Analysis of a financial intermediary

Strong Fees and Net Interest Income Come Through for Bank of America in Third

Quarter

Eric Compton

Senior Equity Analyst

Analyst Note | by Eric Compton Updated Oct 14, 2021

Wide-moat-rated Bank of America recorded solid third-quarter earnings, beating the

FactSet consensus EPS estimate of $0.71 with a reported EPS of $0.85. This equates

to a return on tangible common equity of 16%. Like peers, Bank of America is seeing

historically strong credit quality as net charge-offs fell to 20 basis points of average

loans—a 50-year low. Asset improvements led to a provision benefit of $624 million and

a $1.1 billion release in reserves. Credit wasn’t the only item that outperformed our

expectations, as wealth management and investment banking fees came in ahead of

our projections. The bank also seems poised to reach its goal of gaining an additional

$1 billion in its quarterly net interest income run rate by the fourth quarter, which we

thought the bank might miss. After increasing our net interest income and fee

projections, we are increasing our fair value estimate to $38 per share from $35.

We caution investors that the banking sector appears relatively fully valued to us, albeit

not supremely overvalued. In our Bank of America model, we are projecting roughly $7

billion in extra NII coming from rate hikes by 2025. The fee environment remains

exceptionally strong, and it is admittedly difficult to predict where certain items (like

investment banking) might normalize, but we think future outperformance is now about

exceeding already decent growth and rate expectations.

Business Strategy and Outlook | by Eric Compton Updated Jul 14, 2021

The ill-advised acquisitions of shaky investment bank Merrill Lynch, shady mortgage

lender Countrywide Financial, and the equally dysfunctional MBNA led to a decade of

troubles for Bank of America shareholders. The bank has had to spend billions of dollars

to settle legal and regulatory issues, and it has taken years to reshape the business and

work through the credit losses. With management having significantly reshaped the

franchise, the bank is finally showing its true earnings power.

If you needed a sign of BofA's transformation since 2007, we would point to how it

remained profitable amid the pandemic-driven downturn. Bank of America's strategy of

simplification, efficiency, and risk reduction has paid off. The balance sheet is much

better from a credit perspective, with the bank being a prime focused lender. Further,

expenses have been flat to down for years, and we expect the bank can hold them

steady for another couple of years.

After more than a decade of work, Bank of America now has one of the best retail

branch networks and overall retail franchises in the United States, is a Tier 1 investment

bank, is a top four U.S. credit card issuer, is a top three U.S. acquirer, has a solid

commercial banking franchise, and owns the Merrill Lynch franchise, which has turned

into one of the leading U.S. brokerage and advisor firms. We believe that scale and

scope advantages are increasingly important as the role of technology in banking

grows. Bank of America is seeing increasing mobile adoption, has access to data on

millions of customers, and has one of the largest tech budgets in the industry. Given the

scalability of these platforms, we believe these factors will only matter more as the

industry progresses. We expect the bank to return to offense after absorbing the blow

from COVID-19 by expanding product offerings into new markets and opening more

new financial centers over the next several years. We believe its product scope,

adequate capital levels, and room for further efficiencies and investments all position

the bank well for the future.

Economic Moat | by Eric Compton Updated Jul 14, 2021

We believe Bank of America possesses a wide moat based on sustainable cost

advantages and switching costs that are consistent with our bank moat framework.

Bank of America is the second-largest U.S. money center bank by assets and tends to

have leading share and operations in many of the areas it competes. Bank of America is

one of the top deposit gatherers in the U.S. and has a top-two share in retail mortgages,

home equity lines of credit, and small-business lending as well as one of the top

corporate franchises in the U.S. The bank also has one of the largest online retail

brokerages in Merrill Edge and one of the largest advisor forces through Merrill Lynch

Wealth Management. The bank is a top five global investment bank, one of the largest

U.S. issuers of credit and debit cards, one of the top four U.S.-based merchant

acquirers, and a top-five fee earner from FICC products globally. Given the bank’s

higher capital levels since the crisis, the increasing importance of scale and scope with

changes in technology, and robust fee income, we believe Bank of America will

consistently earn returns that exceed its 9.5% cost of equity through the cycle.

We argue that bank moats are derived primarily from two sources: cost advantages and

switching costs. We see cost advantages as stemming from three primary factors: a

low-cost deposit base, excellent operating efficiency, and conservative underwriting,

with regulatory costs a final factor that must also be considered. Bank of America was

hit quite hard during the crisis and underperformed peers, so it has not historically had

any credit advantage in the last several decades. However, many of the charges were

related to poor acquisitions, as well as credit practices and concentrations which have

changed since the crisis. Bank of America made the ill-timed acquisition of MBNA in

2006 and followed this with the acquisition of Countrywide in 2008. This gave it one of

the largest exposures to unsecured consumer lending and well as subprime mortgages.

This, along with all of the legal charges that followed, plagued the bank following the

crisis.

However, the bank has tamed its high consumer exposures, steered away from

subprime lending, reduced second mortgage exposures, and run off or sold portions of

its past portfolios. It is now rebalanced to roughly half and half commercial versus

consumer lending, and FICO scores and other credit-risk-related metrics are much

improved compared with precrisis vintages. We also believe CEO Brian Moynihan’s

renewed focus on "responsible growth" should set the tone from top when it comes to

chasing outsize loan growth in more risky areas.

Bank of America’s operating efficiency has generally been worse than peers since the

crisis, but this is largely due to the outsize fines the bank has received as well as its

unique integration challenges following the crisis. The bank had made several large

acquisitions before and during the crisis, and the demands of the crisis led to a

prolonged process of full integration as well as trying to rightsize businesses. The bank

also had to deal with more crisis-related fines than any of the Big Four. That said, the

bank has now consolidated over 30% of branches, reduced head count by over 30%,

and sold off noncore assets. We now believe Bank of America will, at the very least, be

able to match peers on operating efficiency. Given the new phase of banking we are

entering, where technological changes are occurring faster and are more impactful than

ever before and can be deployed across singular, integrated platforms, we see potential

advantages for the largest banks when it comes to operating efficiency. With its tech

budget of roughly $10 billion per year, Bank of America may not drop to the lowest

overall efficiency ratio among peers, but it will be able to maintain higher levels of

investment at similar efficiency levels. Further, with its solid mix of fee income, Bank of

America will be better insulated if rates decline as it is less dependent on rate-sensitive

net interest income.

Bank of America’s overall deposit market share is attractive, with one of the highest

weighted average market shares among our coverage. Bank of America is the top

depositee in five of its seven largest metropolitan statistical areas and is one of the top

deposit gatherers across the U.S. On a cost advantage basis, we view the bank’s

deposit base as having a likely chance of being advantaged in the future, based on

historical performance, current noninterest bearing deposit mix, and current deposit

beta trends.

Overall, we believe the bank’s key advantage comes from its scale in certain fixed-cost,

fixed-platform businesses and the breadth of products it can offer to clients. This

contributes to economies of scale and economies of scope and can create switching

costs for customers as they use the bank for more and more products. The bank is one

of the top issuers of credit and debit cards, where many of the costs of running a

payments platform are fixed and high in nature, leading to the need for scale. This has

been borne out in the industry where much consolidation and concentration within the

top performers has occurred. The same has occurred in the mortgage industry and is

occurring for other consumer-based mass-market products. Bank of America is also one

of the more dominant wealth managers in the U.S. through its multiple Merrill Lynch

platforms. This allows the bank to be a convenient one-stop shop for banking and

investment needs and act as a key asset and deposit gatherer, and while advisor

compensation is variable to a degree, the bank can invest in and maintain key

technology platforms in the background that allow the business to run. Bank of America,

while not as dominant as the top investment banks in the world, is still a Tier 1

investment bank and maintains solid share in key areas and respectable share in most

others. While many of the costs of investment banking are variable (most notably

banker compensation), the bank has built up a strong reputation, owns a large

securities distribution platform, attracts top talent, and has a global reach that only the

best can compete with. This leads us to view this segment as a positive contributor to

Bank of America’s moat.

While all of these segments are strong on their own, we believe there are advantages to

combining them all under one banking roof. On the consumer side, Bank of America is

able to cross-sell multiple products, providing advantaged pricing to key customer

segments (such as through its Preferred Rewards banking program), and spread the

overall costs of customer acquisition across more revenue streams. On the commercial

side, similar dynamics apply; the bank is able to offer a complete package with global

scale that few can compete with, while sending out armies of bankers to both existing

and new markets in an effort to win new business. Finally, the largest banks will be able

to spend the most on technology going forward and will have access to unique data on

the largest client bases, and Bank of America is no exception. We believe its ability for

higher investment into tech platforms that can scale, as well as its access to customer

data on millions of households, should bolster the bank’s advantages over the longer

run.

From a systemic standpoint, we believe the U.S. banking system has improved over the

last decade, as capital levels supporting the banking system are at all-time highs.

Further, regulation has become considerably stronger in the past several years. The

U.S. banking market is quite fragmented, and Bank of America must compete with a

variety of regional and community banks as well as large money center institutions,

although this fragmentation has gradually decreased since the 1990s. While we do view

the banking sector as intensely competitive, the largest banks by asset size have

generally been able to earn higher returns on equity for the last several decades and

still do so today. Our outlook is generally positive from a macroeconomic and political

standpoint for the U.S. banking system, as the U.S. is still the world's leading

democracy, has increased GDP at a steady pace for years, and maintains the world's

reserve currency, all of which contribute to banking stability.

Bank of America is large enough to be considered a global systemically important bank

and has a GSIB surcharge of 2.5%. This is below the banks with the highest surcharges

but still above banks without this surcharge. The bank is also large enough to be subject

to the Federal Reserve's annual stress tests, as well as a host of other regulatory

requirements, and we don’t see any massive regulatory relief coming for the large

money center banks. The stringent capital requirements that the largest banks are held

to give us some reassurance that these banks will be able to weather the next economic

downturn.

Fair Value and Profit Drivers | by Eric Compton Updated Oct 14, 2021

After incorporating the latest quarterly results, we are increasing our fair value estimate

to $38 per share from $35. Our fair value estimate incorporates a 100% chance of a

26% statutory tax rate and also accounts for rate hikes occurring in late 2022. Our fair

value estimate is about 1.8 times reported tangible book value per share as of

September.

Coming out of the pandemic, we expect net interest income to grow in 2022 as loan

growth picks up and as rates potentially increase in late 2022. While we expect fees to

contract slightly in 2022 after an exceptionally strong 2021, we think expenses will also

decline in 2022 after increasing in 2021. Altogether, we expect preprovision net revenue

to grow by roughly 14% in 2022 after minimal growth in 2021. We also include strong

growth in NII from rate hikes in 2023 through 2026.

We have been pleasantly surprised by Bank of America's success in the cost-cutting

realm, as well as its improved credit standards. The bank increased 2021 expense

guidance, although this is largely due to one-time factors. We expect 2022 expenses to

come back down, although we now expect a quarterly expense rate above $14 billion in

2022. We then project a roughly 2% annual growth rate thereafter. This should lead to a

solid 54% efficiency ratio by the end of our forecast period.

In the long run, we forecast net charge-offs averaging 0.6% of loans, much better than

in the past. Given the latest credit development, we foresee charge-offs being minimal

in 2021 despite the effects of the pandemic on the economy, which implies material

reserve releases. We use a 9.5% cost of equity, reflecting the bank's increased capital

and derisking since the crisis. We project that returns on tangible common equity will be

roughly 13%-14% through the cycle.

Risk and Uncertainty | by Eric Compton Updated Jul 14, 2021

An investment in Bank of America entails a large amount of regulatory and

macroeconomic risk. For Bank of America, costs of compliance are high, it is large and

complex, and it is clearly a prime target of regulators seeking fines and litigants seeking

compensation for alleged misdeeds. From a macroeconomic perspective, the bank's

profitability will be affected by the interest-rate cycle and the effects of credit and debt

cycles, all of which are not under management’s control. Most lines of business at Bank

of America are economically sensitive.

Another risk is business disruption. The banking industry is arguably going through

more technological change than ever before. Bank branches are declining in importance

as more transactions take place digitally, and it is still uncertain how this dynamic will

ultimately play out. Though scale and regulatory expertise create barriers to entry, new

or existing competitors could take share as the banking industry digitizes and becomes

more and more a technology focused industry.

We don't consider any environmental, social, or governance issues to be material

enough to affect our uncertainty rating or fair value estimate. The money center banks

deal with all of the inherent issues of operating in a highly regulated business, and there

is an inherent cost to this via litigation, investments in internal controls, and more. There

have been times when poor governance did lead to material value destruction, but we

see the risks of a repeat of something like the financial crisis as minimal today.

Because of the benefit of Bank of America's higher investment banking and trading

exposures during the latest downturn, we assign the firm a medium uncertainty rating.

Capital Allocation | by Eric Compton Updated Jul 14, 2021

We give Bank of America a Standard capital allocation rating. In our opinion, the

company’s balance sheet is sound, its capital investment decisions are standard, and its

capital return strategy is appropriate. Bank of America is currently above management's

targeted common equity Tier 1 ratio of approximately 10.5%, with a ratio of 11.8% as of

the first quarter of 2021, and we view the current goal of 10.5% as appropriate. We view

the company's capital investments as standard. Bank of America was at the center of

poor investments and capital destruction during the financial crisis of 2008, but we think

capital allocation has improved materially since then. The bank has downsized,

derisked, cut expenses, and invested capital in much more positive endeavors, such as

organic growth and efficiency efforts. Over the last decade-plus, Bank of America's

turnaround has positioned it as arguably one of the most dominant U.S. banking

franchises. We assess the company’s capital return strategy as appropriate. Bank of

America, like most banks, returns more capital through share repurchases than

dividends, which makes sense for a company whose earnings can be volatile and

where adequate capital is paramount. When internal investments can't use up excess

capital, expect healthy share buybacks.

Investors may never regard CEO Brian Moynihan with the reverence bestowed upon

certain peers, but he should be given credit for returning the bank to form since taking

over the imperiled institution at the height of its troubles. His tenure has not been

perfect; initial underestimates of mortgage-related claims, a handful of regulatory

missteps, and some questionable operational decisions (such as certain extra fees)

stand out. However, his overall record has been decidedly positive, with shareholders

reaping the rewards over the past several years.

With the bank successfully navigating the initial blows of the pandemic-driven recession,

its success in improving the quality of its balance sheet has been on full display. We

think Bank of America is now a much better business, and Moynihan and the

management team should get credit for this. Returns on tangible common equity are

now beginning to reach best-in-class levels among the money centers, although they

haven't quite reached the levels of the top peer. The bank maintains an enviable deposit

base, a broad range of revenue-generating lines of business, and much-improved

underwriting standards. Overall, Moynihan and his management team have nursed

Bank of America back to health, and the bank has turned into a best-in-class franchise.