Inside Bank of America’s Mixed Bag

What should investors make of BofA's third-quarter report?

By Will Ashworth, InvestorPlace Contributor

Bank of America (NYSE:BAC) reported third-quarter earnings this morning, and they were a mixed bag. Investors seemed to like the positive earnings surprise and boosted its shares slightly in early trading. But before you go ahead and purchase its stock, let’s review the good and bad from the report and see what investors should do with this information.

Analysts were expecting a loss of seven cents, but BofA instead broke even, with earnings per share of less than 1 cent. Its actual net income was $340 million, a far cry from the $6.2 billion a year ago.

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Several factors contributed to this significant decline, including $1.9 billion for debit valuation adjustments (DVA) and fair value option adjustments (FVO); $1.6 billion for litigation expenses, including those related to its $2.4 billion Merrill Lynch class action settlement; and $800 million for a charge related to the reduction in its U.K. tax rate. All told, these add up to a 28 cent hit to its EPS.

BofA’s total revenue net of interest expense on a fully taxable-equivalent basis and excluding its DVA and FVO adjustments was $22.53 billion, basically flat compared to the third quarter in 2011. Its largest segment, consumer and business banking, saw revenues decline 13% to $7.1 billion due to lower debit card fees and lower average loan balances.

Its four remaining segments, excluding DVA and FVO adjustments, all chalked up revenue gains in the quarter.

CEO Brian Moynihan had this to say about its third quarter:

“We are doing more business with our customers and clients: Deposits are up; mortgage originations are up; we surpassed 11 million in mobile customers; our small business lending is up 27% year over year; loans to our commercial clients rose for the seventh consecutive quarter; and our corporate clients made us the second-ranked global investment banking firm.”

It’s clear Moynihan believes BofA continues to head in the right direction, and for the most part I think he’s right.

BofA’s most important statistic in the third quarter as it relates to the U.S. economy is its 27% increase in small-business loans for the first nine months to $6.2 billion, a clear sign the hiring of up to 1,500 additional small-business bankers, is having a positive effect. Keep it up, Bank of America! Small businesses are the engine of growth.

From a financial perspective, BofA took big steps forward in the quarter. Its Tier 1 common capital ratio under Basel III capital-reserve requirements improved 102 basis points from the second quarter to 8.97%. In comparison, JPMorgan Chase (NYSE:JPM), which delivered record profits of $5.3 billion Monday, has a Tier 1 common capital ratio under Basel III of 8.4%, an improvement of just 50 basis points from Q2.

When it comes to tangible book value per share, BofA increased that by 2% in the third quarter to $13.48 from $13.22 in Q2. Jamie Dimon’s JPM was able to deliver 5% growth in Q3 book value to $37.53 per share, up from $35.71.

In another comparison, BofA’s common equity as a percentage of total assets was 9.9% in the quarter, 170 basis points higher than JPM’s. Most important, BofA’s long-term debt declined $15 billion quarter-over-quarter and $112 billion year-over-year. Its balance sheet is definitely strengthening.

The glaring negative from BofA’s third-quarter report is the litigation charge related to the Merrill Lynch settlement. It’s not the first financial settlement for the company in recent years, but it’s the largest.

Today’s shareholders will effectively be paying the shareholders from 2008, when the merger took place. Worse, lawyers will end up with $800 million, none of which will have come from the pockets of former CEO Ken Lewis, whose legal fees were paid for by the company as part of his employment agreement. While it’s unlikely that something this egregious would happen again anytime soon, it should give you pause.

Should you invest in Bank of America?

I like the fact it’s increasing its small-business loans. More banks need to get on that bandwagon. Moynihan has done a reasonably good job steering the bank through uncharted waters. BofA looks to be on the good side of a terrible five years.

Having said that, I personally would be more inclined to buy a financial ETF like the Financial Select SPDR (NYSE:XLF), which is cheap at 0.18% and gives you some diversification beyond the banks. But that’s just me. All in all, Bank of America delivered in the third quarter.

As of this writing, Will Ashworth didn’t own a position in any securities mentioned here.

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