Bank of America Corp (NYSE:BAC) was the best performing stock in the Dow Jones Industrial Average in 2012. Shares have climbed a truly impressive 111% over the past 16 months. With the summer months approaching and the economy sputtering along, is there any steam left in the B of A engine?
A Brief Comparison to a Best in Class Bank
Bank valuations are driven by earnings. Warren Buffett agrees, so I will just piggy back on his words here. If we are all now in agreement, then the next step is to take a long, hard look at B of A’s income statement to determine what happens next.
But before diving into the specifics of Bank of America Corp (NYSE:BAC)’s income statement, let’s first compare it to an industry favorite, Wells Fargo & Co (NYSE:WFC). Widely considered best in class, Wells has an impressive return on assets (ROA) of 1.4%. Compare that with 0.19% at Bank of America Corp (NYSE:BAC) for Dec. 31, 2012.
How does Wells Fargo do it?
Wells doesn’t have a big presence in investment banking, global banking, or the derivatives world. But the company is diversified, has a strong balance sheet, and is the best in the business at cross-selling complimentary products. Wells Fargo keeps it simple and executes — that is the key to their success.
By keeping it simple the company escaped the financial crisis largely unscathed, which gives it a significant advantage on the competition. Wells was able to double down on the mortgage market just as mortgage rates fell to historic lows and demand for refinances went through the roof. The company originated $524 billion in mortgages in 2012, a staggering number of which (75%) were refinances.
Contrast that to Bank of America Corp (NYSE:BAC), who has spent the past 4 years working to undo the damage of the much maligned CountryWide acquisition. B of A lost over $20 billion in 2011 and over $7 billion in 2012 directly from CountryWide assets.
Enough about the past, where is B of A going to be tomorrow!?
Bank of America is working to simplify its operations. The company has announced cost reductions across the board to bring down expenses as the bank intentionally shrinks. CEO Brian Moynihan has reorganized management ranks to better align them with the company’s simplified business model. The company has paid out extraordinary sums of money to settle legal claims related to practices at CountryWide.
All of these changes are designed to free Bank of America Corp (NYSE:BAC) from its troubled past and to allow the company to get back to block and tackling banking. Sound familiar? (Hint: Wells Fargo…).
B of A’s revenue is broken down into two primary categories: net interest income and non-interest income.
Interest Income
Net interest income is a function of both loan balances outstanding and the yield on those loans. Because of B of A’s size and footprint in the US, this measure is largely tied to macroeconomic factors. At play today is a continued deleveraging amongst consumers and historically low yields. This drove net interest income down just over $4 billion from 2011 to 2012, but it still represents 49%+ of total income.
Non-Interest Income
Non-interest income is more interesting and more complex. Fee income is both an offshoot of the core lending business as well as other businesses not directly tied to traditional commercial and retail banking.
First, as related to traditional commercial and consumer banking, non-interest income is driven by card income (transaction fees and annual fees), service charges (related to deposit products, some loan products, and misc other customer services), and investment and brokerage services. Together, these three sources of income generated $25 billion of income in 2012.
Card income accounted for 14.3% of non-interest income, service charges 17.8%, and investment/brokerage services 26.7%
In concert with the decline in consumer loan balances mentioned above, these three income sources were also down year over year. However, service charges and investment/brokerage services were up as a percent of non-interest income.
Taken together we can again see both the impact of the macroeconomic factors (income down year over year) but also the impact of the changes in the company’s business model (the increase as a percentage of revenue at the bank).
Investment banking income was $5.3 billion, which is 12.4% of total non-interest expense. This was up 2% year over year. Equity investments were down 72% year over year, another indication of B of A’s simplification.
The Rosetta Stone – The Key to Bank of America’s Near-Term Future
Hidden away in non-interest income is what B of A reports as “Mortgage Banking Income.” This line item is the key to understanding the bank’s real upside potential. This is where the CountryWide legacy assets are reported.
This business is housed in B of A’s Consumer Real Estate Services business segment. This segment overall saw losses of $19.5 billion in 2011 and losses of $6.5 billion in 2012.
Drilling down another level, of those losses the CountryWide assets alone contributed a $20.1 billion loss in 2011 and a $7.4 billion loss in 2012. While the improvement from 2011 to 2012 is noted, these are still staggering figures.
But the company is proving that it can manage its way out of these assets. From 2011 to 2012, these legacy assets reduced 25% from $118 billion to $89 billion. This 25% reduction in assets resulted in a 63% reduction in losses year over year. Drilling down yet again, the total loans and leases in this portfolio reduced by just 16% from $65 billion to $55 billion. This 16% in problem loans and leases yielded a 63% reduction in the portfolio’s net loss for the year.
This is highly indicative that the worst for this portfolio is behind us. Bank of America has proven itself as capable of working these loans out of the bank at the same time as it has been able to reach settlements with the regulators.
This is evidence of steam still left in the engine.
An Oversimplified (yet viable) Conclusion
Since B of A bottomed at around $3 in March of 2009, the stock has seen a high just north of $18. Today it stands around $12.35. By stemming losses just from the CountryWide assets, B of A has the potential to triple earnings for the year.
Assume first that the US economy continues on its current trajectory with positive yet sedated growth. Take 2012 earnings, rounded to $4 billion, and add back the $7 billion in losses tied to CountryWide. By simply cleaning up that portfolio once and for all, B of A could potentially triple earnings to $11+ billion. Of course there are thousands of other variables that come into play, but fundamentally this thesis is viable.
CountryWide is the driving force behind Bank of America’s woes. Clean up the CountryWide portfolio and you have a cleaned up Bank of America. The earnings, ROA, and stock price will follow.
There will almost certainly be some bumps in the road. Goldman Sachs has recently come out with a recommendation to avoid bank stocks in general in the second quarter. The dust has not fully settled on the mortgage settlement. The economy overall is still sputtering. Bank of America has one of the highest beta’s in the Dow at 1.78, making it a very volatile stock. In the short term, there is a very real risk that things could get ugly.
But avoid panic and think long term. B of A is doing everything right. Capital levels are very sound, the company did well in this year’s Federal Reserve Stress Tests, and a dividend announcement is likely not too far in the distant future. The bank’s revised business model is beginning to show a positive impact, and the income statement is poised to rebound as a result.
The volatility is your opportunity to buy.
The article Understanding the Upside Potential of B of A’s Earnings Engine originally appeared on Fool.com and is written by Jay Jenkins.
