Bank Of America: Solid Performance And Future Prospects Make It An Attractive Pick

| About: Bank of (BAC)


Strong growth in the business shows that the stock is currently undervalued.

The credit quality of the bank is improving, ensuring future profitability.

The litigation charge has negatively skewed the earnings and overshadowed the performance of the bank.

Bank of America (NYSE:BAC) was one of the best performers in the banking sector during the last year when the stock gained about 30% - Year-to-date, the stock is up over 3%. However, despite the impressive gain over the last year, I believe there is still a lot more to come from BAC. As I have maintained in my previous articles, I believe the market is putting a heavy discount on the stock due to the ongoing litigation issues of the bank and it is ignoring the impressive growth in the business and the fundamentals.

The most recent earnings announcement was not a surprise as the bank had already announced the settlement and I was expecting a small loss, which I also mentioned in my previous article. However, the litigation issues of the bank are finally close to the end and the strong growth in the business makes it an attractive investment. I remain bullish about the banking sector in general and Bank of America in particular. First of all, I will dig deep into the performance of the bank and pinpoint the improvements regarding different measures and how the bank has strengthened its position.

Source: BAC supplemental data provided with first quarter earnings.

Financial institutions are in the business of taking deposits and lending out that money for interest - as a result, interest income becomes the core income of the banks. However, over the years, the services revenue has also become hugely important for financial institutions as it is clear for BAC that the non-interest income is higher than the interest income, the core-earnings of the bank. A lower interest income for the bank was due to two reasons: First, the quarter had two days less for the accrual, which resulted in about $0.23 billion in less interest income reported (reported net interest income averaged on 90 days), and the second reason was a decrease of about $0.5 billion due to some market-related adjustments. If we add two more accrual days and the adjustments, the net-interest income becomes about $10.8 billion, slightly higher than the figure reported at the end of the first quarter last year. The non-interest income has shown strong growth sequentially. However, it is slightly below the figure reported for the same period last year. An important figure here is the provision for credit losses, which has come down from $1.7 billion to just above $1 billion during the last year, indicating the strength of the loan portfolio and the credit quality.

The non-interest expense has jumped up mainly due to the litigation costs. The image below shows the breakdown of the non-interest expenses of the bank.

Source: BAC first quarter earnings presentation.

As you can see from the image, the litigation expense has been the major reason for the increase in the year-over-year non-interest expense. All other non-interest expenses have in fact come down by $0.2 billion compared to the same quarter last year. Furthermore, there has been a slight increase in the retirement-eligible costs. One of the most important non-interest expenses is the LAS (legacy assets and servicing division) expense - the division handles the delinquent mortgages and foreclosures. The expense from this division has been high due to the mortgage related issues. However, as it is clear from the image, the bank has been successful in bringing this cost down and we have seen a decrease of $1 billion during the last year. Overall, the non-interest expense for the bank has come down by $1.2 billion year-over-year, excluding litigation and retirement-eligible costs. Bank of America is on track to bring down its costs, which is a very encouraging sign for future profitability. The improving economic conditions and the favorable interest rate environment will further magnify the impact of these cost savings.

Source: BAC first quarter earnings presentation.

Let's talk further about net-interest income - above images show the level of NII without market-related adjustments and the reported NII. If we ignore the market-related adjustments, the NII is flat year-over-year. However, the net interest yield of the bank has improved, indicating a better interest rate margin. The net-interest yield for a bank is the spread between the lending rate and deposit rates - it is same as the gross margin for a non-banking company. With the same level of NII, the bank was able to have a better net interest yield - in simple words - the gross margin for the bank has improved by 0.06%. However, as the bank reported market-related adjustments, the reported NII has come down and resulted in 0.07% lower net interest yield.

Let's now look at the capital position of the bank as it is one of the most important metrics for banks. The image below shows the capital ratios and the requirements for the bank.

Source: BAC first quarter earnings presentation.

Financial institutions went through the Federal Reserve's stress test recently, which Bank of America passed and was allowed to increase dividends and share repurchases (you can read the details here). Tier 1 capital ratio is the most important ratio that is evaluated by the Federal Reserve under different scenarios. Bank of America's tier 1 capital ratio has remained unchanged and its common equity tier 1 capital ratio has shown slight improvement. As the first image shows the bank has achieved all of its capital requirements and the ratios are in line with the Basel 3 requirements.

Asset quality is probably the most important aspects for a bank, and I will now talk about this metric in the following paragraphs.

Source: BAC first quarter earnings presentation

Charge-offs or write downs are often one-time expenses for other companies. However, for banks, these expenses are regular as the banks are in the business of lending money. When other businesses report charge-offs, we tend to treat them as non-recurring or one-time expenses and adjust the earnings accordingly. However, for banks, we look at the trend in the net-charge offs. A bank or a company will categorize a loan as a charge-off when there are less chances of recovery, and these loans are added to gross charge-offs. If the previously categorized loans are recovered, then the recovered amount is deducted from the gross charge-offs, which results in net-charge-offs. For Bank of America, the trend in net charge-offs over the last five quarters (first graph in the image) have been extremely encouraging. The net charge-offs figure has come down to $1.4 billion from $2.5 billion at the end of the first quarter last year. Furthermore, the current net charge-offs ratio stands at just 0.62%, down from 1.14% a year ago, which means the bank is losing only about 0.62% of its loans and leases in the shape of bad debts.

Moving forward - the allowances for loans and leases have been way above the net charge-offs, indicating the bank has been on the conservative side when it comes to planning for the bad debts. The coverage for the net charge-offs has gone up from 2.20x at the end of the first quarter last year to 2.95x this year. Furthermore, the provision for the credit losses has come down to $1 billion year-over-year from $1.7 billion.

Bottom Line

The economic environment as well as the fundamental growth in the business show that the stock is currently well below its fair value. Bank of America's stock price has been under pressure due to its litigation issues and we have seen other stocks in the sector grow at a faster pace. However, the settlement with FHFA has taken care of almost 90% of the mortgage related issues of the bank, and the decision to settle the lawsuits is a wise one, in my opinion. I believe over the next two years BAC should see a rapid increase in the stock price as the business of the bank is growing at a rapid pace. I talked in detail about the economic environment in my previous article, which will help the banking sector continue its impressive recovery.

Additional Disclosure: This article is for educational purposes only and it should not be taken as an investment recommendation. Investors are urged to do their own due diligence before making any investment decision.

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.