BAC: Improving Operating and Capital Leverage as Headwinds Abate

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Howard Mason

April 17, 2016

BAC: Improving Operating and Capital Leverage as Headwinds Abate

  • Consolidated results for BAC are unfavorably distorted by market-related (i.e. FAS91) effects on net interest income and the drag on loan growth from the run-off book. Excluding these effects by looking at business-segment results reveals strong operating leverage and loan growth:
  • Operating Leverage: The segment-total efficiency ratio improved to 59% in 2016Q1 from 64% in the year-ago quarter (Chart below) as FTE revenues were flat and expenses fell 6%. As BAC continues to reduce expenses for the legacy-asset-services (LAS) business, the consolidated efficiency ratio, adjusted for FAS-91 effects, can fall from the mid-60s towards the mid-50s.
  • Loan Growth: The segment-total loan portfolio grew 11% versus the year-ago quarter compared with 3% growth at the consolidated level. As the run-off portfolio becomes less important in the mix (representing 25% of loans two years ago and headed to 10% in two years), we expect this drag to reduce to 3% by 2018 allowing BAC to report consolidated loan growth of 7%.

Chart: Improving Efficiency Ratio for BAC Business Segments

Source: Company Reports, SSR Estimates

  • Capital Leverage: Furthermore, BAC’s shareholder payout has been distorted by the need to add ~$140bn to risk-weighted assets (RWA) for adoption of the “advanced-approach” capital regime in 2015Q4; this absorbed ~$14bn of capital representing ~10% of market cap. We now expect RWA to decline in 2016, as it did sequentially in Q1 by ~$20bn to $1.56tn, as BAC optimizes around the new yardsticks allowing the payout ratio to increase to 40%+ from ~30% in 2015. This estimate allows for management to build the fully-phased CET1 ratio to 10.5% by year-end to provide a 50bps buffer over the 2019 minimum regulatory requirement; with no further need to raise the capital ratio in 2017, the net payout can rise to 50%+. The net result is an aggregate stock buyback of over $10bn for the two years and ~6% reduction in the stock count even allowing for price appreciation to $25.

Detail

There is meaningful leverage in BAC’s economic model.

This leverage has been masked, for now, because of legacy/macro headwinds but these are beginning to abate and we expect the stock to re-rate to 1.2x tangible book by year-end (target price of $20) and 1.5x tangible book by end-2017 (target price of $25). The most important of these abating headwinds relate to:

Expenses: In 2014, beyond litigation expenses of $16.4bn, the expense for the legacy asset services (“LAS”) division was $5.4bn. BAC expects to exit 2016 with an annual run-rate for LAS expenses of $2bn with the delta representing a lift to ROA of ~10bps of ROA and to the efficiency ratio of ~4%. Adjusted for these items, consolidated expenses fell 6% in 2016Q1 from the year-ago quarter versus a decline in revenue (adjusted for FAS91 effects) of 3%. Nonetheless, the adjusted efficiency ratio is at ~65% and we expect its decline towards the mid-50s by 2018 to be a key driver in the increase in ROA from the current ~0.7% (adjusting for FAS91 effects) to the target of 1.00%.

The progress on the efficiency ratio is more visible at the business segment level than at the consolidated level because of the distortive effects of non-core expenses reported in legacy asset services and “all other” segments. For example, the efficiency ratio of the combined business segments improved to 59% in 2016Q1 from 64% in the year-ago quarter (Exhibit 1). This was masked at the consolidated level because of a $1bn decline in revenue in the “other” segment arising largely from FAS92 effects (i.e. market-related adjustments to net interest income). To illustrate the expense improvement in a different way, BAC remarks that the fully-loaded cost of deposits is now 170bps versus 300bps coming out of the financial crisis and we expect this trend to continue given the customer shift to digital channels and consequent opportunity for BAC to reconfigure its branch network.

Exhibit 1: Efficiency Improvement in the BAC Business Segments

Source: Company Reports, SSR Estimates

Revenue: The modeled improvement in the efficiency ratio needs help on the revenue side. Rate headwinds are beginning to abate as illustrated by the improvement in the 2016Q1 net interest margin, after adjusting for FAS91 effects, to 2.31% from 2.26% in 2015Q4 as the benefit of the December 2015 rate hike was offset by a 50bps rally in the 10-year Treasury. We expect BAC to show a meaningfully higher run-rate for FAS91-adjusted net interest income in the second half of the year than the (seasonally-adjusted) $10.5bn of 2016Q1. Longer-term, improving loan growth provides a tailwind as the drag from the run-off portfolio abates.

Specifically, the run-off portfolio (comprising loan balances reported for the legacy asset services segment and for “all other”) represented over one-quarter of consolidated loans two years ago and will represent 10% of less in two years. The result is that the drag on consolidated growth from this run-off portfolio will decline from over 8% in the just-reported quarter to ~3% in the first quarter of 2018 (Exhibit 2).

Exhibit 2: Declining Impact of Run-Off Portfolio at BAC

Source: Company Reports, SSR Estimates

Capital: In 2015, as part of the adoption of the “advanced” approach for capital management, BAC added ~$140bn of risk-weighted assets absorbing ~$14bn of regulatory capital at the current CET1 ratio; this represents ~10% of the market cap of the company. With the advanced approach now fully implemented (as of 2015Q4) some of these RWA-increases (particularly in ~$40bn of incremental operating RWA) will be rolled back as BAC optimizes around the new approach and as legacy litigation expenses drop out of the look-back window. Indeed, this likely contributed to the ~$20bn sequential reduction in RWA in 2016Q1.

Of course, the constraint on capital-return for BAC is more the CCAR stress-tests than the 10% minimum regulatory target for the 2019 B3 CET1 ratio (vs. current of 10.2%). Here, the headwind is that as BAC has looked to rebalance its portfolio to be more even across consumer and commercial loans, there has been a mix-shift from relatively low loss-content first mortgages to higher loss-content C&I loans. As a result, using the bank’s mid-cycle stress-tests, the estimated annualized loan loss ratio over the 9-quarter horizon in the severely-adverse scenario increased to 4.0% in 2015 from 3.3% in 2014 (Exhibit 3). We believe this mix-shift is now largely complete so that the impact of BAC’s focus for current originations on higher credit-quality customers (i.e. lower FICO scores) than the back-book will begin to show through in lower loss-estimates under stress scenarios.

Exhibit 3: Impact of Mix-Shift to Commercial on Stress-Test Loss Estimates

Source: Company Reports, SSR Estimates

©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.

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