Bank Of America Brings The Growth

By Stephen D. Simpson, CFA | July 17, 2013 AAA

Nobody likes to be wrong, but I have to admit that I have significantly underestimated just how willing investors would be to pay up for Bank of America's (NYSE:BAC) above-average near-term growth, even if that growth is more a product of just how bad things were rather than how good things are getting. With the shares up more than 75% this year (and 20% in the last quarter), investors continue to reward BAC for capping its legal costs through settlements and launching expensive cost-cutting programs.

Although I still don't see much long-term value in these shares, I cannot ignore that Bank of America is going to post some of the best year-on-year growth numbers this year, and that that is Wall Street is craving from the banking sector today.

B Of A Delivers A Bottom-Line Beat And In-Line Operating Earnings, But Strong Growth
With operating revenue up 6% over last year but down 3% from the prior quarter, Bank of America delivered one of the weakest top lines of the sector, but Wall Street was prepared for it. Net interest income fell 1% from the first quarter, as net interest margin was flat with the prior quarter, but earning assets declined.

Fee income was weak, declining 4% on lower trading results, but expectations were already low going into the quarter. Bank of America's service charge and card income was up slightly on a sequential basis, while mortgage banking income declined about 3%. Bank of America was much weaker than Citigroup (NYSE:C) and JPMorgan (NYSE:JPM) in terms of bond trading, but again that was expected going into the quarter.

SEE: Positive Start To Q2 Earnings Season

Bank of America continues to do legitimately praiseworthy work in cutting its expenses. Expenses were down about 7% sequentially, with core costs down 4% and reported personnel expenses (about half of non-interest expenses) down 14%. Bank of America's efficiency ratio is still very high relative to peers like JPMorgan, Citigroup, Wells Fargo (NYSE:WFC), and U.S. Bancorp (NYSE:USB), but the company is hitting its targets and that is rebuilding management's credibility with the Street. While there are some very large differences in how different analysts calculate the bank's pre-provision profits, suffice it to say that the year-on-year improvement here was very significant (about 40% by my calculations), making Bank of America one of the best-looking growth stories in banking today.

Core Trends Favorable, But Not Overwhelmingly So
Among Bank of America's large bank peers, loan growth is hard to come by these days – Citi, JPMorgan, and Wells Fargo basically had none of it on a sequential end-of-period basis. Bank of America, though, showed about 1% growth, with strong commercial (up 4%) offsetting weaker consumer (down 1%). Commercial real estate lending was particularly strong (up 8%), while residential mortgages declined 1%.

Bank of America also continues to clean up its credit. With non-performing loans down 14% and the charge-off ratio down almost 70bp from last year, Bank of America generated about $0.05 per share of loan loss reserve release income. The company's non-performing asset (NPA) ratio is still elevated (2.5%), but it is improving, and the bank is close to having all of its non-performing loans covered by reserves (currently at 95%).

SEE: Absent Higher Rates, Comerica Has Probably Gone Far Enough

The Bottom Line
Bank of America joined its peers in getting a boost from lower credit costs and seeing lower net interest income, but the bank didn't join in on on the “better than expected fee income” part. Even so, I don't expect investors to care. What investors and analysts want to see today is ongoing progress with expense reduction and lower provisioning expenses, and that's what the company is delivering, as well as strong reported year-on-year pre-provision earnings growth.

While I do praise the company's efforts to cut costs and cap legal expenses, I still have questions about the long-term profitability of the business. I still don't see a reason to lift my long-term target of 8% for return on equity, and my excess returns model suggests a fair value of about $12 on that basis. Likewise, factoring Bank of America's return on tangible assets and net common equity (return on equity minus the cost of equity), a 1.1x multiple of tangible book value ($14.65/share) seems like a fair price today. So while I've learned my lesson with respect to the Street's love of near-term cost-driven banking growth stories, I still don't see enough long-term value here to want to buy the shares with my own money.

Disclosure - As of this writing, the author owns shares of JPMorgan

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