest income.
..By Shedding Assets And Cutting Costs
The bank has been focusing on cutting costs and shedding assets to recover investor confidence and boost the profitability of the bank.
The bank has been cutting costs, currently saving $1.4 billion a quarter. This makes the company on track to save some $2 billion in costs per quarter, or about $8 billion per annum by the mid of 2015.
This comes at an expense, notably through job cuts. The bank currently employs some 248,000 workers, down by 40,000 compared to two years ago.
On top of shedding operating costs, the bank anticipates that it can finally end the huge litigation and warranty costs following the financial crisis. The bank has reported $43 billion in cumulative representations and warranties expenses over the past four years, still having $14 billion in reserves. While there are significant legal headaches still ahead, the bank made huge progress in tackling these issues while the current reserves should at least pay a great deal of these costs.
Looking At The New Bank
The bank reported earnings of $2.5 billion, or around $0.20 per share in the third quarter, on revenues of $22.2 billion. The bank saw modest revenue growth and spectacular earnings growth in the first three quarters of 2013.
Given a solid fourth quarter earnings report, Bank of America is expected to generate revenues of around $90 billion, with earnings coming in as high as $9 billion. While these are impressive numbers, and incremental cost improvements could boost earnings to $12 billion going forward, note that the operations are huge.
The bank works with a $2.1 trillion balance sheet, while operating with roughly $220 billion in shareholder equity. Even when seeing sizable net income of $12 billion for 2014, returns on equity stagnate around 5-6%, trailing the cost of equity. Returns on a tangible base come in around 8-9%, approaching the cost of equity.
I thereby note that shares trade at $16.40 per share, which values the bank at 1.2 times tangible book value, yet the bank still trades at a 20% discount compared to the common equity valuation.
What's Changed In My Opinion
I analyzed Bank of America when the bank released its third quarter results in October of 2013. I noted that expense cuts are the main driver for earnings, but wondered how much further cuts could boost the bottom line.
Within three months, shares have risen another 10-15% on the back of the strong stock market momentum. More job cuts and lower litigation expenses could boost earnings momentum further, but the easiest gains have been made. As such I argued that revenue growth had to show meaningful growth to justify the current valuation and the strong momentum.
Even when I factor in incremental lower costs of $3 billion going forwards, with earnings approaching $12-$13 billion for 2014, I don't believe that shares are a nice investment at the moment. The lack of dividends is a turn off, despite the improved prospects for higher dividends. Note of course that the bank has been paying a dividend, the problem is that it is just a penny a quarter.
Note that the Fed's tapering could provide upside to the earnings forecast with near term rates still guided towards zero, while long term rates are already on the rise. Ten-year yields have risen to 3% already on the improved prospects for the economy, with the steeper interest rate curve being good for banks.
While Citigroup believes the solid state of the US economy could reignite returns on investments and revenue growth, I am still not convinced. Current revenue growth so far in 2013 was not that great, despite a reasonably solid US economy.