Bank Of America Has A Story To Tell

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About: Bank of America Corporation (BAC)
by: WG Investment Research
Summary

Bank of America's stock has underperformed the broader market so far in 2018, but the bank's long-term story remains intact.

There are several reasons to remain bullish, but, in my opinion, Bank of America's improving cost structure is the main reason to stay long the stock.

I am long Bank of America with an overweight position, and I plan to stay long.

Bank of America's (BAC) stock has significantly underperformed the broader market so far in 2018.

Chart BAC data by YCharts

It has been a tough environment for the banks in 2018 and this may continue to be the case over the next few quarters, but, in my opinion, there are several legitimate reasons to stay long Bank of America ("BofA"), with its improving cost structure being near the top of that list.

Expenses Are The Story, At Least For The Time Being

BofA has consistently improved its cost structure since the mid-2010s and, looking ahead, the bank will likely continue to focus on expense management. Some may think that improving its cost structure is not enough to materially impact the bank's bottom-line, but, in my opinion, that could not be further from the truth. Remember, BofA came out of the Financial Crisis with a bloated expense base so, as I previously described, any meaningful change would indeed have a real impact on earnings. The story is playing out exactly how I predicted.

For example, the bank's total revenue is basically flat since 2013, but non-interest expenses are down by $14.4B, or 20%, over the same period of time.

2017 2016 2015 2014 2013
Total revenue, net of interest expense $87,253 $83,701 $82,965 $85,894 $87,502
Non-interest expense $54,743 $55,083 $57,617 $75,656 $69,213
Non-interest expense as % of total revenue 63% 66% 69% 88% 79%

Source: 2017 10-K; table created by author

The results are just as good in the current year, as the bank has reduced non-interest expenses by 3% YoY over the first nine months of 2018.

Source: Q3 2017 10-Q

Directly related to improving its cost structure, BofA has significantly lowered its efficiency ratio over the last few quarters.

Q3 2018 Q2 2018 Q1 2018 Q4 2017 Q3 2017
Efficiency Ratio 57% 59% 60% 65% 61%
Chg -3% -2% -8% 7%

Source: Q3 2018 Earnings Report; table created by author

Back to the original point, how important has rightsizing its cost structure been for BofA's earnings growth potential? Significant. BofA's net income has increased by approximately 115% over a period of time when the bank's top-line grew by only 17%.

Chart BAC Revenue (Quarterly) data by YCharts

BofA's earnings growth significantly outpacing its revenue growth has been (and will continue to be) a key part of the investment thesis for this large bank. Looking ahead, the bank plans to continue to heavily invest in the digital space to cut out costs so investors should expect more of the same in 2019.

However, it is important to also note that there is more to BofA's long-term story than just expenses.

The Other Reasons To Own BAC Shares

BofA's stock has been under pressure so far in 2018, as the market is not really sold on the near-term prospects for the financials. I, however, believe that there are several legitimate reasons to remain bullish (of course, other than the bank's shrinking expense base):

(1) Rising Rates

While expectations for future rate hikes have softened over the last month or so, due mainly to global growth concerns, as described here, most pundits are still calling for at least one-to-two hikes in 2019. Plus, it is looking like an almost certainty that the Fed will raise rates in the weeks ahead.

Source: Investing.com

A rising rate environment will have a material impact on BofA's earnings, as the bank estimates that a 100+ shift in the rate yield curve will add $2.9B in net interest income over a 12-month period. Therefore, the rate environment should be a catalyst for BofA's stock, even if the speed of future hikes may be slower than originally anticipated.

(2) Valuation

BAC shares are trading at a discount when compared to its peer group.

Chart BAC PE Ratio (TTM) data by YCharts

Additionally, the stock is dirt cheap when compared to the broader market.

Source: multpl.com

With the market at (or close to) all-time highs, it makes sense to be invested in great companies that are trading at reasonable valuations. In my mind, BofA meets this criteria and, more importantly, Warren Buffett growing his already sizable BAC position shows that he, too, is extremely bullish about the business prospects for this large financial institution.

(3) Capital Return Story

This bank has a capital return story to tell. For example, BofA spent $6.5B during Q3 2018 on dividends and buybacks and, broadly speaking, the bank is in a great position to return most of its earnings to shareholders over the next two years. To this point, BofA has the wiggle room to significantly increase its dividend in the years ahead.

Source: Fidelity

The 28% payout ratio is impressive, especially given the fact that BofA's 5-year dividend growth rate is close to 80%. Let's also not forget that the bank recently received approval to increase the dividend by 25% and return $26B to shareholders through buybacks/dividends through mid-2019. As such, investors should expect for BofA to be a major player in the income space for years to come, barring any significant changes to the Comprehensive Capital Analysis and Review, or CCAR, process.

Risks

Regulatory concerns always need to be factored in when evaluating large financial institutions, and this includes BofA. I believe that the regulatory environment is actually improving, but this could change in short order.

From a macro standpoint, a deteriorating economy will negatively impact the banking sector. Currently, there are some headwinds, but, in my opinion, a recession is not in the cards in the near future.

Bottom Line

Bank of America has a story to tell. This may sound obvious, and it is, but BAC shares will likely continue to perform well in the years ahead as long as management is able to show improvements in the bank's cost structure. As Peter Lynch said in Learn To Earn, "If earnings continue to rise, the stock price is destined to go up."

From an operational standpoint, this bank appears to be well-positioned for 2019 and beyond. As such, investors with a time horizon longer than one to two years should treat any pullbacks as buying opportunities.

Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.

Disclosure: I am/we are long BAC. 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.