Bank Of America - Set To Outperform?

| About: Bank of (BAC)
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Summary

Bank of America is more rate-sensitive relative to its peers, which may set it up well for the Fed’s likelihood of increasing rates 1-3 times in 2017.

Cost cutting measures put into place during the lower-rate period (still ongoing) to in order to remain profitable will help increase the bank’s efficiency measures.

Median expectations provide the outlook of a stock that will likely return upper- to mid-single digits over the medium-term.

Earnings volatility will likely reduce if the bank limits its risk appetite, maintains strong liquidity and capitalization, and avoids operational/financial trouble from legal costs or external macroeconomic shocks.

Argument

Bank of America (NYSE:BAC) could outperform its other big bank peers as a result of its interest rate sensitivity. A rising rate environment works to the firm's benefit, but will be contingent on avoiding excessive risk taking and maintaining its robust liquidity and capital ratios

Overview

The US Federal Reserve is likely to hike rates anywhere from 1-3 times in 2017, which will be beneficial for those that bear greater levels of interest rate hike, including Bank of America. A general, fairly well-known financial projection of the company entails that a 100-bp parallel shift of the yield curve will add about $5-$6 billion in revenue per year, or about $3.7-$4.5 billion in net income (around $0.35-$0.43 per share). The same shift would also increase ROE by about 120 bps.

The bank recently stated that its expects net interest income to increase 6% quarter-over-quarter as a consequence of the Fed's decision to increase rates by 25 bps in December. If the Fed were to hike rates twice in 2017, that would expect to increase net interest income by $1.2 billion, taking that effect in isolation. Combined with the uplift from December's increase, the cumulative effect could be another $0.06 in earnings per share. Valued at an earnings multiple of 11x, this would be an additional 2.8% lift in share prices. However, the positives stemming from rising interest rates may not be as straightforward if the bank is forced to rise its interest rates on deposits to maintain its competitive standing versus competitors.

The bank also maintains a more conservative risk profile relative to its peers, with a common equity tier 1 capital ratio of 11.0%, tier 1 of 12.4%, and tangible common equity ratio of 8.2x (source: 2016 Q3 10-Q). The combination of higher interest-rate sensitivity in a rising rate outlook and conservatism in its risk profile shows a likely 2017 trajectory of increasing earnings and a lower degree of business volatility. Lending activity and risk-weighted assets have not grown too far out of line with overall economic growth, which suggests that liability growth is running at a broadly sustainable rate. Bank of America also performed the best out of the eight global systemically important banks ("GSIBs") in the US on the Fed's Dodd-Frank stress test. The test measures how the CET1 capital ratio will be impacted under a variety of shocks to its operations and the degree to which various capital ratios may need to be boosted to weather adverse economic conditions. Financial crisis-related litigation costs should also dwindle in future years and attenuate earnings volatility.

The bank's rate sensitivity has strained its profitability in recent years, leading to stagnant share prices. The stock had been flat for three years before the outcome of the November US elections directed future policy initiatives toward an expansionary, deregulatory regime. In the 12 weeks since, the stock has gained 37%, a degree of appreciation that had taken the previous 192 weeks leading up to the election. The combination of low rates, conservative risk taking, and the inherent volatility in its market-tied segments (e.g., capital markets, trading) caused the stock to trade well below book value (like many banks). To its credit, Bank of America funds a greater portion of its operations with core demand deposits relative to competitors and its cash and cash equivalents remains in excess of $660 billion.

The firm is also in the continuous process of shedding excess from its cost structure. Management has been accurate in its ability to estimate and achieve these cost savings in recent years, which offers a level of credibility in estimating them for the future. The cost targets were initially instituted to maintain a level of modest profitability under a lower-rate environment. CEO Brian Moynihan announced an annual cost target of $53 billion back in July 2016 for the 2018 fiscal year, which would slash expenses about 6% relative to its mid-2015 to mid-2016 costs. Its adaptive efforts to grow the business without any upward movement in rates should be doubly beneficial if they are pushed higher as widely believed.

As earnings increase, the dividend will likely be subject to increases as well. With $1.50 in diluted EPS and a $0.30 dividend yield, Bank of America is currently paying out just 20% of its earnings. As superfluous capital builds up and the bank continues to meet federal regulatory standards - which are likely to be less stringent under the current administration - shareholders are bound to receive a larger fraction of these proceeds through buybacks (if the bank feels confident enough in the security of its leverage profile) or dividends. The larger payouts will also keep the stock competitive on a relative basis, as Bank of America's payout ratio is lower than that of its large-cap financial peers.

Rising rates and the bank's higher rate sensitivity can also adversely impact its capital ratio. Assets and liabilities inherently have different maturities on banks' balance sheets given the business model of "borrow short/lend long." As liabilities (e.g., deposits) increase in value and assets (e.g., mortgage loans) decrease in value as a consequence of rising rates, capital ratios decrease and can increase the embedded risk in a financial institution despite higher earnings.

Valuation

Fiscal-year 2016E ROE should come in around 6.7%. Year-end 2017 ("2017E") return on equity projects to come in around 7.3% if we bake in two rate hikes in 2017. The product of the bank's retention rate of 80% (1 - dividend payout ratio) and estimated ROE of 7.3% gives an expected organic growth rate of around 5.8% for 2017.

The value of the book value of equity will combine with the retained earnings balance to form the new book value of equity in the following year. The cost of equity is taken at 10% (require returns on equity). For valuation purposes, the cost of equity is multiplied by the book value of equity to form an "equity cost." This equity cost is subtracted from each net income estimate in the projection period (ROE multiplied by book value of equity) to form an "excess equity return." The present value of these excess equity returns are discounted back to the present and subtracted from the current book value of equity to get the intrinsic value of the equity, or the market cap of the bank.

Dividing by the number of fully diluted shares outstanding gives a fair share price of $20.25, under the current $22.68 as of the end of January. Using a discount rate of around 9.3% would get the valuation to today's share price.

- Base case scenario

On an earnings basis, I obtain, using the assumptions above applied to the company's most recent financial data, a projected 2017 EPS of $1.80. If the economy can continue to grow and if ROE normalizes to around the 9% mark, EPS could stand around $2.80 per share by 2021. An earnings multiple of 11x or better would put shares above $30 for mid-to-high single digit returns from today's prices.

(Source: author)

In terms of IRR (annualized returns) at each projection:

(Source: author)

- Bear case

In the event ROE remains stagnant for the next five years, remaining at 7.3%, a DCF model yields an intrinsic price of $15.40 per share (32% downside). Earnings-based estimates put the annualized figures at lower single-digit share price growth at 11x-12x earnings.

- Bull case

If the ROE increases to 11% through a combination of stronger than expected US growth or continuous internal operational/financial improvements, this would value shares at $26.20 (16% upside) according to the DCF model. Earnings would nearly double in five years' time, yielding high single-digit to low double-digit share price appreciation.

Naturally, none of these estimates take into account future share buybacks, which I believe are likely in the event of a base or bull case scenario.

Conclusion

Where Bank of America falls on this valuation spectrum will rely on its ability to turn greater levels of profitability without a concomitant increase in risk-taking or reduction in its capitalization or liquidity reserves. The bank's ability to meet its expense targets to shed excess weight from its cost structure will help improve return efficiency ratios, better its regulatory standing, and ultimately help ease operational and financial volatility.

Like nearly all financial institutions, Bank of America's prospects are heavily tied to the macro cycle. So long as the US and world economies remain in quality shape, and the firm limits its risk appetite in line with organic growth rates and avoids substantive legal costs, shares should reasonably improve with the additional likelihood for an increase in shareholder returns through dividends and share buybacks.

Disclosure: I/we 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.