Last week, two Turnaround Letter-recommended banks, Bank of America (BAC) and Citigroup (C), reported fourth quarter earnings. Much of the media coverage focused on the weak contributions from their trading activities. Yet we think this misses the more important points that show both companies are doing well.
Trading revenues are a small part of Bank of America’s overall business. Its fixed income, currency and commodity trading revenues fell 15%, or about $200 million. This is insignificant compared to the $7.3 billion in overall net income for the quarter. At Citigroup, its trading revenues fell 21%, or about $521 million, compared overall net income of $4.2 billion.
Just as important, investors don’t pay much for trading revenues. Due to their volatility and unpredictability, trading revenues (which in essence are profits) probably aren’t worth more than a P/E multiple of five. Some might justifiably argue that a multiple of one is about right. Not surprisingly, no public companies exist that make all their profits from trading, as the market wouldn’t place much value on them.
EARNINGS RECAPS:
Bank of America reported strong per-share earnings of $0.70 that were 49% higher than a year ago (adjusted for the tax law) and 11% better than analysts’ consensus estimates of $0.63. The core businesses of Consumer Banking, Global Banking, and Global Wealth and Investment Management all showed a robust level of profits as well as improvements over a year ago. Loans and deposits showed mild yet positive growth.
Credit problems were impressively low: charge-offs of bad loans was 0.39% and only 0.56% of loans were non-performing. Operating expenses actually declined, by 1.1%, despite the revenue and balance sheet growth.
Fourth quarter return on assets (ROA) was 1.24%, well-above the 1.00% rule of thumb threshold for “good” returns. Return on equity (ROE) was 11.6%, approaching but not above the 12.5% rule of thumb threshold for “good”. While return on tangible equity (ROTE) was 16.3%, we tend to give this a bit less emphasis as it ignores goodwill from acquisitions and other capitalized costs.
For the year, Bank of America had similarly healthy returns, with ROA of 1.21% and ROE of 11.0%. Book value grew by 5.6% from a year ago, despite the bank repurchasing $20.1 billion of stock and paying out $5.4 billion in dividends (compared to $28.1 billion in full-year net income). Capital metrics1 remain strong at an 11.6% capital ratio, roughly flat from the 11.7% a year ago, especially considering the large return of cash to investors. From a pure capital allocation perspective, we have mixed views on the repurchases: while it is hard to argue against a healthy and decently-profitable bank returning hard cash to shareholders, BAC is repurchasing shares at prices above book value. This dilutes book value per share, a metric that we find important in valuing banks.
This was a strong and encouraging year for Bank of America. At 29.30, BAC shares are trading at 1.2x book value and 1.6x tangible book value. If profits continue at this pace, book value per share will be around $31 in 2020, implying that the current shares trade at a modest discount to this out-year estimate. On a P/E basis, BAC shares trade at a reasonable 10.2x estimated 2019 earnings.
Citigroup’s fourth quarter per-share earnings of $1.61, adjusted for the impact of tax reform, were 26% higher than a year ago and 4% above analysts’ consensus estimates of $1.55. Results showed moderate improvement over a year ago. Revenues fell 2% while net interest income increased 5%. Operating expenses fell 4% and pre-tax profits increased 4%. The lower tax rate and 8% reduction in shares outstanding boosted per-share net income. Loans increased 3% while deposits increased 6%.
In the Global Consumer Banking unit, revenues and expenses were essentially flat although adjusted net income rose helped by lower taxes. In the Institutional Client Group, revenues and expenses both fell 2% while adjusted net income rose 14% also helped by lower taxes.
Corporate/Other, which represents primary the legacy mortgage portfolio which is in wind-down mode, showed an increase in adjusted net income of 7%.
Overall, credit costs remain low and improving. Credit losses net of recoveries fell 5%, and non-performing loans were 0.52% of total loans, better than the 0.69% rate a year ago.
Fourth quarter ROA was 0.88%, while ROE was 9.0%, both below the level we’d like to see. Year-ago results were obscured by the changes in the tax law. For the full year, ROA of 0.94% and ROE of 9.4% were below the bank’s full potential. Capital metrics1 remain sturdy at a 12.4% capital ratio, but down slightly from the year-ago level of 12.6%.
Like Bank of America, Citigroup returned a vast sum to shareholders totaling $18.1 billion during the year in repurchases and dividends. In effect, Citigroup returned all of its 2018 earnings of $18 billion to shareholders (with repurchases at a sizable discount to book value per share) while modestly improving its operations and maintaining its capital levels. While the bank has more work ahead to boost its ROA and ROE, it clearly is doing many things right.
Helping to motivate management, the board signed an agreement with respected activist investor ValueAct Capital, holder of a 1.3% stake. Under the agreement, Citi provides the investor with confidential information and an open door to engage Citi’s board and senior leadership in exchange for ValueAct’s support through December 2019.
With Citigroup shares at 63.12, they are trading at 84% of book value and 99% of tangible book value, and a P/E on 2019 estimated earnings of 8.3x.
Common equity Tier 1 capital ratio – standardized approach.
We continue to rate Bank of America (BAC) shares a Buy up to 34.
We continue to rate Citigroup (C) shares a Buy up to 85.
Disclosure: An employee of the Publisher owns both BAC and C shares.