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Bank of America (NYSE:BAC) is set to release earnings tomorrow, October 17. The stakes couldn’t be higher. Last week, U.S. banks like JPMorgan Chase (JPM) and Wells Fargo (WFC) released earnings, mostly beating expectations. But while their results were ahead of expectations, earnings still declined, mostly due to increased provision for credit losses (“PCLs”) and weakness in investment banking.
Of the big U.S. banks, BAC probably has the best chance of delivering positive growth in pre-provision net income (i.e., net income not including loan loss reserves). All of the big banks have seen large reserve builds, and probably won’t see positive growth in reported earnings. However, some banks have delivered positive adjusted earnings growth this year; for example, Toronto-Dominion Bank’s (TD)(TD:CA) adjusted earnings grew 5.1% in the most recent quarter. Bank of America will most likely report negative GAAP earnings growth but could report a jump in “pre-tax, pre-provision” earnings, a kind of adjusted earnings metric. In its most recent quarter, BAC’s pre-tax, pre-provision earnings grew 15%, so we could see strength in that metric again this quarter.
Why does that matter?
Because if it happens, it confirms that BAC’s core business is healthy. PCL build is a classic “on paper” cost. It’s money set aside to cover potential non-performing loans, not loans already in default. When the economy gets riskier (e.g., enters a recession), banks typically raise their PCLs, but if the risks abate, then they lower them later, resulting in a rapid spike in earnings. All of the big banks are already reporting higher net interest income (“NOI”) due to the Fed’s interest rate hikes; if the economy doesn’t go into too steep of a recession, they’ll eventually be able to reverse their PCLs and report higher earnings.
Bank of America is extremely well positioned here, because the overwhelming majority of its earnings come from interest. Bank of America brought in $22 billion in revenue in the most recent quarter, of which only $1.1 billion was investment banking fees. BAC brought in the third largest amount of i-banking fees of all U.S. banks in the period, but its exposure to investment banking as a percentage of revenue was much lower than for Goldman Sachs (GS) or Morgan Stanley (MS). So, BAC has a much quicker path to recovery than those banks do.
In this article, I will make the case that Bank of America is extremely well positioned heading into tomorrow’s earnings release. Drawing on the previous quarter’s earnings along with some estimates of third quarter results, I’ll make the case that the release will be strong. First, though, I need to take a look at how BAC stacks up today.
Bank of America – Competitive Advantages
Bank of America has a number of competitive advantages in U.S. financial services. These include:
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A strong brand. Bank of America is one of the best-known U.S. banks and its brand is the most valuable in its peer group (its value was estimated at $36.7 billion).
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Operational diversification. Bank of America operates in retail banking, commercial banking, wealth management and investment banking. This business mix makes BAC better positioned in today’s environment compared to pure-play investment banks.
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Cost efficient operations.
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High market share in domestic deposits.
The point about investment banking deserves a little explanation. Of all financial sub-sectors, investment banking is performing the worst this year. Due to the tech stock crash, companies are opting to not go public. As a result, underwriting income is way down. Bank of America is no different from other banks in this regard: its investment banking fees declined 47% in the most recent quarter. However, investment banking makes up only 5% of BAC’s total revenue, so it’s better positioned than Morgan Stanley, Goldman Sachs, and other pure-play investment banks.
Bank of America’s Most Recent Earnings
Speaking of Bank of America’s earnings, we can now turn to its second quarter results. By understanding what happened in BAC’s second quarter, we can get a sense of what it has in store for the third.
In the second quarter, Bank of America delivered:
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$22.7 billion in revenue, up 5.5%.
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$12.4 billion in net interest income, up 22%.
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$523 million in PCLs, up by $2.1 billion.
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$7.4 billion in pre-tax, pre-provision income, up 15%.
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$2 trillion in deposits, up 7%.
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$1.1 billion in investment banking fees, down 47%.
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A 10.5% CET1 ratio-well ahead of what regulators require.
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A 14.1% return on tangible ROE.
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$6.2 billion in net income, down 32.6%.
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$0.73 in diluted EPS, down 29%.
As you can see, revenue went up, net interest income went up, and pre-provision income went up. Why, then, the decline in bottom line earnings?
It comes down to two things:
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PCLs increased. PCL is not technically a “loss,” but it is a charge taken off of net income. An increase in this metric can cause net income to go down even when operating income goes up.
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Investment banking fees went down. A $1 billion decline in investment banking fees made up the lion’s share of BAC’s second quarter earnings decline apart from PCL build.
So, we can see that of the $3 billion decline in BAC’s earnings, only $1 billion of it was due to a segment performing poorly. PCL build is just a precaution. It lowers net income, but it doesn’t reflect actual defaults. In 2020, all the big banks increased their PCLs, but subsequently reversed the buildup when the COVID lockdowns ended. We could be looking at a similar situation in 2022. The last two quarters saw GDP decline, but only modestly. The economy is still adding jobs. Retail sales are still rising. Employers are struggling to fill positions. Put simply, the economy is still strong in many ways.
This isn’t exactly the kind of environment in which banks struggle to make money. Many people worry about the possible recession we’re in, but ignore the fact that, if this is a recession, it’s a very mild one. The economy does not exist in two states, one where we’re in a recession and everything is bad, the other where we’re not and everything is good. There are degrees of recessions; the Q2 economic contraction was only 0.6%, nowhere near 2008 or even 2020 levels. So there is reason to think that the economy will bounce back from this. If it does, BAC will be able to reverse its PCLs and start reporting higher net income.
What to Expect Tomorrow
Having looked at BAC’s second quarter earnings, we can now move on to tomorrow’s release. We can never say with certainty how a company will do in a given period, but there are some indicators we can go off of.
First, BAC’s competitors beat expectations when they released earnings last week. JPMorgan beat on revenue and earnings, Wells Fargo beat on adjusted but not GAAP earnings. So, companies similar to BAC are doing well.
Second, expectations are not high. In the past 90 days, only 2 analysts revised their BAC earnings estimates upward, 9 revised them downward. So, expectations are low and easy to beat.
Third and finally, there are statements from company insiders that point to strength. Recently, Bank of America CEO Brian Moynihan said that the U.S. consumer was strong. Most likely, that statement was informed by Moynihan’s insights into his own business, so it could portend decent revenue.
Now for one negative: BAC recently agreed to settle a lawsuit for $1.84 billion. The settlement was a win because the Bank managed to lower the amount down from $3 billion, but it will cause a $354 million pre-tax expense in Q3, or $0.03 per share. The markets are expecting $0.78 per share in earnings, up $0.05 from the prior quarter. The settlement isn’t huge, but it could be enough to cause a bottom-line miss. Given the other signs I reviewed above, I’d expect BAC to meet or beat expectations on revenue, but maybe not on EPS.
The One Big Risk to Watch Out For
As I showed in this article, Bank of America’s revenue for the third quarter is likely to be very strong. Earnings could be a little behind estimates, but not by a whole lot. Overall, we’re likely to see a decent release.
There is nevertheless one long-term risk for investors to watch out for:
Deteriorating consumer credit. Bank of America makes a lot of money lending to ordinary Americans; if rising interest rates make life harder on the Bank’s customer base, then it may eventually start seeing defaults. Just recently, BAC launched a pilot program where it offered zero down-payment mortgages to members of under-served communities. The plan had lofty goals, but it ultimately involved lending money to people with little to no credit history or assets. It sounds eerily similar to the sub-prime lending that took place before the mortgage crisis in 2008. That ended up creating some problems.
When interest rates rise, consumers have to pay higher rates on variable rate mortgages. Risky loans become even riskier when interest rates go up, and Bank of America is experimenting with some very risky loans today. On the whole, BAC’s business is strong, but investors will want to keep an eye on consumer health, as a weak consumer often leads to weak retail banking results.
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