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Investment Thesis
Since our last research article, Bank of America (NYSE:BAC) shares have outperformed the market, with a total return of 12.59% at the time of writing. This indicates that the bank is operating well and we believe that we can expect a favorable performance heading into its next earnings report on July 16th.
Bank of America has been gaining market share, especially in investment banking and capital markets. This is good for the bank, given that investment banking is expected to continue to recover as interest rates fall. Interest rates were high due to inflation after the pandemic, but they are trending down, and current Street expectations are for the Federal Reserve to start cutting rates, with some betting that they will start in September.
Along with this, I think another driver of deal flow growth will be credit restructuring efforts and innovative debt transactions with private equity funds. These restructuring efforts will give banks a more stable credit underwriting environment, which will improve profitability and growth prospects, and also increase fee income. PE firms and corporations are in a tough spot, and many of them need to refinance their debt. As interest rates fall, they will need to take advantage of the services that BofA offers. I am optimistic.
While Bank of America still has held-to-maturity (HTM) losses across its balance sheet, the size of these losses has decreased and is expected to decrease further, which is a positive sign for its financial health.
The combination of strong operational structure, improved market positioning, and effective credit restructuring services make me a strong buy pick heading into the next earnings report.
Why I do follow-up interviews
Since I last covered Bank of America in April, the company's stock has outperformed the S&P 500's 7.16% gain. One factor I believe is the market's recognition that the bank is honing its lending risk management strategy. In its last earnings report in April, delinquency rates had improved. During the bank's Q1 2024 earnings call, CFO Alastair Borthwick said:
Delinquency trends are encouraging for the company as late stage growth has slowed and early stage delinquencies have also improved – Q1 2024 earnings report.
Given that my last article was written before the earnings release, I think it is important to revisit the state of the bank's loan portfolio. Low default rates are clearly in the bank's favor and I think the bank is well positioned to ride the next wave of deals. This article also aims to explain how I think about the potential for a new upswing for Bank of America.
Revenue Forecast
As Bank of America's second quarter 2024 earnings release (due July 16th) approaches, the consensus EPS estimate is $0.80, down 8.87% year over year. In fact, I expect this estimate to look low in hindsight. As Piper Sandler noted in their recent rating upgrade for Bank of America (see rating for a more detailed analysis), net interest margins are likely to rise going forward as deposit costs fall. Combined with increased deal flow, I think we could see stronger than expected EPS.
On the revenue side, the current market expectation is $25.23 billion, up 0.12% year over year. On the real side, I think it's going to depend on how the bank's investment banking and capital markets divisions perform on this front. That's where I think we're going to see the biggest upside.
More specifically, I look for a pipeline of deal flow. Speaking at Bernstein’s 40th Annual Strategic Decisions Conference on June 11, Bank of America CEO Brian Moynihan said this about doing business with PE firms:
“There are a lot of companies that we work with, private equity firms and buyout firms, but we're also trying to help them in acquiring not just the largest deals, but $500 million or $1 billion companies. So we have a lot of room to grow,” Bernstein said.
As Moynihan noted, this is a huge deal flow base for them to leverage, given that the majority of their PE buyouts are within this target range: To me, this confirms that there is significant upside potential in their investment banking deal flow.
He also spoke about deal flows in other sectors such as cash management.
And then cash management. Combined, we're investing hundreds of millions of dollars a year in cash management in general to have our digital capabilities, our cash pros and all that. But on top of that, we're also really focused on the international piece, like enabling real-time payments in India, enabling our banknote programs around the world, and other things that we already do most of the time. Our market share is very high. – Conference transcript.
This is one of the areas I mentioned earlier where Bank of America is gaining market share. The bank appears to be more competitive in the cash management space, offering payment processing and short-term cash management services to large corporations. This gives the bank higher margins and a more stable cash flow income, complementing its business model that goes beyond just lending and traditional banking.
Moynihan added:
But in the other areas, corporate and money movement, we have a lot of room to grow. So we're building out cash management, which is 15% of revenue and it's growing, and it's across the GCIB space and the large corporate space. We have $100 billion in outstanding loans. So this is a big business now and we continue to invest. – Conference Transcript.
I think this is very beneficial for Bank of America given that this business line already represents 15% of revenue and is growing. The quote above is taken from a conference call in early June, so I expect similar testimony on their progress on this upcoming earnings call.
The capital return program will also be important to me. On June 28, the bank announced plans to increase cash returns to shareholders through an increased quarterly dividend (up 8% to $0.26 per share) starting in the third quarter of 2024, following its successful run through the Fed's stress tests.
At the Bernstein conference, the topic of returning cash to shareholders came up. Moynihan said:
So organic growth will essentially pay dividends, which at current nominal levels is $2 billion per quarter, and the rest will go back to shareholders – conference transcript.
I really like this. Not only is management laying out Bank of America's strategy for returning cash to shareholders, but it's also highlighting how big a priority it is, even as it makes big investments.
evaluation
One important thing I want to point out about this bank's valuation is the upward revisions to market EPS estimates. In the past three months, there have been 16 upward revisions and only two downward revisions. Despite this, the bank's earnings are not expected to grow significantly over the next few years. The EPS estimate for December 2024 is $3.23 per share, but the EPS estimate for December 2028 is only expected to grow to $3.57. This is less than 10% growth.
While this outlook may be a concern to some analysts, I believe it is misplaced as it suggests the bank's future profitability is underestimated, especially given the combination of share buybacks and improving deal flow.
Seeking Alpha's Quantitative Ratings categorizes Bank of America as a Strong Buy, highlighting the bank's solid financials and growth prospects. We believe this positive outlook is further strengthened by the recent rating upgrade from Piper Sandler, which revised its stance on Bank of America to Neutral, and here's why:
BAC's NII is likely to bottom out this quarter and then enter a stronger uptrend. [a] A compelling reason to focus on underperforming companies – Piper Sandler Note.
Looking more specifically at the NII margin forecast, he expects it to decline to about $13.9 billion in the second quarter, then grow to $14.5 billion to $14.6 billion by the fourth quarter of 2024. Seifers also expects net interest margins to normalize to around 2.30% to 2.40% over the next few years. A wider NII margin means Bank of America has to pay less to depositors, which will improve the bank's performance.
Bank of America's current non-GAAP P/E of 12.83 is 20.80% higher than the industry average of 10.62. However, given the accelerated deal flow and expanding NII margins mentioned above, the P/E should be closer to 15 to account for future EPS growth, which I believe is undervalued. While I believe the company's EPS is likely undervalued, I believe a P/E closer to 15 would allow the stock to reach a fairer valuation with the strong tailwinds propelling the bank.
This could translate into roughly 17% upside for the stock, not including share buybacks or dividend increases, if the stock price rises from 12.83 to 15. I think this is an attractive proposition.
risk
While I think Bank of America is a strong investment, I think the most significant risk that could derail their plans is the impact of an economic slowdown that could lead to higher default rates.
A weak economy typically leads to higher unemployment and lower consumer spending, both of which can have a negative impact on a bank's loan portfolio.
But while I think the reality is the economy will slow and overall default rates could rise, I'm not too worried about defaults in Bank of America's loan portfolio because the bank appears to have them under control.
We're seeing our five-day and 30-day delinquency rates recover and plateau, so we're very pleased with our customer base and where our cards are. – Conference Transcript.
While there are inherent risks associated with investing in Bank of America, we believe the bank's default risk management strategy and financial strength mitigate these concerns. The bank has clearly managed to contain consumer loan delinquencies, even as default rates for most consumer loans are rising. The bank is bucking the trend, which we believe is a sign of good management.
Conclusion
I think Bank of America stands out as they report earnings on July 16th. Ahead of the release, the bank has shown signs of increased deal flow and a strong commitment to returning cash to shareholders while maintaining disciplined capital ratios. They seem to be all in.
Of course, in the current economic environment, there are concerns about loan defaults and the impact that has on the bank's balance sheet. But not only has Bank of America proven it can lower its default rates, interest rates are also starting to fall, which should help improve default rates.
In the upcoming earnings release, we will likely see further signs of a stronger recovery in the investment banking and capital markets segments. If this is the case, I believe Bank of America is well positioned to continue delivering strong financial performance. For this reason, I believe Bank of America is worth buying.