BAC: Despite Energy, Loan Reserve to Decline in 2016

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Howard Mason

203.901.1635

hmason@ssrllc.com

January 19, 2016

BAC: Despite Energy, Loan Reserve to Decline in 2016

“Our long term goal is to return more and more capital to shareholders through dividends and buybacks …. at this price, stock buybacks are favored” BAC CEO Brian Moynihan, 2015Q4 earnings call

  • If 2016 consensus earnings are accurate, and assuming a modest capital build to bring the CET1 ratio to 10% by end-2016 from the current 9.8%, BAC can deliver a 50% payout ratio, versus 30% in 2015, and buyback $5bn of stock; at today’s prices, this will reduce the stock count by 3% (more than double the net decrease in 2015).
  • Of course, the analysis is oxymoronic since today’s prices will not last if consensus holds up to current energy concerns. But, how wrong can it be? BAC has reserves of $500mm (~6%) against its $8.3bn ENP/OFS[1] portfolio and expects losses of $700mm if oil stays at $30/bbl over the next nine-quarters with “a fairly high offset when we do the stress testing around oil where credit is better for the 91% of our [consumer] portfolio that has nothing to do with those [oil-producing] states”; this compares with a $75mm sequential increase in net losses on the commercial portfolio this quarter “driven by energy-related exposure”.
  • In other words, a supply-side framing is relatively benign. In a demand-side framing, where weak oil is signaling US recession, there are no exempt zip codes and all reserve-bets are off. But BAC is not reporting this sort of scenario: “outside of energy we are not seeing asset quality change nor are we seeing a reduction in appetite for credit”. Indeed, in aggregate, consumer non-performing loans declined sequentially while delinquencies were flat. BAC guidance remains for aggregate reserves to fall in 2016 as consumer releases (particularly from legacy portfolios and assuming at-least stable home prices and consensus economic growth) migrate to commercial builds.

Overview

Absent concerns about transparency of the energy portfolio, BAC’s solid Q4, encouraging activity report, and reassuring guidance would have moved the stock higher. The bull-case is straightforward: loans are growing (12% annualized sequentially for the core book), the core net interest margin is improving (given the December rate hike, a reduced headwind from the run-off of high-yield legacy portfolios, and BAC’s ongoing removal of high-cost debt through, for example, redemption of trust-preferred in the quarter), and core expenses are flat while legacy expenses are declining. All this gives credibility to CEO Brian Moynihan’s target to drop the efficiency ratio from the current 65% on an adjusted basis so that the tangible return on equity can increase from 9% in 2015 to 12%. He is coy about timing given the uncertain rate environment, but we see a 10%+ tangible return as achievable this year (see Appendix for model).

In practice, this counted for little in the market today as BAC traded on concerns around energy risk and hence the oil price. Management provided quite detailed disclosure – if oil stays at $30/bbl for nine quarters, the firm expects losses in the energy portfolio of $700mm and has reserves of $500mm representing 6% of loans to E&P and oil-services companies (although these reserves would obviously need to be replenished and likely increased as losses are booked against them). Management added that “outside of energy we are not seeing asset quality change nor are we seeing a reduction in appetite for credit” and “we’ve seen relatively modest deterioration or none in the consumer side … in ZIP codes that are heavily oriented towards shale production … and where we have ~9% of our consumer loans”.

Indeed, assuming oil price weakness reflects supply-side effects, it is likely to benefit oil-consuming clients hence the above reserve build will be offset by lower reserve requirements for these creditors. Obviously, this is difficult to quantify although Mr. Moynihan has commented that “there is a fairly high offset when we do the stress testing around oil where credit is better for the 91% of our portfolio that has nothing to do with those [oil-producing] states”. We have no view on oil but even if the write-off is $2bn excluding any offset the effect on tangible book value (tbv) is less than 15 cents/share and BAC will still finish 2016 with tbv/share of near-$16.

For us, given the stock price, the more important issue is how much stock BAC can buyback, and this is turn depends on the trajectory of risk-weighted assets (RWA). Adjusting for the effect of finally-adopting the advanced-approach, RWA were sequentially flat at $1,570bn as optimization of the risk balance-sheet offset loan growth. There is further optimization to be done, particularly as amounts linked to operating risk on discontinued businesses run-off over time, but we nonetheless model a net $50bn increase through 2016. Given consensus earnings, and assuming BAC lifts the CET1 ratio from 9.8% to 10% (on the way to 10% plus a buffer), this allows a 50% payout ratio, versus 30% in 2015, corresponding to a net buyback of just over $5bn. If accomplished at an average price of $15/share, the share count falls by 330mm or just over 3% of the outstanding.

Appendix: BAC Model

Source: Capital IQ/SSR Analysis

Source: Capital IQ/SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, BAC, WFC, and GS.

  1. Exploration and Production/Oil Field Services
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