Bank of America ( BAC ) reported better-than-expected results for the third quarter earlier this week, primarily due to a sharp increase in forex trading and interest rate trading revenues. (( Q3 2016 Results , Bank of America Earnings Release, Oct 17 2016)) With two of the bank's major competitors - JPMorgan Chase ( JPM ) and Citigroup ( C ) - already setting the stage for a strong earnings season from the banks late last week, Bank of America certainly did not disappoint.
But elevated trading revenues were not all that drove profits at Bank of America this time around. The bank also did extremely well on the cost front. Total operating expenses fell to the lowest level since the bank's acquisition of Merrill Lynch and Countrywide at the peak of the economic downturn. To put things in perspective, operating expenses for the quarter were below $13.5 billion (or about 62% of total revenues) compared to figures averaging ~$20.5 billion over 2010-2011 (well over 80% of total revenues). The marked change stands testimony to Bank of America's efforts over recent years to work through its legacy legal issues while also cutting costs by streamlining its business model.
Another metric that has been moving in the right direction over recent years is the provisions set aside by the bank to cover loan losses. Loan charge-offs have remained largely stable over the last few quarters - indicating that Bank of America is reaping the benefits of its cautious lending approach since the downturn. Add to this the stability provided by the bank's industry-leading wealth management business, and we find it quite difficult to justify the fact that its shares are trading at ~ 5% lower than its tangible book value . We believe that investor concerns about the quality of the bank's assets are misplaced, and maintain a price estimate of $18.50 for Bank of America's stock . This is roughly 15% ahead of the current market value.
FICC Trading Revenues Upbeat, Backed By Strong Debt Underwriting Fees
The table above summarizes the factors that aided Bank of America's pre-tax profit figure for Q3 2016 compared to the figures in Q3 2015 and Q2 2016. The largest contribution is clearly from the bank's trading and investment banking operations, which swelled by more than $750 million from a year ago. Bank of America reports the results of its trading operations as a part of its Global Markets operating division, while a majority of the investment banking (advisory & underwriting) revenues come from the Global Banking division. Taken together, total trading and investment banking division revenues for Q3 2016 were just under $5.2 billion - almost 24% of the bank's total revenues. The fixed income, currencies, and commodities (FICC) trading desk was responsible for more than 50% of this figure, as it reaped handsome profits for a period where macroeconomic conditions triggered by the unexpected Brexit vote boosted interest rate and currency trading activity. We expect things on the debt trading front to remain upbeat in the fourth quarter, too, as the Fed looks poised to hike benchmark interest rates before the end of the year.
Notably, revenues from Bank of America's debt origination operations ($908 million) rivaled those from its equity trading operations ($960 million). In fact, this was the highest in debt origination fees that the bank has reported in the third quarter of any year throughout its history.
Wealth Management Division Facing Some Headwinds, But This Is Where Cost Cutting Helps
Bank of America's wealth management operations may not be responsible for driving the top line as aggressively as its trading operations, but it definitely provides the bank's diversified business model a steady and reliable revenue stream - one that has anchored results for several quarters now. According to our estimates, more than 11% of Bank of America's total share value comes from its wealth management operations.
The division witnessed a poor start to the year, as total assets under management fell from almost $901 billion at the end of 2015 to $832 billion at the end of Q2 2016 - a 7% decline due to a combination of outflows and falling asset valuations under volatile market conditions. But things improved considerably in Q3, as inflows of $10.2 billion coupled with a strong revival in market valuations helped the figure reach $871 billion. The table below summarizes the factors that contributed to the change in size of wealth management assets from the end of Q3 2015 and Q2 2016.
Strong overall inflows are good news for the division in the long run, as they should boost both fee-based as well as performance-related revenues. However, the gains are yet to be realized fully in the top line, with total revenues for Q3 2016 falling y-on-y as well as q-on-q. This, in turn, led the division's "Financial Advisor Productivity" metric lower to $983,000 for the period from over $1 million a year ago. This metric captures the ratio of annualized revenues for the division to the total number of advisors, and has fallen for seven consecutive quarters now from $1.07 million in Q4 2014.
However, overall profits for the wealth management division have not suffered too much over recent quarters thanks to the bank's cost-cutting efforts. While revenues for the division fell 1.6% y-on-y, costs fell by a steeper 6.2% over the same period. This, in turn, helped operating margins improve from 22.1% in Q3 2015 to 25.5% this time around. You can see how changes to Bank of America's wealth management profit margin affects our price estimate for the bank's stock by modifying the chart below.
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