Bank Of America - Earnings Shortfall Driven By New 'One-Time' Litigation Charges

Jul.16.14 | About: Bank of (BAC)

Summary

Bank of America reports disappointing earnings.

Litigation costs of $4 billion bring the year-to-date bill towards $10 billion, as the major settlement with the Justice Department still has to be announced.

With operational improvements being made, I remain neutral.

Bank of America (NYSE:BAC) was the large major bank to post its earnings for the second quarter. New large litigation charges resulted in a shortfall in earnings, which sent shares about 2% lower. This is as investors grow tired of the seemingly endless stream of litigation charges which are "one-time".

Despite the charges, I appreciate some of the underlying progress being made, notably in terms of cost cuts. Therefore, I remain neutral on the bank.

Highlights Of The Second Quarter

Bank of America posted second-quarter revenues of $21.96 billion, down by little more than 4% compared to last year's sales of $22.95 billion.

On the bottom line, the bank posted net earnings of $2.29 billion, which is 43% less compared to last year. Earnings fell by thirteen cents to $0.19 per share as a result. The shortfall is the result of much larger litigation costs, with analysts looking for a modest fall in earnings towards $0.29 per share.

Looking Into The Quarter

CEO Brian Moynihan sees the economy continuing to gain strength, witnessed by greater consumer spending, while brokerage assets are up and business customers are doing more business with the bank.

Despite the optimistic tone about the economy and future prospects, investors are disappointed with yet another "unexpected" litigation charge. This time, the charge was $4.0 billion, bringing the year-to-date charges to a whopping $10 billion.

Total net interest income fell by 5% to $10.2 billion. Net interest margins of 2.26% were just 2 basis points less than last year, while other competitors typically reported more margin compression. The reason for the revenue shortfall is a $528 million change in "market-related amortization expenses."

Non-interest revenues were down by 4% to $10.9 billion, driven by a lower performance of the mortgage business, which should not be a surprise to anyone keeping an eye on bank earnings these days. Excluding the litigation expenses, total expenses would have been down by 6% to $14.6 billion amidst job cuts and general cost cuts under the "New BAC" program.

Looking Into The Segments

Consumer and business banking revenues fell by nearly a percent to $7.4 billion. Profitability of the unit improved markedly on the back of lower provisions for credit losses, which nearly halved to $534 million. As a result, earnings were up by 29% to nearly $1.8 billion.

The consumer real estate business is the troubled child of the bank, this is the place where all the major litigation expenses hit the bottom line. Revenues plunged by nearly 35% to $1.4 billion on the back of lower mortgage activity levels, while the unit posted a $2.8 billion loss on the back of the litigation settlement.

The wealth and investment management business posted revenues of nearly $4.6 billion, which represented a modest 2% increase compared to last year. Earnings were down nearly 5% to $724 million on the back of higher costs, while deposits, assets under management and client balances rose amidst rising markets.

Global Banking revenues came in at $4.2 billion, which is a modest 1% gain compared to last year. Net earnings were up just slightly to $1.35 billion amidst slightly lower provision for credit losses.

The real surprise came from the global markets business, which posted a 9% jump in sales to $4.6 billion. Earnings rose by nearly 15% to $1.1 billion, thanks to an unexpected 5% jump in FICC revenues which have been declining at double-digit rates at competing banks.

Capital Ratios, Balance Sheet & Valuation

Despite the signs of an economic recovery, the size of the bank remains rather stable. The total balance sheet of $2.17 trillion was about 0.5% smaller compared to last year.

The company did improve its capital ratios, with the common equity Tier 1 Capital Ratio under the Basel III method now coming in at 12.0%. Under the more sophisticated and stringent "fully phased" model, the ratio came in at 9.5%.

The book value of shares improved as well. Tangible book value now stands at $14.24 per share, while the common book value per share is $21.16 per share. At $15.50 per share, the bank now trades at about 1.1 times its tangible book value and roughly 0.73 times its common book value.

The back was able to manage its operations more efficiently. It now employs little over 233,000 workers, about 9% less compared to last year.

Looking At The Past Decade To Gauge The Future

Despite the economic crisis, Bank of America has shown real revenue growth over the past decade. Revenues have grown from about $50 billion back in 2004 to a trailing rate of $87 billion.

The bank posted peak earnings of $21 billion back in 2006, and only reported one year of losses during the crisis. This was back in 2010, when the bank posted an annual loss of just $2 billion. Yet, the crisis and related uncertainty at financial markets had the consequence that the bank had to raise fresh capital at very low levels, thereby causing severe dilution.

As a result, the outstanding share base has nearly tripled, with the bank having 3.8 billion shares outstanding in 2004 versus 10.5 billion shares at the moment. This makes a return to the highs of $50-$60 back in 2006 no longer realistic. Accounting for the dilution, shares now trade at about $40 per share, based on an equivalent number of outstanding shares before the crisis.

Final Takeaway

While investors were very pleased with the results of Citigroup (NYSE:C), JPMorgan (NYSE:JPM) and Goldman Sachs (NYSE:GS), investors are disappointed by the earnings miss reported by Bank of America.

The ongoing litigation issues are the main reason for this, as the bank has already spent over $50 billion to settle issues stemming from the financial crisis. The latest settlement was a relatively modest $650 bill after it has settled with reinsurer AIG (NYSE:AIG) involving mortgage securities. Yet, the big settlement on which everybody is waiting is the one relating to mortgage-backed bonds with the Justice Department.

Reportedly, the Department is asking the bank to pay up to $17 billion in settlements. These are, of course, very serious sums, being equivalent to about $1.60 per share. Investors are perhaps fearful that such a large settlement will again delay the bank to allow it to raise its dividend to $0.05 per share, up from merely $0.01 per quarter at the moment.

As should be well known, Bank of America has earlier this year gained approval from the FED to pay out $0.05 per share to its shareholders. This was until the bank found an error which overstated its capital levels by some $4 billion.

At the start of this month, I checked out the prospects for the bank, following an upgrade from analysts at Deutsche Bank. I concluded that I didn't share the optimism displayed by analysts, partially as a result of prospects for further multi-billion dollar settlements which appear to be materializing.

With nothing fundamentally changed in the business, I remain cautious until some of the overhang finally disappears. Although I appreciate the underlying strength in the business, notably in investment banking, which would result in healthy adjusted earnings, I remain neutral on the back of further litigation overhang.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.