Bank Of America Offers Value For Long-Term Investors

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Second quarter performance

Bank of America (NYSE:BAC), the second-largest bank in the United States, surprised the market by reporting a 70% increase in profits for the second quarter as cost cutting measures showed earlier than expected signs of success. Although revenue grew by only 3.5%, compared with 14% at JPMorgan Chase (NYSE:JPM) and 11% at Citigroup (NYSE:C), operating expenses, which increased at the other two banks, fell 6% at Bank of America. In 2011, the bank started a cost saving initiative with the goal of saving $8 billion annually and says it is on track and expects to cut costs by $1.5 billion per quarter by the fourth quarter of 2013. Experts say that if the bank can get over its legal regulatory problems, it has the potential to perform well if the economy can get a little stronger.

Revenues net of interest costs rose from $21.97 billion to $22.73 billion and net income in the second quarter was $3.57 billion, representing EPS of $0.32 per share compared with $2.10 billion and $0.19 per share in the same quarter of the previous year. Analysts had, on average, estimated an EPS of $0.25 per share. As bond markets weakened towards the end of the second quarter, the bank's investments, called the "available for sale portfolio," generated big losses of $4.2, which almost wiped out the gains in earnings and caused shareholders' equity to decline to $231.03 billion from $237.29 billion in the first quarter.

Most of the bank's businesses reported higher income, but the picture for revenues was mixed. Consumer and small business banking revenues declined by nearly 1%, and consumer real estate revenues declined by 16%. However revenues grew at its asset management and retail brokerage, sales and trading, and investment banking segments. The bank says that the first priority is to get a grip on operating costs and bad assets and then to concentrate on operational efficiency and increased revenues. Sales and trading revenue rose to $4.15 billion from $3.73 billion in the prior year and income in the global markets unit soared to $935 million from $595 million. The sales and trading results were largely generated by equities sales and trading, where revenue grew 53% to $1.2 billion. Fixed income, currency and commodities sales and trading revenue declined by just under $300 million to $2.3 billion.

The acquisition of mortgage lender Countrywide Financial for $2.5 billion in 2008 at the peak of the financial crisis has been expensive because it has subsequently cost Bank of America, according to analysts' estimates, in excess of $40 billion by way of bad loans, litigation costs and settlements. However, fourth quarter expenses connected with the servicing of bad assets are expected to be less than $2 billion, better than the forecast of $2.1 billion and the actual expenses of $2.3 billion in the second quarter.

The investment thesis

Despite the reported net income and the share buybacks, the bank actually reported a decrease in tangible book value. What actually happened? Quite simply, as interest rates rose, the bank earned more by way of interest income as the value of their bond holdings declined. As a result, the net income was wiped out by the depreciation on the bond portfolio. It is important to remember that these bond portfolio losses are unrealized losses caused by accounting practices and not losses in cash. Moreover, there are aspects in Bank of America's performance from which investors can take heart. The Merrill Lynch wealth management business acquired in 2008, for which the bank is thought to have overpaid, is starting to look much better with strong operating margins. The trading business also looks good and credit in the consumer and commercial portfolios continues to improve.

The bottom line

The banking sector is currently generating strong investment momentum because of the encouraging results reported by the sixth largest bank in the country. It may still be premature to conclude that the problems are all over, but the movement is certainly in the right direction. Bank of America will, I expect, return to earnings at normal levels and a double digit return on equity. This is neither going to be a smooth ride nor an easy one as many people would like. However for an investor with patience and a long-term outlook, there is value to be had in buying Bank of America's stock.

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.