Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, breaks down Bank of America’s first quarter earnings results.
Bank of America reported first quarter earnings of $0.21 per share. This is $0.02 per share below my estimate and $0.05 per share below fourth quarter results. The new earnings estimates are as follows: a) the 2016 estimate is being reduced slightly to $1.28 per share from $1.29 per share; b) the 2017 estimate is being maintained at $1.61 per share; and c) the 2018 estimate is being raised to $1.88 per share from $1.81 per share.
During the quarter, the bank indicated that it had two special charges that totaled $0.12 per share. The first was related to adjustments to its bond amortization values which were negatively impacted by a decline in rates. This cost $0.07 per share. The second was a $0.05 per share retirement benefit cost. While there is an inclination to count these as one-time charges, they are not since interest rates will continue to fluctuate and there will always be first quarter benefit adjustment charges.
During the quarter, Bank of America’s average earning assets fell by 0.1% linked quarter. The loan portfolio was up by a minimal 0.8%. The weak gain was due in part to the re-categorization of $50 million in leases, the sale of approximately $4 billion in residential loans, the run-off of another $6 billion in legacy assets, plus sales of some credit card assets.
Despite the impact of these events, the bank’s average commercial loan performance was quite good. Linked quarter C&I loans grew by 3.4% and commercial real estate loans were up by 2.0%. Auto loans grew by 1.7% and the other category was up by 4.7%. The declines were recorded in residential mortgages and credit cards where run-offs and sale of assets were in place.
Average deposit growth also remained positive. It was up 2.9% linked quarter. The bank now has end-of-period deposits of over $1.2 trillion. The cost of this money is only 12 basis points. The loan to deposit ratio is 74.0%. These three numbers indicate significant unutilized earning capacity.
The net interest margin fell by 10 basis points in the quarter. This was due to the bond amortization cost noted above. Since long-term interest rates are continuing to fall, it is possible that the bank will continue to miss the benefit of the increase in short rates. However, at some point this year it is expected that rates will rise pulling Bank of America’s net interest margin higher.
The loan loss provision raises questions. During the quarter, unlike its peers who have reported, Bank of America saw its non-performing assets decline and its net charge-offs fall. Consequently, there was a reduction in the bank’s reserves. This needs to be questioned.
All of this occurred despite the need to add $500 million to the energy and metals reserves. And, despite the fact that commercial loans are rising. I simply do not believe that this trend can continue and, therefore, assume that the loan loss provision will start to rise for the foreseeable future.
Bank of America – Non-Interest Revenue
Non-interest revenues went up 4.3% linked quarter but in reality there were no positives here. Traditional banking fees were all down. Service fees were down by 1.3%; and credit card fees declined by 9.4%. Seasonality plays a part in these declines in the first quarter. However, businesses like brokerage commissions and investment banking should see seasonal gains in the first quarter but they fell by 1.7% and coincidentally 9.4% respectively.
The increase in non-interest income came from a 72.6% jump in trading revenues linked quarter (down 26.0% y-o-y) and a 65.3% jump in mortgage banking revenue. Trading activity is expected to continue to rise in the second quarter given the initial indications from March and April activity. Mortgage banking is expected to decline due to the bank’s decision to hold more of the mortgage loans it originates on to its in-house portfolio.
Despite the iffy first quarter results, the second quarter could be a good deal stronger. The equity markets are doing better. This should help the brokerage and investment banking businesses and lift trading, further.
Most companies are hit with a meaningful increase in first quarter benefit costs every year and Bank of America is no exception. Personnel expenses rose by 17.5% sequentially in the quarter. This increase was so significant that it caused overall expenses to rise by 5.8%. Excluding personnel expenses all other non-interest expenses fell by 7.9%.
In the second and subsequent quarters, the benefit cost issue will disappear. Thus, the bank’s relentless campaign against cost increases will continue. It is expected that expenses will be flat to down in the next two quarters.
Thinking about Bank of America’s longer term future, it becomes apparent that the key issue is revenues. The bank has been effective in controlling loan losses and costs. This has allowed it to offset the failure to build revenues. From 2010, to the present, revenues have been down in every year except 2013. It appears that revenues will decline in 2016, also.
If my predictions are correct, the bank will not exceed 2010’s net interest income until 2019. It will not reach the non-interest income levels posted in 2010 until sometime in the 2020s. Who knows if it will ever get back to the non-interest income levels posted in 2009.
This raises the question as to how the company can reach revenue levels that delineate growth. Classically this will happen if:
- It sells more widgets, or
- Raises prices.
To get more widget sales it needs:
- More customers;
- More products sold to its existing customers; or
- A higher turnover in the products currently being sold.
Obtaining more Customers
This will not be easy.
- Population growth even in the bank’s most rapidly growing markets is not particularly robust.
- The bank is not able to make acquisitions – i.e., buy someone else’s customers.
- It is very difficult to steal someone else’s customers because the biggest banks all have adequate resources to fend of competitive thrusts.
- Existing markets are already saturated.
Thus, obtaining new customers is actually a heavily labor intensive effort. Sales people must aggressively seek personal contact with target clients to bring them into the bank. Bank of America has increased the number of its sales people and it is refashioning its branches into sales offices that sell multiple products.
Additionally new customers can be acquired if the bank is present at the time when the new client needs financial services – i.e., it is in the auto dealership when the car is being sold; it is in the real estate office when the house is being purchased; it is at the business when inventory is being acquired. This requires advanced, sophisticated technology which the bank has.
Another method of obtaining new customers is to enter new or underserved markets. Bank of America does not want to go overseas and Merrill Lynch’s previous attempts to open new markets outside the United States have not met with great success. Penetrating the underbanked and non-banked markets is fraught with risk. Banks are doing this by aligning with specialty lenders who have developed customer bases that the specialty firm lacks the capital to finance.
Overall it is very difficult to obtain new clients. It is arduous and very costly.
Sell More Products to Existing Clients
This technique offers greater promise. However, the biggest problem here is that the product being sold – i.e., money — is a commodity and it is impossible to differentiate it from what the competitor is offering.
Thus, the method of conveying the product to the customer is the key to selling more. Here one meets the challenge that most customers do not generate enough sales to make it profitable to reach them through labor intensive delivery systems. Thus, banks rely on innovative technology to reach the target client. At the moment, mobile banking is the key and Bank of America does unusually well in this regard.
The best approach is to define the customers need before the customer knows about it and convey a solution to the client to define and meet the need – i.e.; offer a low cost auto loan to a customer who is continually bringing in his/her car for repairs; provide longer term financing to a business that has built too much inventory. To do this a bank needs a large customer base and a way to track the customer transactions. It is unclear if Bank of America is doing this.
Most banks rely on age defined needs to develop target products for the customer. Or, they utilize heavy sales appeals through aggressive calling campaigns. Or, they literally walk the streets and bang on doors at commercial enterprises. The latter two approaches are very costly and initially yield low returns.
What is needed here are disposable products. Trading comes to mind as a product meeting this need. Mortgage refinance is another product. Consolidating debt would be a third.
Best of all is raising prices. This increases revenues without a commensurate increase in costs. Banks do this by unbundling products. It is risky, however, since it may alienate the clients.
The ideal condition for a bank is if the economy expands. This increases the income of the customer base and it spurs the demand for more products that have to be financed. Additionally, if interest rates rise at the same time the economy is improving, then prices go up on the incremental sales.
What this says is that it is very hard to internally generate more revenues. What are needed are favorable macro-economic developments. Bank of America cannot produce these so like most banks all it can do is position itself to be ready when the “tide” comes in. Until that time it can only focus of reducing costs while it makes limited forays into the market.