Bank of America: Optimism Is Unwarranted

Bank of America Corporation (BAC), a financial holding company, provides a wide range of banking and nonbanking financial services and products to customers in the United States and internationally. The pending merger with Merrill Lynch (MER) will make Bank of America one of the largest financial services companies in the world.

Initiating with SELL Rating

We believe that Bank of America’s balance sheet will ultimately have to be fortified by a Citigroup (C) type of government bailout. As a result, BAC's stock price continues to have substantial downside risk. We are initiating coverage with a SELL rating.

While we expect earnings at BAC to erode throughout 2009, our short call is based on a rapidly deteriorating balance sheet that will force the company into drastic measures, such as a government bailout, much like Citigroup's recent agreement with the federal government.

While the recent mergers with Countrywide Financial and Merrill Lynch (still pending) positions BAC as a behemoth in the financial services industry, these transactions have also loaded the company with questionable assets that are likely to be written down substantially in the near future.

On a pro-forma basis, level 3 assets, which are valued almost exclusively by internally generated models, represent $144 billion, or approximately 74% of the company’s equity. This represents a jump of 344% in level 3 assets since Q4:07.

Off-balance sheet assets and derivative exposure have also jumped since the beginning of the year, and write-downs are likely. We believe that as this becomes apparent to investors, the stock price will decline towards tangible book value.

As a result, we are initiating coverage of BAC with a SELL rating.

Risks

The federal government has already initiated several bailout plans that are intended to improve the current credit crisis and unfreeze the credit markets. BAC will benefit to the extent that these plans are successful.

Investment Thesis

Since the first quarter of 2007, when New Century Financial filed for bankruptcy due to its exposure to subprime loans, we have witnessed one of the greatest financial crises since the Great Depression unfold over the past 24 months.

The leverage that many companies took on ultimately forced hundreds of firms, including Bear Stearns and Lehman Brothers (LEHMQ.PK), to either declare bankruptcy or be swallowed up by the competition at fire sale prices. Credit markets froze, bond spreads reached record levels, and foreclosures continue to swell to levels once thought unimaginable.

Bank of America, as well as a few others, such as JPMorgan (JPM), were thought to be the beneficiaries of this carnage. BAC, in particular, was essentially given Countrywide Financial and it is in the final stages of completing the acquisition of Merrill Lynch. By most accounts, BAC was positioning itself to be the number one competitor in virtually all segments of the financial services industry and once its acquisitions were fully integrated, it would post profits and returns that would be the envy of the industry.

We do not doubt that BAC will have a number one or two market share in many segments of the industry. We do, however, question the ultimate price that the company will pay to achieve this goal. While both of its major acquisitions were thought to be at “fire sale” prices, the questionable assets and leverage that came along in these deals will, in our opinion, lead to a very steep price paid for both Merrill and Countrywide.

On a pro-forma basis, BAC will have approximately $2.6 trillion in assets, and net tangible equity of approximately $130 billion, or a tangible leverage ratio of 20x. What is especially troubling is that the combined company will have something in the range of $367 billion in questionable assets. These include level 3 assets, off balance sheet CDOs, VIEs, etc., and a substantial exposure to derivative contracts.

This does not include commercial real estate and credit card exposure, which also has its share of risk.

Ultimately, we believe that a large portion of these assets will have to be written down, and that the company’s net equity position will be at significant risk.

While we believe that revenues and especially earnings will be hampered during the next several quarters, our thesis is based mainly on balance sheet risk. We believe that as writedowns increase, the stock will tend to trade towards tangible book value. Without some sort of government bailout, such as the recent bailout of Citigroup, we expect tangible book value to decline to approximately $5 over the next several quarters.

As a result, we are initiating coverage of Bank of America with a SELL rating.

Disclosure: no positions

Comments

[It Figures:]

"Optimism Unwarranted"?

Where do you see optimism in BAC's price, estimates, P/E, yield or analyst commentary? Market is profoundly pessimistic on BAC presently.

This post simply reiterates the widespread popular opinion.

2008 Dec 23 09:06 AM

[smerritt:]

Over the long run, perhaps one of the most useful tools to the enterprising investor is research and thesis development pieces exactly this one, where the stock is trading at $13.30 down from $55/share and the author wants the public to think the company will go substantially lower. One need only go back and look at past reccomendations to bring sobriety back into the thinking process. The majority of investors presume that what goes up, goes up forever and the same is true on the downside (Think $300 Oil and "Qualcomm is going to $1000/share). The best time to buy is when the blood is running in the streets and the time to sell is when people want to mortgage their homes to buy whatever the new things is.

2008 Dec 23 11:01 AM

[jackooo:]

BAC is for the long term. If you can stay the course it will easily double from these lows. If you will need your cash within a year then I recommend looking elsewhere. It is the top US bank in my humble opinion. They always charge the customer the highest fees of all banks. They always give poor service. And they always give the lowest interest rate on monies held there.
My rating on this stock is a buy for long term.

2008 Dec 23 02:07 PM

[M-P:]

I like this piece as I've been looking at BAC for months now ... the difference between this piece and others is that the author has some basis for his recommendation and opinion - and the basis can be verfied and is objective. Given the risk-adjusted value of their recent acquisitions, it appears that BAC paid too much for Countrywide and ML. The amount of Level 3 assets - mark to model assets - are troubling. When times are tough, most banks go down to their tangible book value. For BAC, that's around 10. However, given the Level 3 asset exposure, you could discount the book by 20 to 30%. They are probably a great buy - with a year or two time horizon - at 8 or so. In the long term, I think they will do well and go back to the 20's, 30's, and beyond. The up-sell and cross-sell potential is signficant - if they can figure how to have a single view of the customer, BAC will be dangerous. The biggest issues for them going forward - in the near term - are capping their exposures and learning to integrate and execute against the assets and entities they've acquired. I'd be watching customer retention, products per customer (wallet share), and exposures.

2008 Dec 23 03:12 PM

[Football Geek:]

Thanks for the news flash bob

Of course BAC is long term play

2008 Dec 23 07:15 PM

[NC Trader:]

M-P, Citigroup tried the supermarket model and proved it doesnt work. A distressed bank like BOA has even less of a chance of making it happen.

2008 Dec 24 12:38 AM

[Unklfungus:]

So, some advice for a neophyte. While I am new to investing, and I have always thought that it was a long term goal, what do all of you think is the future of BAC for the next year, five years, etc? I am interested in buying stock in them and I figured it would be for my children, currently 3, 4, 11.

I figure on it being part of a trust, maybe until they are 18 or 20ish.

Thanks in advance!

2008 Dec 31 02:16 AM