Bank of America Stock: Strong Performance, But Late Cycle Concerns Weigh

Despite a solid quarter, Bank of America stock remains under pressure as investors expect the economic cycle to turn.

Bank of America (NYSE:BAC) failed to impress the market despite reporting a beat on both top and bottom line. BoA’s non-GAAP earnings came in at $0.63 per share, six cents ahead of Wall Street’s estimate while revenue was $340 million higher than expected at $22.61 billion. Not only that, the bank also reported improving credit quality. All in all, the bank had a solid quarter. But all this failed to excite investors. Despite improving asset quality “late cycle concerns” continue to weigh upon the stock. In this post, we will focus on the factors behind Bank of America’s earnings growth and stock performance.

Source: Bank of America stock price chart by uniquefinance.org

Banks are riding high on the booming economy.

Banks have been one of the biggest beneficiaries of the strong macroeconomic environment. BoA reported its best first-half results this year. Continuing its strong performance in the third quarter, BoA reported a massive diluted EPS growth of 43% to $0.66. However, a look at the sources of EPS growth indicates not all the growth was from sustainable sources.

Source: BoA eps chart by uniquefinance.org

Leveraging operating assets and technology.

The main drivers behind the bank’s EPS growth are positive operating leverage, declining credit loss reserves, lower taxes and lower share count. BoA’s continued improvement in efficiency and positive operating leverage magnified the impact of revenue growth on the bottom line. For the fifteenth consecutive quarter Bank of America reported a positive operating leverage. The positive operating leverage boosted the bank’s PBT by 7%.

The bank has been investing heavily in technology to improve its operating efficiency. BoA’s efficiency ratio came in at 57%, down from 61% in the comparable quarter last year. The bank’s ability to generate positive operating leverage and efficient cost management with the help of technology is a good source of long-term growth.

Solid credit quality

Another source of earnings growth was $118 million decline in provision for credit losses which benefited from one-time net reserve release of $216 million. This indicates that BoA expects its credit quality to remain strong. The bank’s non-performing asset ratio is down from 0.75% a year back to 0.59% in the third quarter. However, given the fact that we are already in the late cycle phase, credit quality will worsen from here, dragging the corporations’ bottom line. This one of the main reasons why BoA’s shares have not moved higher despite posting beat on both the top and bottom line.

Lower tax liability

Banks have been one of the biggest beneficiaries of the “Tax Cuts and Jobs Act” passed last year. BoA’s effective tax rate is down from around 29% in the Q3 2017 to around 21% this year. This massive reduction in tax liability helped the bank grow its net income by 32% despite ‘just 18%’ growth in pre-tax income. Since this is a one-time event, BoA will see its profit growth decelerate in the coming quarters.

Aggressive capital return policy

Like most of the other U.S corporations, Bank of America has been returning huge amount of capital back to its shareholders, through buybacks and dividends. BoA has repurchased $14.9 billion of common shares and paid $4.0 billion in common dividends year-to-date, in the process returning 96% of net income available to common shareholders. This massive capital return program has several benefits for the company and shareholders.

Returning excess capital to shareholders ensures that the management doesn’t destroy shareholders wealth chasing some fancy projects. Additionally, share buybacks boost return on equity and EPS numbers by decreasing the shareholder equity and share count. BoA has been able to reduce shareholder count by 5% in the last one year, allowing the company to grow its EPS at a faster rate than net income. Q3 net income growth was 32% while diluted EPS growth stood at 42%.

However, EPS growth driven by capital return is not sustainable. BoA’s CET1 ratio (standardized approach) has declined from 12.2% to 11.4% in last year. While this is still above the minimum requirement, declining CET1 ratio could limit the ability of the corporation to grow. Moreover, with the current economic cycle already in late phase investors are worried that banks will require more capital to provide for the eventual build up in loan losses and provisions as the economy loses steam.

Rising cost of deposits.

Bank of America’s net interest yield has benefited from its ability to pass on the rising interest on loans while keeping the interest it pays on deposit in check. This might change going ahead. BoA is likely to see its interest paid on deposits rise. Deposits, especially non-interest paying deposits, are a very cheap source of funds for a bank. Over the past years, given the very low-interest rate prevailing in the BoA has been able to attract a large amount of non-interest bearing deposits.

However, with interest rates expected to rise higher, customers are pulling out billions of dollars of non-interest bearing deposits and deploying it in higher yielding investments. BoA saw its non-interest bearing deposits decline by $14 billion. As the interest rate continues to rise, consumers will seek better avenues to invest their money. BoA will have to compete for its deposits. As a result, not only will the amount of interest-bearing deposits increase, the amount of interest paid on these deposits will also increase, squeezing the bank’s net interest margin and the bottom line.

Takeaways

Bank of America had a solid quarter with NII growing by 6%, efficiency ratio declining by 400 basis points to 57% and EPS growing by 43%. BoA’s asset quality remains solid, with non-performing asset ratio declining by 25 basis points to 0.5% in the last twelve months. However, with the economy already nearing the end of the growth phase, investors are worried that BoA will see its credit quality deteriorate and its NIM fall, which will drag its bottom line. The stock is likely to remain under pressure for now.