Bank of America’s Shares Look Undervalued, But Flattening Yield Curve Presents A Potential Downside

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Investors were not thrilled when Bank of America (NYSE:BAC) reported its results for the second quarter earlier this week, with the bank’s shares falling over trading despite the fact that it produced a solid earnings beat. Investors’ disappointment largely stemmed from the fact that the bank reported a very small increase in its loan portfolio, and also because its net interest margin (NIM) figure nudged lower. We have summarized Bank of America’s Q2 2018 earnings and also detailed the major takeaways from the announcement in our interactive dashboard for the company, the key parts of which are captured in the charts below.

Bank of America’s subpar loan growth is not good news, but one factor to keep in mind is that the bank is still running off its legacy mortgage portfolio. This, along with the weak mortgage industry activity for the period, had a negative impact on total loans. As for the shrinking net interest margin, this issue is not specific to Bank of America, as rival JPMorgan also reported a reduction in its net interest margin for the quarter due to the flattening yield curve. While we acknowledge the potential downside to the bank’s stock from further reductions to its net interest margin, we stick to our $35 price estimate for Bank of America’s stock. Our price estimate is roughly 15% ahead of the current market value.

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

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Investors Will Be Watching Net Interest Margins

The rate hikes implemented by the Fed have helped the interest rate environment in the country recover steadily from the record low levels seen over 2014-2015. The ongoing rate hike process helped Bank of America’s NIM figure climb from a low of 2.05% in Q1 2016 to 2.39% by Q2 2018. However, the flattening yield curve in recent months hurt the bank’s NIM figure in Q2 – leading it marginally lower to 2.38%. This is because banks borrow funds at short-term interest rates and lend them out at long-term interest rates, so the narrowing gap between interest rates in the short- and long-terms led to higher interest expenses and pressure on interest revenues. With investors expressing concerns about a possible inversion in the yield curve over coming months (i.e. short-term yields potentially exceeding long-term yields), Bank of America’s profits could come under additional pressure from a shrinking NIM figure.

Despite these headwinds, Bank of America did well to report a small increase in net interest income compared to the figure for the previous quarter, thanks to an increase in its total interest-earning assets. The most important component of interest-earning assets – loan growth – was below industry levels for the period, though, because of two primary factors: a run-off in mortgages and mortgage industry headwinds hurt the bank’s mortgage portfolio growth, while negative currency movements weighed on the non-U.S. commercial loan portfolio. The smaller-than-expected increase in total loans, therefore, is not a cause for concern over the long run in our view.

 

Wealth Management Will Continue To Lead Growth

Bank of America’s Wealth Management unit has been an anchor for the bank’s results over recent quarters due to its stable revenues and margins. And the bank has rightly focused on pushing its wealth management services to its retail banking customers in an attempt to boost inflows while keeping costs in check. The strategy yielded results yet again in Q2, as total client assets for the Wealth Management division crossed $2.75 trillion for the first time ever. This included strong gains in assets under management (AUM), as well as loans to wealth management clients which more than made up for lower valuations across asset classes compared to the peak values seen in late 2017.

Bank of America Is Expected To Keep A Close Eye On Costs

Finally, a key factor behind Bank of America’s strong results has been its focus on keeping costs under control. For the quarter, the bank reported total operating expenses of just $13.3 billion – down from the average figure of ~$20.5 billion over 2010-2011 – thanks to its efforts since 2011 to work through its legacy legal issues while also streamlining its business model. Over recent years, the bank has also been closing branches in low-profitability areas, with increasing adoption of mobile and internet banking allowing it to make its smaller branch network more efficient.

All the cost cutting efforts helped Bank of America reduce its expense-to-revenue ratio to just 58.8% for the quarter – below its target level of 60%, and the lowest level since 2009. We expect that the figure will continue to hover around 58-59% going forward, and is a key factor behind our optimistic outlook for the bank’s share price.

Based on Bank of America’s Q2 2018 results, we now expect the bank to report EPS of $2.50 for full-year 2018. Taken together with our estimated P/E ratio of 14, this works out to a price estimate of $35 for Bank of America’s shares, which is about 15% ahead of the current market price.

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