Bank Of America Is Still An Attractive Pick

About: Bank of America Corporation (BAC)
by: IAEResearch

The trend in net interest income is a little worrying, but it should get better as the interest rates start to rise.

Falling non-interest expenses will further enhance the profitability of BAC.

The market has already priced in the biggest risk for Bank of America, and the upside potential is larger than the downside.

Bank of America's (NYSE:BAC) stock price remains attractive at around $15.50 on the back of solid fundamental progress. The stock price has been moving between $15-16 over the last two months and the stock has not been able to breach its resistance level at $16. However, short-term price movements are of less importance to the long-term shareholders and I believe the long-term investors are going to be happy with the direction of the stock price.

There are a number of factors to consider while talking about Bank of America - along with the progress in fundamentals, one should also consider the overall prospects of the banking sector as well as economy - there are a number of company specific factors, but the most important is the risk from litigation in case of Bank of America. I will first take a look at the second-quarter results and try to explain some key points before moving onto the prospects of the sector and valuation.

Source: BAC second quarter earnings presentation

First of all, net interest income - this component of earnings is the most important for banks as it represents the core business of banks - it is the spread between the interest income and interest expense. Reported net interest income has shown a declining trend over the last two quarters after a considerable jump in the last quarter of the previous year. The decline in net interest income despite an additional accrual day is a little worrying for the bank. However, the trend in net interest margins is consistent in the sector as the quantitative easing process has affected the long-term interest rates.

Quantitative easing is a systematic process that is used by the Federal Reserve to induce economic activity. The Fed has been buying long maturity securities in order to bring down the long-term interest rates. However, as we are seeing a gradual decline in quantitative easing, the long-term interest rates will likely increase. The figure above shows two components: Reported Net Interest Income and NII without Market Related Adjustments. The trend in NII, excluding market related adjustments, is almost identical to the reported net interest income and the net interest yield. There were two major factors causing a decline in NII: lower consumer balances along with lower loan yields, and seasonal decline in trading NII.

Source: BAC Second Quarter Earnings Presentation

Non-interest expense has come down substantially during the second quarter. The biggest reason behind this decline is a decrease of about $2 billion in litigation expenses; litigation expenses for the first quarter were $6 billion and came down to $4 billion for the second quarter. Another important expense component to consider is LAS (legacy assets and servicing division) - this segment handles the foreclosures and delinquent mortgages. The trend in the expenses from this segment is encouraging for the company as it is showing consistent decline. There was a decline of another $200 million during the last quarter.

Source: BAC Second Quarter Earnings Presentation

The last metric I am going to discuss is related to the asset quality. As I have mentioned in my previous articles, the asset quality of BAC has been improving consistently over the last few quarters. The image above shows that BAC's net charge-offs have almost halved from a year ago - this means that the credit quality is better and the core assets are of high quality. The decrease in net charge-offs was magnified by the recoveries worth $200 million from sales of NPLs. However, even without these recoveries, the net-charge offs have come down by about $100 million. Net charge-offs ratio is also at the lowest [0.48%] in the last five quarters. Moreover, the trend in the allowance for loans and leases is also encouraging - the decrease in allowance shows that the bank is more confident about the recovery of the assets. The ratio of allowances to annualized net charge-offs is rising as the net charge-offs [denominator] is decreasing.

There are a lot of other metrics that investors should look at - all of these cannot be discussed here and I strongly urge BAC investors to go through this presentation. Overall, the performance of BAC has been good and the net interest margins will also likely rise as the QE process ends.

At the moment, the monthly purchase of securities by the Federal Reserve stands at $35 billion. Central banks buy securities from the open market in order to inject liquidity into the banking system to stimulate economic activity. The Federal Reserve has been successful in its objective as the availability of credit has kept the interest rates low and the economy has started to grow again. However, the Federal Reserve has been decreasing the amount of securities purchased and it currently stands $50 billion below the starting amount of $85 billion. As the tapering ends, the interest rates will be impacted as the Federal Reserve policy has been shielding interest rates in the past. However, with the QE ending, interest rates will be open to a lot of factors, including market forces.

Bottom Line

The most important company specific factor for BAC is the risk arising from litigation. BAC will need to make considerable payments in terms of fines and litigation charges. As a result, the profitability of the bank will be under pressure in the short-term. However, the downside risk is minimal for BAC investors, in my opinion. Bank of America's biggest risk, litigation, has already been priced in. The markets are fully aware of this risk and it is a major factor why BAC has been behind some of its peers such as Wells Fargo (NYSE:WFC) and JPMorgan (NYSE:JPM). I believe the market has already priced the stock for upcoming fines and other litigation issues. As the bank settles these issues, we will see a consistent upward trend in the stock price as the fundamentals of the business remain strong.

Additional Disclosure: This article is for educational purposes only and it should not be taken as an investment recommendation. Investing in stock markets involves a number of risks and readers/investors are encouraged to do their own due diligence and familiarize themselves with the risks involved.

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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.