Circling Back on Bank of America After Q4 Earnings; Lowering Our Fair Value Estimate to $37 From $39

Strategist

Eric Compton

Revenue segments as reported by the company.

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The acquisitions of shaky investment bank Merrill Lynch, shady mortgage lender Countrywide Financial, and the equally dysfunctional MBNA led to a decade of troubles for Bank of America. The bank had to spend billions of dollars to settle legal and regulatory issues, and it took years to reshape the business and work through the credit losses. With all of this behind it, Bank of America has emerged as one of the pre-eminent U.S. banking franchises. The bank now has one of the best retail branch networks and overall retail franchises in the United States, is a Tier 1 investment bank, is a top four U.S. credit card issuer, is a top three U.S. acquirer, has a solid commercial banking franchise, and owns the Merrill Lynch franchise, which has turned into one of the leading U.S. brokerage and advisor firms.

We believe that scale and scope advantages are increasingly important as the role of technology in banking grows. Bank of America is seeing increasing mobile adoption, has access to data on millions of customers, and has one of the largest tech budgets in the industry. Given the scalability of these platforms, we believe these factors will only matter more as the industry progresses.

Bank of America has been investing in organic growth initiatives across its franchises. The bank has opened hundreds of new financial centers across the U.S. over the last several years in an attempt to build its client base across its product offerings. However, the bank's expenses have started to creep up for the last several years, and we expect 2023 could be another year of increases above the longer-term target of 1%-2% annual growth. 

Meanwhile, the bank isn't the only one investing for future share gains, so the space remains as competitive as ever, and we don't see the bank quite catching up with rival JPMorgan. Even so, with its scaled and integrated retail and commercial offerings, Bank of America remains in an enviable competitive position. Further, the bank is one of the most rate-sensitive under our coverage, and should see some of the strongest revenue growth among peers during the current rate hike cycle, although expect this to unwind when rates start to fall once again.

Business Strategy & Outlook

We believe Bank of America possesses a wide moat based on maintainable cost advantages and switching costs that are consistent with our bank moat framework. Bank of America is the second-largest U.S. money center bank by assets and tends to have leading share and operations in many of the areas it competes. Bank of America is one of the top deposit gatherers in the U.S. and has one of the top retail lending footprints as well as one of the top corporate franchises in the U.S. The bank also has one of the largest online retail brokerages in Merrill Edge and one of the largest advisor forces through Merrill Lynch Wealth Management. The bank is a top five global investment bank, one of the largest U.S. issuers of credit and debit cards, one of the top four U.S.-based merchant acquirers, and a top-five fee earner from FICC products globally. Given the bank’s higher capital levels since the crisis, the increasing importance of scale and scope with changes in technology, and robust fee income, we believe Bank of America will consistently earn returns that exceed its 9.5% cost of equity through the cycle.

We argue that bank moats are derived primarily from two sources: cost advantages and switching costs. We see cost advantages as stemming from three primary factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting, with regulatory costs a final factor that must also be considered. Bank of America was hit quite hard during the crisis and underperformed peers, so it has not historically had any credit advantage in the last several decades. However, many of the charges were related to poor acquisitions, as well as credit practices and concentrations which have changed since the crisis. Bank of America made the ill-timed acquisition of MBNA in 2006 and followed this with the acquisition of Countrywide in 2008. This gave it one of the largest exposures to unsecured consumer lending and well as subprime mortgages. This, along with all of the legal charges that followed, plagued the bank following the crisis. 

However, the bank has tamed its high consumer exposures, steered away from subprime lending, reduced second mortgage exposures, and run off or sold portions of its past portfolios. It is now rebalanced to roughly half and half commercial versus consumer lending, and FICO scores and other credit-risk-related metrics are much improved compared with precrisis vintages. We also believe CEO Brian Moynihan’s renewed focus on "responsible growth" should set the tone from top when it comes to chasing outsize loan growth in more risky areas.

Bank of America’s operating efficiency has generally been worse than peers since the crisis, but this is largely due to the outsize fines the bank has received as well as its unique integration challenges following the crisis. The bank had made several large acquisitions before and during the crisis, and the demands of the crisis led to a prolonged process of full integration as well as trying to rightsize businesses. The bank also had to deal with more crisis-related fines than any of the Big Four. That said, the bank has now consolidated over 30% of branches, reduced head count by over 30%, and sold off noncore assets. We now believe Bank of America will, at the very least, be able to match peers on operating efficiency. Given the new phase of banking we are entering, where technological changes are occurring faster and are more impactful than ever before and can be deployed across singular, integrated platforms, we see potential advantages for the largest banks when it comes to operating efficiency. With its tech budget of roughly $10 billion per year, Bank of America may not drop to the lowest overall efficiency ratio among peers, but it will be able to maintain higher levels of investment at similar efficiency levels. Further, with its solid mix of fee income, Bank of America will be better insulated if rates decline as it is less dependent on rate-sensitive net interest income.

Bank of America’s overall deposit market share is attractive, with one of the highest weighted average market shares among our coverage. Bank of America is the top depositee in five of its seven largest metropolitan statistical areas and is one of the top deposit gatherers across the U.S. On a cost advantage basis, we view the bank’s deposit base as having a likely chance of being advantaged in the future, based on historical performance, current noninterest bearing deposit mix, and current deposit beta trends.

Overall, we believe the bank’s key advantage comes from its scale in certain fixed-cost, fixed-platform businesses and the breadth of products it can offer to clients. This contributes to economies of scale and economies of scope and creates switching costs for customers as they use the bank for more and more products. The bank is one of the top issuers of credit and debit cards, where many of the costs of running a payments platform are fixed and high in nature, leading to the need for scale. Bank of America is also one of the more dominant wealth managers in the U.S. through its multiple Merrill Lynch platforms. This allows the bank to be a convenient one-stop shop for banking and investment needs and act as a key asset and deposit gatherer, and while advisor compensation is variable to a degree, the bank can invest in and maintain key technology platforms in the background that allow the business to run. Bank of America, while not as dominant as the top investment banks in the world, is still a Tier 1 investment bank and maintains solid share in key areas and respectable share in most others. While many of the costs of investment banking are variable (most notably banker compensation), the bank has built up a strong reputation, owns a large securities distribution platform, attracts top talent, and has a global reach that only the best can compete with. This leads us to view this segment as a positive contributor to Bank of America’s moat.

While all of these segments are strong on their own, we believe there are advantages to combining them all under one banking roof. On the consumer side, Bank of America is able to cross-sell multiple products, providing advantaged pricing to key customer segments (such as through its Preferred Rewards banking program), and spread the overall costs of customer acquisition across more revenue streams. On the commercial side, similar dynamics apply; the bank is able to offer a complete package with global scale that few can compete with, while sending out armies of bankers to both existing and new markets in an effort to win new business. A final point relates to the switching costs created and the advantages that come from lowering customer acquisition costs. In banking, where many of the products are commodified to a large degree, getting potential clients into your banking platform (having more products in more places helps with this) and then keeping them there (more products and therefore higher switching costs helps with this) matters a lot, and we see Bank of America being able to pull this off.

Finally, the largest banks will be able to spend the most on technology going forward and will have access to unique data on the largest client bases, and Bank of America is no exception. We believe its ability for higher investment into tech platforms that can scale, as well as its access to customer data on millions of households, should bolster the bank’s advantages over the longer run.

From a systemic standpoint, we believe the U.S. banking system has improved over the last decade, as capital levels supporting the banking system are at all-time highs. Further, regulation has become considerably stronger in the past several years. The U.S. banking market is quite fragmented, and Bank of America must compete with a variety of regional and community banks as well as large money center institutions, although this fragmentation has gradually decreased since the 1990s. While we do view the banking sector as intensely competitive, the largest banks by asset size have generally been able to earn higher returns on equity for the last several decades and still do so today. Our outlook is generally positive from a macroeconomic and political standpoint for the U.S. banking system, as the U.S. is still the world's leading democracy, has increased GDP at a steady pace for years, and maintains the world's reserve currency, all of which contribute to banking stability.

Bank of America is large enough to be considered a global systemically important bank and has a GSIB surcharge of 2.5% (likely to increase to 3% by 2024). This is below the banks with the highest surcharges but still above banks without this surcharge. The bank is also large enough to be subject to the Federal Reserve's annual stress tests, as well as a host of other regulatory requirements, and we don’t see any massive regulatory relief coming for the large money center banks. The stringent capital requirements that the largest banks are held to give us some reassurance that these banks will be able to weather the next economic downturn.

Wide

Economic Moat

Bank of America

Merrill Lynch Wealth Management is a wealth management division of Bank of America. The firm is headquartered in New York City, and occupies the entire 34 stories of 250 Vesey Street, part of the Brookfield Place complex, in Manhattan. Merrill Lynch employs over 15,000 financial advisors and manages $2.2 trillion in client assets.

Merrill Lynch

U.S. Trust is a private bank serving the needs of high net worth and ultra high net worth individuals and families by providing investment management, financial and succession planning, philanthropic and specialty asset management, family office services, custom credit solutions, financial administration and family trust stewardship.

U.S. Tust

Bank of America Corp. is a bank and financial holding company, which engages in the provision of banking and nonbank financial services. It operates through the following segments: Consumer Banking, Global Wealth and Investment Management (GWIM), Global Banking, Global Markets, and All Other. The Consumer Banking segment offers credit, banking, and investment products and services to consumers and small businesses. The GWIM segment offers solutions to meet clients’ needs through a full set of investment management, brokerage, banking, and retirement products. The Global Banking segment deals with lending-related products and services, integrated working capital management and treasury solutions to clients, and underwriting and advisory services. The Global Markets segment includes sales and trading services, as well as research, to institutional clients across fixed-income, credit, currency, commodity, and equity businesses. The All Other segment consists of asset and liability management activities, equity investments, non-core mortgage loans and servicing activities, the net impact of periodic revisions to the mortgage servicing rights (MSR) valuation model for both core and non-core MSRs, other liquidating businesses, residual expense allocations and other. The company was founded by Amadeo Peter Giannini in 1904 and is headquartered in Charlotte, NC.

Earnings data Q2 2023

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