After a stock more than doubles, it is only sensible to reassess the investment rationale to ensure that an adequate margin of safety still exists. Few companies have had to tread through the mountains of litigation, loan losses and legacy expenses associated with the Great Recession that Bank of America (NYSE:BAC) has experienced. Due to the most damaging acquisition in recent memory, Bank of America is earlier in the rehabilitation process than its closest competitors such as J.P. Morgan (NYSE:JPM) and Wells Fargo (NYSE:WFC), but because of the discounted valuation I believe it offers a superior investment opportunity over the next 2-3 years. For the long-term investor, I believe that even at current prices Bank of America offers a substantial margin of safety and significant upside.
CEO Brian Moynihan inherited a gem of a business that was obscured and tainted beyond recognition. His predecessor's history of poorly conceived acquisitions had produced a never ending stream of lawsuits and losses, which impaired Bank of America's capital base. To combat the internal crisis Moynihan took some drastic steps. In 2011, Moynihan accepted a very expensive preferred stock and warrant deal with Warren Buffett to boost capital and arguably more importantly, to instill confidence in the bank being a surviving entity years into the future. During the CCAR process of 2012, Moynihan intelligently did not ask for a dividend increase or stock buyback, but instead the company put its head down to build up its capital base. This was achieved through reducing liabilities, disposing of non-core assets, and reducing the expense structure of the company.
Despite posting anemic 2012 earnings, tangible book value per share grew to $13.36 from $12.95 at the end of the 4th quarter of 2011. The Basel 1 Tier 1 common capital ratio increased by 120 basis points YoY to a very healthy 11.06%. Meanwhile the estimated Basel 3 Tier 1 common capital ratio now sits at 9.25% at the end of the 4th quarter of 2012, which is comfortably higher than the 8.5% 2019 requirement. Risk weighted assets decreased to 55% of overall assets versus 60% a year ago, highlighting the company's efforts to rid itself of non-core assets. Moving into 2013, Bank of America has one of the strongest loan and lease coverage ratios in the industry at 2.69%. The biggest concern early in 2012 was the allowance for representation and warranties largely stemming from the Countrywide acquisition, but at $19 billion in reserves the company has gotten rid of the majority of the heavy lifting. For all banks credit quality has been improving at a rapid rate and Bank of America is no exception. Full year net charge-offs declined by $5.9 billion, or 28% from 2011. 30+ days delinquencies in the 4th quarter were down 26% YoY. Because Bank of America is earlier in the recovery process than its peers, I believe it will generate a larger portion of earnings from recovering some of the loan loss reserves as credit quality continues to improve.
Consumer and business banking deposits grew 7.4% in 2012 to $498.7 billion, and Merrill Edge brokerage assets increased 14% YoY to $75.9 billion. Total deposits are an incredible $1.1 trillion and this low cost deposit base lays the foundation for Bank of America's future high powered earnings when interest rates increase. Many people forget that before the Great Recession and Ken Lewis's string of bad deals, Bank of America along with Wells Fargo had the highest quality deposit base in the United States, and I believe this is still the case today. To be able to acquire this business at a significant discount to tangible book value is extremely attractive. Loan growth grew by 6% in the 4th quarter from the 3rd quarter, and if the economy continues to pick up steam this trend is likely to continue. Due to its problematic legacy asset servicing business, Moynihan made the difficult decision to stop the correspondent mortgage channel, which has weakened BAC's earnings during this refinancing boom. While easy money was left on the table, I believe the strategy made sense because Bank of America can't risk any more excessive litigation in an environment where the mortgage rules have been quite vague. Despite these headwinds, retail mortgage production growth still exceeded 10% on average for the last 3 quarters, and now the company is shifting some of the servicing staff to production, which could provide a boost to earnings moving forward. Merrill Lynch has performed quite well for Bank of America and this is reflected by a 20% increase in sales and trading revenue in 2012, excluding the non-economic DVA. Long-term debt was reduced by $112 billion in 2012 to $275.6 billion, which has reduced the annual interest expense by $3.3 billion, somewhat reducing the pressures on net interest margins.
Very importantly, the company is on target to achieve $8 billion in annualized cost savings from NEW BAC initiatives by mid-2015. These cost savings initiatives will drastically improve profit margins and the return on assets moving forward. 60+ days delinquent loans serviced declined 33% YoY and the company recently announced a sale of mortgage servicing rights, which will reduce loans serviced by 232K from 773K. Like too many other recent quarters, Bank of America's 4th quarter was a throw-away quarter largely due to a $2.5 billion provision for representations and warranties, and the $1.1 billion independent foreclosure review acceleration agreement. The good news is that the vast majority of GSE problems should be a thing of the past moving forward, and the most significant remaining litigation are the cases involving bond insurer MBIA, which shouldn't be too much of a game-changer for Bank of America after taxes. I believe it would behoove Moynihan to settle that case so that Bank of America can move forward without the uncertainty and legal fees, but in full disclosure we are also long MBIA bonds so I might be a tad bit biased.
While tangible book value grew slightly in 2012, book value declined by $.16 to $20.24. In 2014, I believe Bank of America is more than capable of generating a return on tangible book value of 15%, and I believe there is actually upside beyond that when interest rates increase. Even at current tangible book value that is likely to grow in 2013, a 15% return on tangible equity would equate to $2.00 of normalized earnings per share. Therefore at a recent closing price $11.14, Bank of America's stock offers a normalized earnings yield of 18%. Bank of America is extremely well capitalized and in the near future will be over-capitalized, so I don't believe the possibility of a 50% dividend payout ratio to be too far-fetched. At the current price the normalized dividend yield would be close to 9%. Now I certainly would prefer stock buybacks at a discount to tangible book value, but simple mathematics tells us that the stock is just too cheap despite the 2012 rally.
For those investors that might not have the stomach for volatility, selling long-term put options can increase the margin of safety at the cost of some longer-term upside. We generally buy the stock and sell puts along with those positions. We run concentrated portfolios generally with 90% of assets in the top 7-10 companies. Selling the January 2014 $12 puts for roughly $2.06 would create a breakeven price of $9.94 on the stock, while generating about a 20% return on the maximum risk. There is not a doubt in my mind that Bank of America is taking the right steps and Brian Moynihan is the right guy for the job. As the true earnings power emerges over the next several years I believe the stock could more than double from its still depressed valuation. Those market participants that sell today to lock-in profits are going to miss out on some considerable upside and dividends.
Disclosure: I am long BAC, WFC, JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I'm long MBIA bonds.