Friday, July 19, 2013

Bank of America: Good Fundamentals But Not Yet Ready for Prime Time?

Bill Murray in "What About Bob?" plays a hyper-neurotic, emotionally stuck man who can't get out of bed in the morning.  In this clip, he achieves a breakthrough and goes "sailing." But, his version of sailing is not ours: he is lashed to the mast high above the water.  I hope this lightens up the end of a heavy earnings week.  There is a loose analogy to Bank of America's position after the second quarter. (An aside: Richard Dreyfuss as Bob's hyper-anal shrink resembles which current Fed Chairman?)

It was an eye opening quarter in a lot of ways:

  • $1.1 trillion in deposits, up 4%;
  • Net income of $4 billion;
  • Non-interest expense down $1 billion from the prior quarter;
  • Net credit loss rates at 0.94%, the lowest since the second quarter of 2006.
The problem?  BAC is hamstrung by two distinct legacies.  The first is of its own corporate actions: the acquisition of Countrywide Financial and its consequences which resonate throughout the consumer business.  The second is the overhang related to the Federal bailout, impending regulations and restrictions on dividend policy.  

The company increased its consumer and commercial banking sales force (financial solutions advisers, mortgage loan officers and small business bankers) by 21% year-over-year in order to extract more relationships, products and revenue from the huge deposit base.  However, the company has to judiciously balance this against the ongoing costs of dealing with the thousands of mortgages which had to be restructured due to errors in applying fees and foreclosures by the mortgage servicers. The former Countrywide mortgages and loans (PCI--"purchased credit impaired") are reported separately and are still a drag.  

The net charge off rate for consumer and business loans was 0.94%, but if the PCI loan portfolio were included the reported rate increases very modestly to 0.97%, because of the fact that most of the principal is insured, even though interest in not accruing on the loans.  If the PCI write-offs are included then the NCO rate goes to 1.07%.  

Overall fee income was down in the quarter compared to the prior-year period.  Having to deal with the Countrywide legacy has resulted in BAC ceding mortgage market leadership to Wells Fargo, in terms of originating new home mortgages and refinancings.  

Overall, for Consumer and Business Banking, the return on average allocated capital (a non-GAAP measure) was 18.6% in the second quarter, down from 19.5% in the first quarter.  Average loans in the second quarter were flat to the first quarter and down $10 billion from the prior-year period. 

So, things are improving in terms of banking relationships and credit quality, but the company can't go full speed ahead to capitalize on its opportunities because of the legacy of bad loans, especially those associated with the Countrywide acquisition.  

Global Wealth and Investment Management (GWIM) comprises Merrill Lynch, U.S. Trust and other operations.  In the second quarter of 2013, this business recorded $4.5 billion in net revenue with non-interest expense a surprisingly high 72% of net revenue. The pre-tax margin for this business was a record high of 28 %.  GWIM's return on average allocated capital was 30.6% , ahead of the prior quarter's 29.4% and compared to a return of 18.6% for the capital-intensive core banking business.

The problem with GWIM and core banking, as we have written about before, is one of cultures.  They are totally different, and I don't believe that any company has been able to make them work together to effectively cross-sell and work together on accounts.  GWIM responds instantaneously to rising equity and bond markets, as they did in the second quarter.  Right now, GWIM fits into BAC, but let's see if the marriage has legs, or if, at some point, Merrill Lynch's leaders cry to be on their own.  

Global banking and investment banking had nice quarters, and Bank of America's global banking franchise, like that of Citi, is something of real value.  

Capital ratios for all the current and soon-to-be standards are improving and close to where they need to be.

Tangible book value at the end of the quarter was $13.32, and most analysts argue for an appropriate P/TBV multiple of less than one, around 0.95 in the case of Credit Suisse.  On their projected 2014 TBV of $15.12, the stock appears fully valued after the strong second quarter.  It has had a glorious run from the low, though.  One day it may really be sailing!  

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