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Bank of America Corp (BAC): Understanding the Upside Potential of Its Earnings Engine

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Bank of America Corp (NYSE:BAC) was the best performing stock in the Dow Jones Industrial Average in 2012. Shares have climbed a truly impressive 111% over the past 16 months. With the summer months approaching and the economy sputtering along, is there any steam left in the B of A engine?

A Brief Comparison to a Best in Class Bank

Bank valuations are driven by earnings. Warren Buffett agrees, so I will just piggy back on his words here. If we are all now in agreement, then the next step is to take a long, hard look at B of A’s income statement to determine what happens next.

Bank of America Corp

But before diving into the specifics of Bank of America Corp (NYSE:BAC)’s income statement, let’s first compare it to an industry favorite, Wells Fargo & Co (NYSE:WFC). Widely considered best in class, Wells has an impressive return on assets (ROA) of 1.4%. Compare that with 0.19% at Bank of America Corp (NYSE:BAC) for Dec. 31, 2012.

How does Wells Fargo do it?

Wells doesn’t have a big presence in investment banking, global banking, or the derivatives world. But the company is diversified, has a strong balance sheet, and is the best in the business at cross-selling complimentary products. Wells Fargo keeps it simple and executes — that is the key to their success.

By keeping it simple the company escaped the financial crisis largely unscathed, which gives it a significant advantage on the competition. Wells was able to double down on the mortgage market just as mortgage rates fell to historic lows and demand for refinances went through the roof. The company originated $524 billion in mortgages in 2012, a staggering number of which (75%) were refinances.

Contrast that to Bank of America Corp (NYSE:BAC), who has spent the past 4 years working to undo the damage of the much maligned CountryWide acquisition. B of A lost over $20 billion in 2011 and over $7 billion in 2012 directly from CountryWide assets.

Enough about the past, where is B of A going to be tomorrow!?

Bank of America is working to simplify its operations. The company has announced cost reductions across the board to bring down expenses as the bank intentionally shrinks. CEO Brian Moynihan has reorganized management ranks to better align them with the company’s simplified business model. The company has paid out extraordinary sums of money to settle legal claims related to practices at CountryWide.

All of these changes are designed to free Bank of America Corp (NYSE:BAC) from its troubled past and to allow the company to get back to block and tackling banking. Sound familiar? (Hint: Wells Fargo…).

B of A’s revenue is broken down into two primary categories: net interest income and non-interest income.

Interest Income

Net interest income is a function of both loan balances outstanding and the yield on those loans. Because of B of A’s size and footprint in the US, this measure is largely tied to macroeconomic factors. At play today is a continued deleveraging amongst consumers and historically low yields. This drove net interest income down just over $4 billion from 2011 to 2012, but it still represents 49%+ of total income.

Non-Interest Income

Non-interest income is more interesting and more complex. Fee income is both an offshoot of the core lending business as well as other businesses not directly tied to traditional commercial and retail banking.

First, as related to traditional commercial and consumer banking, non-interest income is driven by card income (transaction fees and annual fees), service charges (related to deposit products, some loan products, and misc other customer services), and investment and brokerage services. Together, these three sources of income generated $25 billion of income in 2012.

Card income accounted for 14.3% of non-interest income, service charges 17.8%, and investment/brokerage services 26.7%

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