Bank of America: Disappointing Profits

The second-largest U.S. bank pumped more cash than expected into reserves for potential credit losses and said it's worried about the health of consumers

Like its banking peers, Bank of America’s (BAC) profitability in the first quarter suffered from its exposure to the credit markets. Still, the company is getting some kudos from analysts for getting out ahead of potential future losses by aggressively adding cash to its reserves.

The Charlotte, N.C.-based company posted net income of $1.21 billion, or 23 cents per share, compared with $5.26 billion, or $1.16 per share, in the first quarter of 2007, mainly due to writedowns and a large increase in its reserves for potential losses.

The company's EPS were far below the consensus estimate of 41 cents among Wall Street analysts, which disappointed investors and caused shares to fall 2.5% to $37.61 on Apr. 21.

The weak results indicate that the tough times in housing and credit markets, plus rising inflation, are taking a toll on consumers. "We remain concerned about the health of the consumer, given the prolonged housing slump, subprime issues, employment levels and higher fuel and food prices," Chairman and Chief Executive Kenneth Lewis said in a news release.

Lewis said he expects minimal growth at best in gross domestic product in the second quarter and only a slight pickup in growth in the latter half of 2008.

Provisions for credit losses increased nearly five-fold, to $6.01 billion from $1.23 billion a year ago, including the addition of $3.3 billion to its reserve – in recognition of higher credit costs, especially in its home equity, small business and homebuilder portfolios.

The second-largest bank in the U.S. also reported $1.31 billion in trading-related losses, vs. $1.66 billion in trading income a year earlier, mostly due to writedowns of collateralized debt obligations, or CDOs, totaling $1.47 billion and $439 million in writedowns of loans made to finance leveraged buyouts. Trading-related losses were $5.15 billion in the fourth quarter of 2007, which included CDO-related writedowns of $5.28 billion.

Credit losses aside, Bank of America’s underlying businesses continued to do well. Total retail sales climbed 10% to 13 million products, led by a 14% increase in retail checking accounts. Recent acquisitions of U.S. Trust and LaSalle Bank, along with solid gains in certificates of deposit and consumer checking accounts, contributed to a $51 billion, or 11%, increase in total average retail deposits.

In its global wealth and investment management business, loans were up 30% and deposits jumped 29%, partly reflecting the impact of the U.S. Trust and LaSalle acquisitions.

The integration of those acquisitions is on schedule, with U.S. Trust slated to convert trust, custody and investment management accounts for long-time clients to the Bank of America platform and LaSalle set to migrate to the new brand in May. The $4.0 billion Countrywide Financial (CFC) acquisition is expected to close in the third quarter of 2008.

Analysts said they were impressed by how aggressive the company is being by adding more to its reserves than had been expected. But they warn that capital levels could become a problem, with tangible equity capital to total average assets at 3.1% and a Tier 1 capital ratio of 7.5%.

"The loan loss was bigger than a lot of folks, including us, were expecting," says David George, an analyst at Robert W. Baird & Co. in St. Louis, Mo. "Capital levels are below where they would normally be, and, I would guess, where ratings agencies would like them to be in this economic backdrop." (Baird and/or its affiliates expect to receive or intend to seek compensation for investment banking from Bank of America within the next three months.)

The weakened capital position prompted Moody's Investors Service (MCO) to downgrade Bank of America’s long term senior debt to Aa2 from Aa1 on Apr. 21 and to place a negative rating outlook on the company. Moody's also cut the bank financial strength rating on Bank of America, N.A. to A- from A, also with a negative outlook, but re-affirmed the bank's Aaa rating for deposits. Moody’s said the downgrade concludes a review that began in January, 2008, when the bank announced it was buying Countrywide Financial.

Although the ratings outfit noted the $13 billion of capital that the company raised in January, it said that the continuing credit market crisis combined with management's commitment to a dividend has slowed capital generation. Moody’s cited the decline in the Tier 1 ratio to 7.5% at the end of March from over 8% last year before its pricey acquisition of LaSalle Bank.

While Bank of America seems to have ample cash earnings to cover the dividend, it "certainly didn’t take a dividend cut off the table," says George at Baird. "We think there’s less than a 50% probability of a cut, but the dividend doesn’t appear as secure today as it did six months ago."

On its conference call to discuss the latest results, CEO Lewis said the company would rather try to raise additional capital by issuing preferred shares than cut the dividend.

Whether the company will need to raise more capital will depend on how successful it is in dealing with credit issues, says George. But he believes most of the losses from structured products like CDOs should be behind the company, given how substantial those writedowns have been.

The bank has other options available to raise cash if needed. It could dispose of its prime brokerage business, which it has said it's actively trying to do, or sell part of the big stake it holds in China Construction Bank (601939.SS), says Tom Kersting, an analyst at Edward Jones in St. Louis, Mo. Given the long-term advantages of keeping its interest in the Chinese bank, Bank of America is unlikely to sell it off entirely, he adds. (Edward Jones has provided investment banking services for Bank of America within the past year and expects to do so within the next three months.)

After initially reaffirming its buy opinion on the stock, Standard & Poor’s Equity Research lowered it to hold, citing the need for Bank of America "to continue an elevated level of loss provisions, based on rising net chargeoffs and non-performing assets." While S&P said it expects securities writedowns – totaling $2.6 billion in the March quarter – to decline in coming quarters, it said it remains wary of the bank’s exposure to high-risk assets. S&P cut its 2008 earnings forecast by 71 cents to $2.55, and pared its target price by 2 to 40. (S&P, like BusinessWeek, is owned by McGraw-Hill (MHP).)

In an Apr. 21 research note, UBS Investment Research analyst Matthew O'Connor reiterated his buy rating on the stock. While he noted the difficulty of projecting a normalized run rate for earnings in view of the bank's moving parts, he said he now expects earnings for the full year to be $3.50 to $4.00 per share. (UBS does and seeks to do business with companies covered in its research reports.)

With high underwriting standards and a strong business model, Bank of America should "be able to rebuild their financial position over time and again be a high-quality company," says Kersting, as long as the housing and credit markets return to somewhat normal levels of activity eventually.

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