Bank Of America: On The Road To Doubling Returns On Shareholder Capital

Apr.14.14 | About: Bank of (BAC)

Summary

Bank of America's ROATCE was unsustainable during the pre-crisis years.

BAC has been de-leveraging its balance sheet, which has depressed ROATCE in the short term but has put the bank in a much better position going forward.

My medium term ROATCE target is 15%, just over double the current level.

In the years leading up to the crisis, Bank of America (NYSE:BAC) and other large banks like Citi (NYSE:C) were producing enormous profits for the amount of equity on their balance sheets. As a key metric in banking, these companies were showing prodigious efficiency in terms of producing returns on tangible equity and it made their respective managements look like they really knew what they were doing. In this article, we'll see what Bank of America's pre-crisis return on tangible equity was and how it compares to the post-crisis period including today to see what we can learn from BAC's past relative to what kind of numbers we can reasonably expect going forward.

To do this, I've selected return on average tangible common equity, or ROATCE, as my metric of choice for this exercise. ROATCE is a measure of how much money a bank makes on the amount of tangible common equity that's on its balance sheet. This measure excludes things like goodwill from the equity calculation and also preferred stock and other forms of capital that aren't common stock. This measure provides a raw look at how efficient a bank is at taking common shareholders' capital and earning a return from it.

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As we can see from the above chart BAC routinely earned more than 30% on its shareholders' tangible common equity before the crisis. It is downright insane that a company the size of BAC was earning 30%+ on its tangible equity but those were the days of pre-crisis excess and unreasonable risk taking. As we can see beginning in 2008, those days ended quickly and BAC's ROATCE plummeted to just over 5% before actually going negative in 2010 (the value is excluded from the graph as it is a non-meaningful number). The next year saw a tiny ROATCE but it has begun to ramp in the most recent two years, with 2013 coming in at 7.1%.

So what does this data tell us about BAC's ability to earn on its tangible common equity? I think it shows us two things with the first being that BAC was far too levered headed into the crisis. The only ways to earn 30%+ on tangible common equity are to take on an enormous amount of risk with the capital you've got or to lever up using debt, which allows a bank to produce a return without additional capital. Earning over 30% on tangible equity is nearly impossible by simply taking risks when you are lending your money to other people as your main source of income. BAC has many other sources of revenue but it is still a bank and as such, earning 30% on its capital is a near impossibility.

That is, unless it is highly levered and that is in fact exactly what happened prior to the crisis. BAC took on enormous amounts of debt, in the hundreds of billions, in order to finance its lending bonanza that eventually brought the company to its knees and required a bailout. This chart shows the amount of long term debt on BAC's balance sheet each year over the same time period as the ROATCE chart above.

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It is easy to see the ramp in debt in the pre-crisis years although the numbers look quite small by comparison on this chart. However, remember that BAC was a much smaller company before it bought Merrill and Countrywide so when it took on an additional $80 billion in debt prior to the crisis that was real money to shareholders. $80 billion seems almost like an afterthought at this point but at the time, BAC was levering up to a high degree, we just didn't know how bad it would really get.

So what does this mean going forward? At the end of last year BAC had $144.8 billion in tangible common shareholders' equity and earned 7.1% on that equity during 2013. We can see that BAC is in a process of rapidly deleveraging its balance sheet in terms of retiring debt that was issued during the go-go years prior to the crisis and its aftermath which means its return on equity will be lower, all else equal, as it has less money it can lend or otherwise use to earn a return. The debt reduction party has been going strong since 2010 and only management knows the level of debt it ultimately wants to have but it appears BAC is focusing more on returning capital to shareholders now as well instead of simply reducing leverage, with much of that work already complete.

Given this, I think we can reasonably expect a value of 10% to 12% ROATCE over the medium term given BAC's still-improving fundamentals and that the company's revenue base has hit bottom and is rebounding. If we assume these numbers on the company's tangible common equity base of $144.8 billion we get net income of $14.5 billion to $17.4 billion possible over the next couple of years. On the current 10.57 billion shares outstanding we are talking about $1.37 to $1.65 in EPS and I think these numbers are reasonable in the next couple of years. In fact, analysts are looking for $1.59 in EPS next year so even my conservative ROATCE calculation looks pretty good for 2015.

BAC has done a lot in the past few years to de-leverage its balance sheet and the results show. The days of 30%+ ROATCE are over but that doesn't mean we won't see BAC get into the 15% range over the medium term. Margins are increasing and when rates finally do rise, we'll see those margins increase further. The bottom is in for ROATCE and as such, we should see much higher values going forward. Prudent management will keep ROATCE elevated for years to come, not to mention the company's buyback activities that will occur in the next few years, reducing tangible common equity and boosting EPS.

Disclosure: I am long BAC. 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.