Bank of America's (BAC) fourth quarter earnings report was generally a very good one. The stock reacted positively to the news and those of us that have been pounding the table to be long BAC felt somewhat vindicated. In this article, rather than make general, sweeping comments regarding the company's direction, we'll get down into one particular metric in order to understand how it impacts BAC's earnings. By doing this, we better understand BAC's business and in turn, our ability to value it increases.
This article will focus on BAC's net interest margin, a measure of how much money BAC makes on lending its money versus how much it costs to raise the money. This is the quintessential bank profit metric and by examining it, we can understand BAC's margins in the way a retail stock analyst would look at gross margins to determine potential profitability.
This chart depicts BAC's NIM for the past ten years and while we all know a lot has happened in ten years, the chart is useful nonetheless. We can see that prior to the financial crisis, BAC's NIM was in the 2.8%+ area very consistently. However, 2012 saw NIM of 2.35%, a steep drop in profitability. This was reflected in BAC's terrible earnings for 2012 but the good news for shareholders is that 2013 saw a sharp increase in NIM to 2.47%. While not at pre-crisis levels yet, this sharp rebound shows that BAC will not only survive the increase in interest rates that is coming, but thrive with increased profitability. As interest rates on the long end of the yield curve move up, so should BAC's NIM and in turn, profitability.
This chart of the 30-year Treasury shows the time period of the beginning of 2011 to today, and the similarity to BAC's NIM is quite striking. There is a very strong correlation to the 30-year Treasury rate and BAC's NIM as you can see that the trough in interest rates that occurred in 2012 had a direct impact on BAC's NIM, with the company posting its lowest NIM in the past ten years. We also see that as long yields rebounded in 2013, so did BAC's NIM and in turn, its profitability. The good news for shareholders is that 3.7% is still far from a "normal" rate on the 30-Year so once the Fed's tapering efforts are complete and quantitative easing is no longer forcing bond yields artificially lower, I believe we'll see markedly higher profitability for BAC.
So what does this mean for BAC's earnings? BAC defines its NIM in terms of its average earning assets, or the amount of the company's assets that are income-producing, such as loans. By knowing what BAC has on its balance sheet and having projections for its NIM, we can predict the level of net interest income BAC may have under certain scenarios. BAC, following its deleveraging efforts that have been so well-publicized, has had a pretty steady earning asset level of ~$1.75 trillion for the past year or so. At the end of 2013 BAC showed $1.747 trillion so we are in the ballpark still and as such, we'll use $1.75 trillion as the baseline for our analysis.
At that level of earning assets, BAC's 12 basis point increase in NIM for 2013 theoretically produced an additional $2.1 billion in net interest income over what it would have produced at 2012's NIM level. While a 12 bps increase may seem underwhelming, when you're talking about earning asset levels in the trillions, it doesn't take much to make a material impact to the financials of the company. The great thing about rising interest rates for banks is that while increases in the longer end of the curve allow for higher rates on lending, depositors see much less of that increase on the short end of the curve. This means that, all else equal, BAC should see some earnings leverage when rates increase, further boosting NIM and net interest income. And since additional net interest income requires little-to-no additional SG&A expenditure, it largely flows to the bottom line. BAC has also shown an aversion to debt financing since Moynihan took the helm, so its cost of funding shouldn't see much in the way of increases due to refinancing of existing debt.
Going forward into the medium term, once the Fed's QE efforts have expired and rates begin to normalize, there is no reason why we wouldn't see the leaner, meaner BAC produce NIMs in the 2.8%+ range once again and if rates really take off, we could potentially see 3%. For the sake of conservatism, we'll assume a medium-term NIM target of 2.8% for our analysis. If we also assume that BAC's earning assets remain static at $1.75 trillion, the company would see an additional $5.8 billion in net interest income and if we assume 80% of that would flow to net income (a reasonable assumption given low taxes for BAC and little-to-no additional SG&A), BAC would see roughly 40 cents per share in additional earnings each year. For a company that earned 90 cents in all of 2013 - that is robust - and remember, it doesn't include any kind of cost savings or other efforts to increase earnings; this is simply from rising rates.
If we take that target and apply an earning asset number of $1.9 trillion, we get an additional 57 cents of EPS from rising rates. While my assumptions may prove not to be exactly correct, the point is the earnings outlook for BAC is very strong even following its huge growth of the past two years. Given all the efforts of the company to remove costs from the model and the increase in rates coming, BAC's chances to earn $1.50 per year or more in the next three years is very high. And given that shares trade at just over $16, that means that shares are still cheap despite the meteoric rise they've seen since 2011.
Some investors fear the rise in rates but for shareholders of BAC, it should be embraced. BAC has done an extraordinary job of turning around a broken company and while the turnaround isn't yet complete, it is well under way. And as we've just seen, BAC simply needs to sit back and wait for rates to rise and collect the additional net interest income, producing substantial additional profits in the process. BAC has tremendous earnings leverage from rising rates and I don't think it will be long before we are talking about BAC earning close to $2 in EPS.