Quality, Value, And A Little Bit Of Growth - Bank Of America Seems To Offer Quite A Bit

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About: Bank of America Corporation (BAC), Includes: C, JPM, PNC, USB, WFC
by: Stephen Simpson, CFA
Summary

Bank of America seems to offer an attractive trade-off of quality, value, and some growth potential at this point in the bank cycle.

Bank of America has a well-diversified loan book, an attractive core deposit base, and good credit quality, as well as the leverage to make major investments in IT.

With a fair value in the low-to-mid $30's, Bank of America has above-average appeal now.

There are some exceptions, of course, but investors who want to invest in U.S. banks today have to make some choices and trade-offs between quality, value, and growth. JPMorgan (JPM) has quality and growth, but not as much value. U.S. Bancorp (USB) has quality and maybe more growth potential than believed, but also not much value. Citi (C) and Wells Fargo (WFC) may offer more value, but quality is certainly an issue with both franchises.

And that brings me to Bank of America (BAC). Bank of America has the scale (#2 overall in deposits and assets) to keep up with the likes of JPMorgan and Wells Fargo in IT investments and drive operating scale, but it also done quite well with expenses and deposit costs without overly compromising loan growth. I don’t wish to position or suggest Bank of America as a scintillating growth story, because it’s not, but management continues to invest in growth opportunities like digital banking and opening branches in new strategic markets, and I believe Bank of America can beat the average large bank in pre-provision profit growth over the next three to five years.

All that, and a stock I think should trade closer to the mid-$30’s.

Nothing Scary In The 10-Q

Most of the large banks have learned not to try to hide bad news in the 10-Q, so these releases have become a bit less dramatic over the years. Still, there were a few items of note.

First, management’s call for 3% net interest income growth in 2019 (consistent with Q1 guidance) means that spread income growth is going to slow from here (NII was up 5% in Q1). With the rate-hike cycle over and only modest loan growth, it stands to reason that spread income growth will be more challenged. Arguably that puts more pressure on the investment banking and trading operations to step up, investment banking (down 7%) was disappointing in Q1 despite recent investments, and the trading desk likewise did not exactly cover itself in glory.

B of A is also still uncommonly asset-sensitive for a large bank. It doesn’t have the rate sensitivity of say Comerica (CMA), but it is high relative to JPMorgan, Wells, Citi, U.S. Bancorp, and PNC (PNC). I’d also note that B of A still also has an uncommonly attractive deposit base – there are a few large banks with a larger percentage of non-interest-bearing deposits in their deposit base (including Comerica, Regions (RF), M&T Bank (MTB), and BB&T (BBT) ), but 31% is an attractive percentage, and Bank of America continues to benefit from lower funding costs and a lower deposit beta.

The 10-Q also pointed to generally favorable credit quality trends. Criticized C&I loans are only about 2.3% of the total, comfortably below a peer average around 3% (JPMorgan is better, Wells and PNC are worse). Criticized CRE loans shot up 83% over last year, but CRE lending is a small part of the book and B of A’s overall ratio of criticized CRE loans (about 1.5%) is in line with peers.

A Familiar Growth Plan – New Branches And Digital

While Bank of America has cut something on the order of 1,000 branches since the housing crunch, and has done a very strong job of reducing personnel costs, management is now looking to drive growth with selective and strategic branch openings.

The bank is targeting about 500 branch openings in total (some of which have already have happened) in major Ohio markets, as well as Minneapolis, Denver, Indianapolis, Pittsburgh, and Salt Lake City. At the same time, the bank continues to make similar national digital investments as JPMorgan, Citi, et al, as these large banks look to leverage their considerable IT resources and the brand recognition gained through large branch networks and large national businesses (like credit cards).

Of course, Bank of America is also on the receiving end of this “attention”. JPMorgan is opening branches in markets like Boston and Charlotte, U.S. Bancorp is also targeting Charlotte, and PNC has targeted Denver and Minneapolis as well.

Sticking To A Fairly Simple Formula

At this point it doesn’t sound as though Bank of America is looking to make big splashes with further overseas expansion or fintech investments. Bank of America also can’t do anything on the whole bank M&A front, or at least not without special permission, as its deposit share is over 10% nationwide.

And that’s all fine, really. Bank of America already has a global banking business built around serving large multinationals and the international needs of smaller U.S. businesses, and I don’t think many investors would be pleased to see the bank chase growth by trying to buy franchises in growth markets like SE Asia or Latin America. As far as fintech goes, while there are arguments to be made that Bank of America could do with a stronger fee-driven franchise in payments and corporate/treasury services, they’re looking to build payments at least through their own internal IT investments.

What Bank of America is doing now is more of your basic “blocking and tackling”. B of A has an attractive deposit franchise, underpinned by low-cost deposits with generally satisfied long-term customers. The loan book is likewise well-balanced between commercial and residential, and management avoids risky lending – its card business could be bigger if they wanted to compromise on credit, and likewise with the auto portfolio (that is primarily prime/super-prime). B of A’s CRE lending business seems undersized, but now is not the time to grow that business given where we are in the cycle.

I also want to mention again that Bank of America has done a good job cutting costs over the last decade, and the end result is that the bank is now on the lower (better) end of the curve for efficiency ratios.

The Outlook

I don’t see Bank of America getting all that much leverage from rates anymore, but there should be some room to improve loan growth and fee income, and then leverage that through its lower expense base. All told, I’m expecting about 4% annualized pre-provision profit growth over the next five years, which I believe will be at least a point better than the average for its peer group. Higher provisioning costs (the credit cycle) will chew into that, but I believe Bank of America will generate long-term core earnings growth in the neighborhood of 3%.

Discounting those core earnings back gives me a fair value around $33, while the bank’s near-term ROTE argues for a fair value closer to $35.

The Bottom Line

Bank of America looks like a good compromise between investors unexcited about the potential returns still available from names like JPMorgan, PNC, and U.S. Bancorp and the operational challenges and/or risks at banks like Citi, BB&T, and Wells Fargo. While not a growth leader, I think B of A can outdo its peers by a modest amount, and coupled with good quality and valuation, I think this is a name to consider even though the banking cycle isn’t at its most attractive point.

Disclosure: I am/we are long JPM, BBT. 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.