Bank of America made a $4.6 billion profit between April 1, 2015 and June 30, 2015. Investors are finally getting a glimpse of what Bank of America’s profit engine looks like without lawyer fees, judgments, and settlements clouding the picture. This time last year, in contrast, Bank of America only provided a $2 billion profit after all expenses were taken into consideration.
The company’s Common Equity Tier 1 Capital Ratio remained at 10.3%, unchanged over the past few quarters. This will likely put Bank of America on the path to meaningful dividend growth in the years ahead, as it’s finally past the point of having to use profits to shore up the capital base.
In 2012 and 2013, Bank of America had a Common Equity Tier 1 Capital Ratio in the 9% range. This was enough to meet the Basel III target of 8.5%, but it fell short of the 9.5% required by the Fed in order for Bank of America to receive regulatory approval to raise the dividend payments to shareholders.
Usually, Bank of America’ results improve by a little bit each quarter (that is to say, Q4 profits are usually the highest of the year, followed by Q3, Q2, and Q1). The $4.6 billion in profits amounted to $0.41 per share. It is fair to describe Bank of America as a company making $1.64 in profits while only paying $0.20 per share in dividends.
There are two reasons why Bank of America should appear especially attractive for income investors over the next five to ten years.
One is that interest rates will likely increase. For every percentage point increase in interest rates, Bank of America makes another $4 billion. Bank of America made $21 billion back in 2006. It could pass that figure in the next couple of years if interest rates go up two or three points. Banks are usually one of the asset class waves you want to ride as interest rates increase because banks tend to raise loan rates faster than the rates paid to depositors during the rising-rate portion of the economic cycle.
The second reason is that Bank of America has that large gap between the current dividend payout and profits. There is no reason why Bank of America shouldn’t be able to get its annual dividend payout up to $0.80 annually in the next couple of years.
It has issued 1,300,000 new credit cards to consumers in the past year, and the average default rate is less than 0.5%. During a stress-test scenario, in which America would re-enter recession, the expectation is that the default rate would be in the 4% to 6% range (compared to the 14% default rate during the worst of the 2009 recession).
I still think of it as a five to ten year holding rather than a lifetime holding. My concern is that capital is not fully appreciated the way it is at financial institutions like Wells Fargo, Franklin Resources, Visa, U.S. Bancorp, or M&T Bank. Share dilution is often accompanied by cultural rot, and a leading signal of cultural rot is high turnover in the executive ranks (if your net worth is in the millions, you’re not going to be willing to suffer a lot of abuse and shenanigans because you don’t need the paycheck to get by).
Bank of America is now going on its fourth CFO since Brian Moynihan took over in 2010. When it was Nations Bank, there were a lot of people who were employees of the company for thirty or forty years, and were defensive about it they way you would be about a family member. Dedication and support ran in the culture’s DNA.
That culture has been dead and gone since the merger, and it’s hard to respect Bank of America’s record with handling capital. Since it began repurchasing stock in 2013, it is only expected to retire 1.5% of the outstanding shares by the end of 2015. That’s because the executives at the bank are paid compensation like they are Wells Fargo. The idea that the sinners have performed full penance for the doubled share count dilution during the financial crisis associated with the Countrywide acquisition hasn’t settled in; accountability has not become a part of the company’s culture.
But still, this lower quality explains why Bank of America has maintained a lower valuation while many of its banking peers have soured. A lot of stems from the $0.20 annual dividend, I think. If Bank of America was returning $0.60 to shareholders right now, which would take up 36% of the profits, I expect that the share price would be higher and the overall sentiment surrounding the bank would be improved.
I think Bank of America benefits from a favorable valuation, a low dividend payout ratio that will ratchet up, and profits that will rise quicker than many currently project as interest rates increase. That is the thesis driving the investment. The $16 billion in current profits are real. My guess is that it will take a few years of dividend growth before the rest of the investor community internalizes that fact.