Bank of America: Stability Shown in Q2, P/E Still Less Than 10x

Company Update (BAC US) (Buy)

Highlights

• ROTCE was 15.5% in Q2, above our assumption but down q/q

• NII fell 2% sequentially but is guided to be more stable in H2

• Expenses will continue falling in H2, credit costs are still modest

• At $30.70, P/TBV is 1.32x, P/E is <10x and Dividend Yield is 3.1%

• We expect a total return of 71% (25% p.a.) by end of 2025. Buy

Introduction

Bank of America (“BAC”) released Q2 2023 results on Tuesday (July 18). Shares finished the day up 4.4%, taking them back to their level before the U.S. regional banking crisis began in March, though still down 8.0% in the past year:

BAC Share Price (Last 1 Year)

Source: Google Finance (18-Jul-23).

We have followed BAC and other U.S. banks for more than a decade, and first published our research on BAC online with a Buy rating in October 2019. At present, BAC shares have gained just 21.0% in roughly 4 years since our initiation, largely due to a reversal since the start of 2022 during which the share price has fallen 31.0%.  

We believe BAC shares continue to be attractive. Return on Tangible Common Equity (“ROTCE”) was 15.5% in Q2 2023, above our long-term assumption. Net Interest Income (“NII”) fell 2% from their peak last quarter, but are guided to be relatively stable for the rest of 2023. Investment banking revenues were higher year-on-year. Expenses grew less than revenues year-on-year, and should continue to fall in coming quarters. Credit losses continued to normalize upwards, and should have only limited impact on earnings. As with other U.S. banks, Net Interest Yield having passed its peak is a headwind, but the impact may be smaller for BAC because its Net Interest Yield had gained less. We continue to believe a 15% average ROTCE to be sustainable on the current capital structure. Regulations are the main risk, with the Fed potentially imposing higher capital requirements.

At $30.70, BAC shares have a 1.32x Price / Tangible Book Value (“P/TBV”) and a 9x normalized P/E, significantly lower than the multiples for JPMorgan; the Dividend Yield is 3.1%. Our forecasts indicate a total return of 71% (25.3% annualized) by 2025 year-end, mainly driven by a re-rating. Buy.

(For a recap of our BAC investment case, see our first Substack article on BAC, published in April.)

BAC Q2 2023 Results Headlines

BAC reported a ROTCE of 15.5% in Q2 2023, above our long-term assumption of 15% and higher than the prior-year quarter’s 14.1%, though lower than Q1’s 17.4%:

BAC Results Headlines (Reported Basis) (Q2 2023 vs. Prior Years)

Source: BAC results supplements.

Common Equity Tier-1 (“CET1”) ratio was at 11.6%, 20 bps higher sequentially and comfortably ahead of the regulatory minimum of 10.4%.

Importantly, Q2 results indicate BAC’s business remains stable and ROTCE should remain healthy in coming quarters.

Net Interest Income & Deposits

BAC’s Q2 2023 NII was 13.8% higher year-on-year but 2.0% lower sequentially:

BAC Net Interest Income (FTE Basis) (Last 5 Quarters)

Source: BAC results presentation (Q2 2023).

The NII decline from Q1 was due to a lower Net Interest Yield, which fell 14 bps from 2.20% to 2.06% (on a reported basis), offset by Total Interest-Earning Assets rising 3.8% and one more day this quarter. On a Fully-Tax-Equivalent (“FTE”) basis, Net Interest Yield (excluding Global Markets) fell 20 bps sequentially from 2.85% to 2.65%:

BAC Net Interest Yield (FTE Basis) (Last 5 Quarters)

Source: BAC results presentation (Q2 2023).

The 20 bps sequential decline in Net Interest Yield was described by management as “a little anomalous, driven by our decision late first quarter to position the balance sheet around higher cash levels”. This point is demonstrated in the table below, which shows further details on BAC’s interest expense, income and rates (on a reported basis):

BAC Interest Revenue, Balances & Rates (Q2 2023 vs. Prior Periods)

Source: BAC results supplement (Q2 2023).

The average rate on deposits rose by 32 bps sequentially, slightly less than the average rate on all interest-earning assets (which rose by 34 bps), but the average rate on all interest-bearing liabilities rose by 62 bps. The gap between the two was due to a mix shift, with BAC having raise more cash from Repurchase Agreements during Q2:

BAC Interest-Bearing Liabilities (Q2 2023 vs. Q1)

Source: BAC results supplement (Q2 2023).

This is now reversing. Management decided to raise more cash in late Q1 because of the “extraordinary” environment. They now see “the environment is normalizing”, and expect cash levels should “continue to come back down”.

The average balance of the Debt Securities portfolio fell by another $80bn sequentially in Q2 to $771bn.

NII in Q2 2023 was also negatively impacted by temporarily lower loan growth. BAC observed that its (Commercial) “clients seem to be waiting for some of the economic uncertainty to lift before borrowing further”.

BAC still expects full-year 2023 NII to be “a little above $57bn”, including Q3 “at approximately the same level as second quarter”, i.e. $14.2-14.3bn, and Q4 “somewhere around $14 billion”. Management described the Q3 and Q4 expectations as “a slightly better viewpoint” and believed that this “provides a better start point for 2024”.

BAC’s slightly better NII outlook was based on the continuing relative stability in its deposit base. As CFO Alastair Borthwick described on the earnings call:

“We ended the second quarter at $1.88 trillion (of deposits), down 1.7%, with several elements of our deposit seeming to find stability. Given the normal tax seasonality impacts on deposit balances in Q2 and the monetary policy actions, we believe this is a good result … We did see some competitive pressure this quarter within about roughly $40 billion of CDs (Certificates of Deposit) … And at this point with deposits far exceeding our loans. we've not yet felt the need to chase deposits with rate.”

We believe large money center banks like BAC continue to be advantaged in their deposit franchises. JPMorgan similarly reported better-than-expected deposit pricing in their Q2 results last Friday.

Investment Banking Better Year-on-Year

BAC’s investment banking revenues were higher year-on-year, despite weak M&A activity and capital markets. Total Corporation Investment Banking (“IB”) fees were 7.4% higher, while Sales & Trading (“S&T”) revenues were 9.8% higher, consisting of an 18% growth in FICC (Fixed Income, Currency & Commodities) and a 2% decline in Equities:

BAC IB Fees & Trading Revenues (Q2 2023 vs. Prior Periods)

Source: BAC results presentations.

Compared to the same quarter in pre-COVID 2019, Q2 2023 IB Fees were 11.6% lower, while S&T revenues were 34.0% higher, benefiting from the decision to allocate more capital to Global Markets since 2021. (Global Markets’ Average 99% Value-at-Risk per day has more than doubled since then, from $34m to $76m).

Operational Leverage & Expense Reductions

Operational leverage and expense reductions should help BAC’s earnings in the coming quarters.

Expenses grew 11.0% year-on-year in Q2 2023, less than revenues, which grew 5.0%, This helped Pre-Provision Profit Before Tax (“PBT”) grew 23.5%, and gave BAC its eighth consecutive quarter of operational leverage since Q3 2021.

Expenses fell just 1.2% ($200m) sequentially, despite seasonal payroll taxes in Q1, partly due to higher litigation expenses (including a $250m for the OCC/CFBP settlement announced on July 11):

BAC Expense (Last 5 Quarters)

Source: BAC results presentation (Q2 2023).

Excluding interns, BAC has reduced its headcount by 4,000 (or about 2%) during Q2, and the benefit of this reduction will materialize more fully on the P&L from Q3 onwards. Management expects expenses to fall further in the coming quarters, to around $15.8bn in Q3 and around $15.6bn in Q4.

Credit Losses to Have Only Modest Impact

Credits losses rose only modestly sequentially, with the Net Charge Off (“NCO”) ratio rising from 0.32% to 0.33%, and actual NCOs rising from $807m to $869m:

BAC Net Charge-Offs (Last 5 Quarters)

Source: BAC results presentation (Q2 2023).

The NCO ratio is still below pre-COVID norms, but the difference was modest. (BAC reported NCO ratios of 0.43%, 0.44% and 0.41% and 0.38% in each year in 2016-19.) Another 10 bps in the NCO ratio, which would take it to the level seen in 2016-18, would have costed BAC another $265m in Q2, or less than 3% of its PBT.

Therefore, while credit costs should continue to normalize upwards, we expect them to be a relatively modest headwind.

Lower NII Headwinds Than Peers

As with other U.S. banks, BAC faces headwinds from Net Interest Yield having passed its peak, but the impact may be smaller because BAC’s Net Interest Yield had gained less.

Excluding Markets, BAC’s Net Interest Yield peaked at 2.85% in Q1 2023, less than 10 bps higher than the 2.77% it achieved in Q4 2019, and has already fallen below the latter as of Q2; by contrast, JPM’s Net Interest Yield was at around 3.80% for both Q1 and Q2 2023, more than 70 bps higher than the 3.06% it achieved in Q4 2019:

Net Interest Yield ex. Markets – BAC vs. JPM

Source: Company filings.

Simplistically, a return to pre-COVID 2019 norms will mean a smaller Net Interest Yield decline for BAC than for JPM.

The difference between the two banks is structural, and partly attributable to BAC’s much-criticised decision to deploy much of the deposit balances gained during the pandemic years into fixed-rate debt securities relatively early on. However, BAC believes theirs is a more balanced approach that should mean a narrower NII corridor in both directions, as CFO Alastair Borthwick said on the earnings call:

“If you look at our disclosures around interest-rate risk over the course of the past couple of years, you'll see it's more balanced both upside and downside and it's a narrower corridor overtime. So we're trying to sustain NII at a higher level for longer, that's what we're trying to engineer”

However, it is worth noting that, based on figures in the past year, JPM has achieved a better Net Interest Yield than BAC by doing better than the latter on both liabilities (where its rate went up less) and assets (where it went up more):

Average Interest Rates – BAC vs. JPM (Q2 2023 vs. Prior Periods)

NB. All figures on reported basis and include Markets; JPM Q2 2023 figures included FRC contribution. Source: Company filings.

Q2 2023 figures are distorted by BAC’s decision to hold more cash and JPM’s acquisition of First Republic on May 1, but the picture is similar if we compare Q1 2023 figures instead.

BAC having put more of its interest-earning assets in fixed rates will protect its interest income, but not protect it against increases in its interest expense on interest-bearing assets. It is therefore possible for BAC’s Net Interest Yield to underperform JPM’s further in future quarters.

Regulations as the Main Risk

We continue to believe regulations to be the main risk for our investment case.

The Fed is planning to impose higher capital requirements to reflect “operational risks”, with comments by Fed chair Jay Powell pointing to a potential 20% increase across the board.

In theory a higher capital requirement would translate linearly into a lower ROTCE. Banks will try to reprice their products and services to offset higher capital requirements, but they are also competing against non-bank financial institutions such as private credit funds and private equity firms that are not subject to these requirements.

Management comments on the subject were mostly around how BAC currently has ample capital. For now, regulatory changes remain uncertain, though consensus seems to be for some sort of increase.

BAC Valuation on <10x P/E

At $30.70, BAC stock is trading at 1.32x its Q2 2023 Tangible Book Value (“TBV”) of $23.23.

The P/E is less than 10x on most measures. Relative to our assumed long-term ROTCE of 15%, the normalized P/E is 8.8x. Relative to history, BAC shares are on 8.5x 2019 EPS and 9.5x 2022 EPS (adjusted for subsequent buybacks).

BAC raised its dividend by 9% to $0.24 after the Fed’s stress tests results in July, and this represents a Dividend Yield of 3.1%. Management has historically targeted a Payout Ratio of around 30%.

Buybacks may be more limited until regulatory changes (from both the Fed and Basel III) on capital requirements have been finalised, and may be temporarily lower as a result. BAC has recently been purchasing enough shares to offset shared-based compensation, and management believe “we've got flexibility to do a little bit more”. (The Q2 2023 average diluted share count was 1.2% lower sequentially and 1.0% lower year-on-year.)

BAC Stock Forecasts

We continue to believe a 15% average ROTCE to be sustainable on the current capital structure. As proposed regulatory changes remain unclear, we have kept our long-term ROTCE assumption unchanged, but reflects the uncertainty by lower the exit P/E by 1.0x. We also reduce the ROTCE in 2024 to 10% to reflect a mild U.S. recession.

Our updated assumptions are now:

• ROTCE to be 15.0% for 2023, 10% for 2024 and 15% for 2025 (was 15% for all years)

• Dividends to be $0.92, $0.94 and $1.00 for 2023-25 (was $1.07, $1.14 and $1.23)

• Net Income to be 15% retained for growth

• After dividends and retention, earnings to be spent on buybacks at a P/TBV of 1.5x

• 2025 year-end P/E of 12.5x (was 13.5x)

Our new 2025 EPS forecast of $4.02 is 2% lower than before ($4.10):

Illustrative BAC Return Forecasts

Source: Librarian Capital estimates.

With shares at $30.70, we expect an exit price of $50 and a total return of 71% (25.3% annualized) by the end of 2025.

The most important part of our investment case is the re-rating. Fundamentally, our forecasts are that ROTCE will be 15% in 2025, similar to 2022, and that TBV/share will be 26% higher after both retained earnings and share buybacks. This gives a 2025 EPS that is 26% higher than in 2022. The P/E re-rating adds another 37% to the total return (when applied to 2025 EPS), and dividends add another 8%, giving the total return of 71% after slightly less than 2.5 years.

Conversely, without the re-rating, our forecasts would show a total return of 32% (12.5% annualized).

We reiterate our Buy rating on Bank of America stock.

Ends

Stocks mentioned: BAC 0.00%↑ , JPM 0.00%↑ . We are long both.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.