Massimo Giachetti
This year has not been a good one for the stocks of money center banks, as investor nervousness over higher capital requirements, weaker capital markets revenue, and a slowing macro environment have pushed valuations back to levels well below historical averages. Bank of America (NYSE:BAC) has been no exception, as the shares have lost about 20% of their value since my last update, underperforming other large banks over that time.
Money center banks clearly aren’t in favor right now, but I believe strong earnings growth should drive improved sentiment later this year, particularly as the banks build capital and get closer to a point where significant returns of capital to shareholders can resume. With Bank of America still offering above-average rate leverage, loan growth potential, and earnings growth leverage, I think the shares still have appeal at this lower level.
As Rate Sensitivity Fades, Loan Growth Should Pick Up Some Slack
Bank of America’s second quarter certainly had some areas of concern. While net interest margin, net interest income, and loan growth were better than expected, earning assets, fee income, revenue, expenses, and pre-provision profits were all weaker than expected. Fortunately, the outlook for revenue growth in FY’22 and FY’23 remain quite healthy.
Bank of America remains the most asset-sensitive of the major banks, and while there has been evidence of higher-than-expected deposit betas (how likely depositors are to withdraw/move money as rates rise) across the sector, the incremental deposit beta for Bank of America has been better than average. What’s more, while loan/deposit ratios are also rising across the sector, Bank of America’s is still comfortably low enough to support significant loan growth.
Bank of America isn’t taking the steps to deliberately reduce rate sensitivity like Comerica (CMA), but sensitivity should fade some as the cycle moves on, largely due to increases in the deposit beta and loan/deposit ratio. Still, investors should expect B of A to remain a highly rate-sensitive bank – a likely positive for at least a couple more quarters, though more of a risk later in FY’23. With that, the bank should see a big upward move in full-year net interest margin in FY’22 and then only modest improvement thereafter (assuming that the economy doesn’t go into a more significant downturn).
As the impact of higher rates works its way into the financials (as it did in the second quarter), loan growth will become an even more important driver. Bank of America was basically on par with other large banks in terms of second quarter loan growth (up around 4% qoq ex-PPP), but management has made it clear that funding loan growth is the top priority for capital today, and the bank has been investing considerable resources in recent years to build up its C&I lending capabilities.
There may be some incremental opportunities to pick up share in mortgage and card lending (BAC’s card loans grew almost double the sector average rate in Q2), but I expect C&I to be the real focus for loan growth. Whether its lending to support working capital growth (expanded inventories to mitigate supply challenges) or capex lending to support capacity growth (including what could be a multiyear reshoring initiative), I expect stronger growth opportunities here. That said, while Bank of America’s roughly 6% C&I loan growth in Q2 wasn’t bad, rivals like PNC (PNC), U.S. Bancorp (USB), Regions (RF), and Truist (TFC) did even better, and competition is well worth monitoring.
Capital Markets Likely To Remain Stressed
The second quarter wasn’t a particularly good one for Bank of America where its capital markets business is concerned. The 11% year-over-year growth in trading revenue was weak next to peers like JPMorgan (JPM), as was the 47% decline in investment banking revenue.
Ongoing volatility will be a positive for trading revenue across the sector, but it remains to be seen if Bank of America will be able to gain meaningful share over its rivals. One competitive dynamic worth monitoring is what these large banks (BAC, Citi (C), JPMorgan, et al) do in terms of their trading exposures – reducing risk-weighted assets would help banks meet their new stricter capital requirements, but would also reduce earnings power.
With capital markets weighing on results for a few more quarters, I expect that money center banks will see a slower ramp in earnings than their more “Main Street” peers, and I believe this at least partly explains the underperformance from these larger banks this year.
The Outlook
Capital markets businesses are likely to weigh some on Bank of America’s near-term results, and the need to build up capital will weigh on capital returns to shareholders, but I nevertheless like how Bank of America is positioned for 2023. The bank has substantial “Main Street” operations, and remains well-leveraged to loan demand growth and higher rates, while also enjoying a high-quality, low-cost deposit base that should give it a funding advantage over many of its rivals.
In terms of reported financials, this year has gone more or less as I expected, and I haven’t had to make many changes to my model – my FY’22 core earnings number is 1% lower than when I last wrote about the stock and my FY’23 number is 2% higher. I’ve also tweaked some of my capital return assumptions (to account for a CET1 build to 11.4% by 2024), but the net impact to my fair value is quite modest.
Importantly, I’m still expecting over 20% pre-provision profit growth in FY’23 and higher adjusted net income and EPS growth; I believe BAC could post some of the best year-over-year EPS growth in its comp group for FY’23 and top-quartile growth in FY’24 as well. With that, there should be a positive rerating on the shares later this year.
The Bottom Line
A lot could still go wrong from here – the economy could take a turn for the worse, other banks could gain lending share at BAC’s expense, and so on. I don’t dismiss those risks, but I think a lot is already reflected in the share price, and with discounted long-term core earnings, ROTCE-driven P/TBV, and P/E all supporting a fair value above $40, I believe these shares are still worth consideration.
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