BAC: Room to Run as Rising Net Interest Margin Levers over Declining Expenses and Share Count
On the last earnings call, BAC guided to a tangible ROE of 14% “as we look out over three years” based on a 1% ROA and tangible equity/assets ratio “that’s just over 7%” (7.5% in the last quarter). In practice, we expect this profitability to be achieved in 2016 consistent with a one-year price target of $22 being 1.5x our estimate of $15 for tangible book value (“TBV”)/share at end-2014; the target is 12x our 2015EPS estimate of $1.83 (versus consensus of $1.62).
– Our estimates include $7bn of litigation expenses over the next two years. While the outcome could be meaningfully higher, we note an additional $10bn reduces TBV/share after tax-effects by 70 cents and hence our price target, at a 1.5x multiple, by just $1.
– If headline risk creates volatility in the share price, we expect BAC to be a size-buyer particularly given proximity to forward TBV (forecast at $15/share for end-2014 and $16 for end-2015).
Our variance from consensus lies in the net interest margin (“NIM”) forecast. Consensus apparently discounts a core NIM (i.e. excluding the impact of trading and market-related effects such as MBS premium amortization) of 3.15% in 2015 reflecting a “grind” higher from 3.08% in 2013Q4 as, for example, BAC continues to manage down long-term debt. Rather than anchoring to today’s rate environment, we believe the proper default for the NIM forecast is the implied yield curve which has 6-month Libor (“6ML”) in mid-2015 at 1.5%. Banks have historically captured about half of an increase in short rates in their deposit franchises (and will not give this up on the asset side as the forward markets also indicate curve-steepening) and we expect BAC to do at least as well; that said, to be conservative, we model the NIM for 2015FY at 30 basis points higher than in 2013Q4.
– Each 10 basis point increase in 2015FY net interest margin adds 8 cents/share to the EPS estimate. We note that for mid-2016, the forward markets are indicating 6ML at 2.5%.
A rising NIM at BAC is levered by declining non-interest expenses, with the benefit from re-engineering initiatives (“Project New BAC”) and the wind-down of the legacy asset services (“LAS”) business, and a declining share count as the payout ratio rises from the 35% in 2013 to 90% in 2015. Specifically (see Exhibit), we expect:
– Expenses, excluding litigation, to fall by $7.5bn for 2015 versus 2013 of which the legacy asset services (“LAS”) business contributes over $5bn and “Project New BAC” re-engineering the balance even after allowing for an increase in revenue-related expenses.
– The common stock count to fall 8% by end-2015 as stock buyback increases to $7bn in 2014 and $16bn in 2015 (with an average buyback price of $20 and $25 respectively). Given an assumed increase in dividend/share to 15 cents and 30 cents respectively, these buyback amounts generate respective payout ratios of 60% and 90% and assume BAC does not de-lever from the current tangible equity/assets ratio of just over 7%.
Beyond litigation expense, possible CCAR constraints on the payout ratio, and changes in the implied yield curve, a key risk to our thesis is around volatile revenue streams such as investment and mortgage banking and equity investment gains as well as trading activity. Between them, these contributed $24bn to, or over one-quarter of, 2013 revenues. While normal variation will affect our 2015 EPS estimate, we do not expect an enduring impact on valuation from anything but structural change and see this as unlikely given BAC’s competitive positioning and strong execution.
– We expect a step-down in debit interchange fees (booked through otherwise relatively stable card income), from litigation and structural shifts in the payments industry, to be offset by consumer charges notwithstanding the public backlash against, and consequent withdrawal in November 2011 of, a $5 monthly debit-card fee for a debit card proposed by BAC.