- 'Consumer Banking' reported $1.8 billion on the bottom line, but revenue growth is very muted.
- The 'Global Markets' division surprised many on the upside considering the volatility in Q4 and trading revenues dropped less than expected.
- The energy sector and delinquent loans may not be a huge part of the bank's balance sheet but they will affect sentiment nonetheless.
Even though Bank Of America earnings beat estimates yesterday, its share price failed to garner the confidence of investors, finishing the trading day down by around 1.5%, at $14.24 a share. Sales increased by over 4% to $19.5 billion, but this still wasn't enough to convince investors after the earnings release. Why? Well Bank of America (NYSE:BAC) is having the same problem as other financial institutions in this space. The sustained low interest rate environment has meant that many banks have had to cut hard on costs in order to keep operations going. What this does is make the bottom line (net income rose almost 10% to $3 billion) look better than it really is. Wall street is aware of this, which is why the sentiment is currently neutral on the Bank of America stock.
Cost cutting has been very aggressive in the past few years with 10,000 employees leaving Bank of America not long ago, over a hundred branch closures last year and the ongoing divestiture in its servicing business and legacy assets. Nevertheless, these measures are all temporary and the market knows that for net income growth to continue (2015 was the Bank of America's highest net income since 2006), revenue growth has to get in gear. Until we see meaningful top line growth, the market, being forward looking, won't envisage sustained higher earnings. In saying this, the banking sector is wide open to macro influences and sentiment. Bank of America definitely has potential growth triggers. Let's go through the ones that would meaningfully change sentiment on Wall Street going forward.
I discussed in a previous article how Bank of America's balance sheet is highly linked to interest rates and if the Fed's tightening cycle continues, this bank stands to gain more than its peers in this sector. Why? Well it has a very low cost deposit base, which means that long term loans especially would become profitable in a rising interest rate environment. The bank's biggest division 'Consumer Banking' brought in $7.79 billion in revenue last quarter which was more or less flat compared to Q3-2015 and Q4-2014. Net interest income rose $145 million or 9% (see chart), despite deposits growing at a far faster rate in the quarter compared to loans.
Bulls believe this divergence will change once interest rates rise meaningfully, and I agree, since a tightening Fed policy looks on the cards. Furthermore, it appears as if there are switching costs for customers, given that over one third of its $1.2 trillion deposit base is presently costing the bank nothing to hold. This illustrates to me that once customers start borrowing more (rate hikes indicate better economic outlook and more borrowing), Bank of America will use its "staying" power among its customers to try and up-sell them on different products. This is essentially the bank's operating model - to increase the value of each customer by creating switching costs which essentially ties them to the bank. This gives the bank leverage, but leverage as we know is a double sided sword. If the US economy deteriorates from here, loan demand will stall, a price war will emerge for deposits among the banks, and that will hurt Bank of America, given its $400 billion+ plus in deposits, which currently is costing it nothing.
The second area where the Bank of America has some momentum is in its global markets division, where fixed income rose by 20% and equities dropped by 3%. Citigroup (NYSE:C) recently entered this area on the equities side as they know its a growth area despite the volatility equity markets experienced in the fourth quarter. This segment for Bank of America reported a profit of $185 million in the fourth quarter despite non-interest expenses increasing by $232 million. This division stands out for me because revenues grew faster than expenses which grew the bottom line despite 4th quarter volatility. This is what the bank needs in every division. If it can replicate this in its other divisions, I'm sure the sentiment will change on Wall Street.
Finally Bank of America's energy exposure is small relative to its loan book (2%) and shouldn't affect the bank that much going forward even if the price of crude goes lower. In saying this, the bank wrote off $75 million in energy loans in Q4, which means it still has over $21 billion exposure to the energy sector through loans to exploration companies. Exploration and production oil companies are all reporting negative earnings, with the exception of the likes of Exxon Mobil (NYSE:XOM), which means that $20 billion is definitely not safe.
Again, sentiment plays a huge role here also despite Bank of America's light exposure to this sector at present. On a more serious note, the bank reported that the number of 60 day+ delinquent loans have now dropped to 103,000, down by 46%. It's imperative that the bank continues to work in this area, as huge damage was done to the balance sheet due to bad loans between 2004 and 2008. One would only think that both litigation and non-interest expense would drop in a thriving economy but these loans are still stifling Bank of America's growth as investors still don't know when the bank's legal troubles will be over.
To sum up, Bank of America reported an impressive set of earnings but once again investors were not that all impressed. Revenue growth is becoming a problem and cost cutting has its own lifespan before the bottom line gets affected as well. Bank of America's balance sheet is highly linked to interest rates. If you believe the Fed will continue its tightening cycle, then Bank Of America will easily get back to $17 a share.