Interest Rate Improvement, Upbeat Trading Outlook Justify $23 Price For Bank of America’s Stock

A stronger-than-expected performance for the last quarter of the year helped Bank of America (NYSE:BAC) report its best full-year operating results since the economic downturn late last week. ^[1] The diversified banking giant made the most of the jump in securities trading activity over the last two months of the year, even as its revenues benefited from the Fed’s decision to hike benchmark interest rates in December. Seasonally elevated card fees and a sizable reduction in loan provisions from improved economic conditions for the period also aided the bank’s performance.

But the single biggest factor behind the bank’s strong results for the period was its continued focus on keeping costs under control. Total operating expenses fell to below $13.2 billion for the first time since the bank’s acquisition of Merrill Lynch and Countrywide at the peak of the economic downturn – representing a sharp reduction from the average figure of ~$20.5 billion over 2010-2011. Bank of America has put in considerable effort since 2011 to work through its legacy legal issues while also streamlining its business model. It has been able to reduce its expense-to-revenue ratio from over 85% in 2011-12 to just over 65% now.

Additionally, the bank’s loan provisions also appear to have stabilized. In fact, the bank’s ratio of loan allowances to gross loans outstanding is currently at 1.24% – below the figure of 1.3% seen before the economic downturn in 2006-07. This indicates that the bank’s legacy loan portfolio has been cleaned up almost completely and also that the bank has been more cautious with its lending over recent years. At the same time, the bank’s $900-billion loan portfolio will boost net interest revenues considerably over 2017-19 given the strong outlook for interest rates. Taking all these factor into consideration along with the fact that the bank secured the Fed’s permission for an additional $1.8 billion in share repurchases over the first half of 2016, we have revised our price estimate for Bank of America’s stock upwards from $18.50 to $23. Notably, the revised share price is slightly below the book value of the bank’s share ($24.04), and is slightly ahead of its current market value.

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

The table above summarizes the factors that aided Bank of America’s pre-tax profit figure for Q4 2016 compared to the figures in Q4 2015 and Q3 2016. The year-on-year improvement across all revenue and cost heads (except wealth management revenues) stands out here – especially the marked reduction in compensation as well as other operating expenses. The decrease in total investment banking revenues compared to the previous quarter can be attributed to the unusually high debt trading revenues for Q3 2016. Also, it should be noted that the seasonal investment banking business is slowest in the last quarter of the year. As for the sequential reduction in “all other revenues,” this stems from lower one-time fees and revenues for the bank in Q4 compared to Q3 and is not a cause for concern in terms of long-term value.

FICC Trading Revenues Will Continue To Drive Profits Going Forward, Even As Other Investment Banking Fees Recover

Bank of America reports the results of its trading operations as a part of its Global Markets operating division, while a majority of the investment banking (advisory & underwriting) revenues come from the Global Banking division. Taken together, total trading and investment banking division revenues for Q4 2016 were just under $4.2 billion – an improvement from $3.9 billion a year ago but well below the $5.2 billion reported in Q3 2016. The table below details the changes in Bank of America’s investment banking revenues for Q4 2016 compared to Q4 2015 and Q3 2016.

Not surprisingly, the bank made less from each of its investment banking units in Q4 compared to Q3, as market conditions were particularly strong globally in the third quarter as a direct result of the unexpected Brexit vote. Poor equity underwriting activity levels and sub-par M&A deal volumes also weighed on fee revenues for the quarter. In fact, the sequential decline would have been accentuated further if debt and equity trading activity had not increased after results for the U.S. presidential election were revealed. Debt trading activity received an additional push in December after the Fed’s second rate hike since the downturn.

With the Trump administration expected to water down some of the stringent regulations passed against the largest U.S. banks since 2009, Bank of America’s full-fledged fixed income, currencies, and commodities (FICC) trading desk should benefit considerably in the future. In any case, the positive outlook for the U.S. economy in general and a hawkish forecast for interest rates by the Federal Reserve over 2017-19 should play an important role in elevating securities trading revenues for the banking giant over subsequent quarters.

Wealth Management Division Gains From Strong Inflows While Improving Efficiency

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 over recent years. According to our estimates, more than 10% of Bank of America’s total share value comes from its wealth management operations, and the bank refocused the division last year by completing the sale of its money market fund offerings to BlackRock.

Taking into account the divestiture, Bank of America’s wealth management division has seen a steady increase in its asset base over the last four quarters. After a small outflow of assets in Q1, the division reported net inflows in excess of $10 billion over Q2 and Q3 before closing the year with inflows of just under $19 billion in Q4. The table below summarizes the factors that contributed to the change in size of wealth management assets from the end of Q4 2015 and Q3 2016.

Strong overall inflows are good news for the division in the long run, as they should boost both fee-based as well as performance-related revenues. Notably, the fact that Bank of America has increased the number of financial advisors on its payroll over the last two quarters after gradually reducing the number over several quarters before that indicates that the bank foresees a continued increase in demand for its wealth management services in the near future.

Although the larger employee base has led the division’s “Financial Advisor Productivity” metric (the ratio of annualized revenues for the division to the total number of advisors) lower to $964,000 for the period from almost $1 million a year ago, we expect this trend to reverse as revenues grow in subsequent periods. Additionally, the bank’s efforts in cutting costs for the division coupled with the positive impact of higher interest rates on revenues should help margins for the wealth management operations nudge higher going forward.

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1. Q4 2016 Results, Bank of America Earnings Release, Jan 19 2017 [↩]