With Bank of America’s Profits Recovering To Pre-Recession Levels, Its Shares Look Undervalued

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Bank of America’s (NYSE:BAC) results for the fourth quarter of the year were lukewarm at best, but they were hardly unexpected given the weak economic conditions that prevailed during the period. ((Bank of America Reports Q4-15 Net Income of $3.3B, EPS of $0.28, Bank of America Press Releases, Jan 19 2016)) The bank reported a sharp reduction in trading and mortgage-related revenues, even as strong loan growth and a jump in card activity partially mitigated the impact on total revenues. These trends were also seen in the Q4 results reported by peers over the last few days. Fortunately, the bank’s exceptionally strong performance for the second quarter allowed it to report a full-year earnings figure comparable to those seen before the downturn. Dragged down by billions in loan charge-offs and legal settlement costs (which largely stemmed from the ill-fated acquisition of Countrywide in 2008), Bank of America’s average net income figure from 2008-2014 was less than $4.3 billion. The bank’s 2015 earnings reached $15.9 billion – bettering the $15 billion figure for 2007.

Bank of America’s business model has changed fundamentally since 2007. The mortgage banking division, which swelled immediately after the acquisition of Countrywide, is now smaller in size than it was in 2007. Securities trading has taken a less prominent position, the credit card unit has refocused on the U.S., and the addition of Merrill Lynch has made the wealth management business a more important profit driver. Overall, these changes have made the bank’s revenue streams less volatile. The bank has also done well to put its legacy legal issues behind it, even as efforts to streamline operations across business segments have boosted profit margins. Moreover, operating metrics have generally moved in the right direction over recent quarters, and the bank’s capital position is well ahead of regulatory requirements.

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So why is Bank of America currently trading at just 60% of its book value? In fact, the bank’s shares are valued at about 15% lower than its tangible book value – indicating that investors have doubts about the quality of its assets, and are also wary about the bank’s exposure to energy loans. However, we believe that these fears are overblown, and maintain a price estimate of $18.50 for Bank of America’s stock. This is roughly 35% ahead of the current market value.

See our full analysis for Bank of America’s stock here

Trading Revenues Depressed, But Should Improve Going Forward

Bank of America reports the results of its trading operations as a part of its Global Markets operating division. Excluding the impact of CVA/DVA accounting charges, the bank’s fixed income, currencies and commodities (FICC) trading desk reported revenues of just under $1.8 billion for the fourth quarter – 12% lower than the $2 billion figure for the previous quarter, but a good 20% above the exceptionally low $1.5 billion reported a year ago. Notably, this is slightly better than the sequential decline of between 15-20% reported by other banking giants, and can be attributed to the relatively weak performance of Bank of America’s FICC trading desk in Q3.

The fall across global equity markets in Q4 also weighed on the performance for Bank of America’s equity trading desk, which reported revenues of under $900 million after churning out roughly $1.15 billion in revenues for the first three quarters of the year. Total adjusted trading revenues for the quarter were $2.65 billion – 11% higher than the figure for Q4 2014, but 14% lower sequentially.

Things are likely to improve considerably over subsequent quarters, though. While the seasonal nature of the trading industry usually makes the first quarter the strongest of the year, the Fed’s decision to begin its rate hike in late December should also have a positive impact on debt trading activity. As debt trading revenues are responsible for more than two-thirds of Bank of America’s total trading revenues, we expect a sizable improvement in the top line this quarter.

Weak Demand For Investment Products Hurts Wealth Management

Bank of America’s wealth management operations may not be responsible for driving the top line as aggressively as its trading operations, but it definitely provides the bank’s diversified business model a steady and reliable revenue stream – one that has anchored results for several quarters now. According to our estimates, more than 12% of Bank of America’s total share value comes from its wealth management operations.

But the division has faced considerable headwinds over the last two quarters due to volatile market conditions. Although net inflows into long-term funds improved in Q4 2015 ($6.7 billion) compared to Q3 2015 ($4.8 billion), it was well below the $9.4 billion in Q4 2014. Also, a sharp reduction in market valuation in Q3 resulted in a decline in Bank of America’s client assets from $2.5 trillion at the end of Q4 2014 to $2.46 trillion at the end of Q4 2015 – the first year-on-year decline since 2011. The negative impact of this on the top line and overall profitability is evident from the fact that the division’s “Financial Advisor Productivity” metric fell to below $1 million for the first time since Q1 2013. This metric captures the ratio of annualized revenues for the division to the total number of advisors, and has fallen for four consecutive quarters now from $1.07 million in Q4 2014.

With the decline in crude oil prices driving the current volatility in equity markets, and with oil prices estimated to continue to decline over the first half of the year, the wealth management division will likely remain under pressure in the near term.

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