Bank Of America: Buy Now Before Dividend Increases

| About: Bank of (BAC)

With Comprehensive Capital Analysis and Review (CCAR, or "stress test") results due out on Thursday, March 7th, money center bank investors are wondering what it means for the too-big-to-fail banks' capital return plans. RBC has provided some estimates of capital return levels it thinks are reasonable based on what it considers to be the best, average and least capitalized banks. Bank of America (NYSE:BAC) is listed as a "least" capitalized bank and thus, RBC thinks the Federal Reserve will only allow the bank to return something like 10% to 30% of its earnings to shareholders when the capital return plans are released next week.

The implications of this are great, considering that BAC has been forbidden from returning meaningful capital to shareholders since the financial crisis was in full effect. BAC's near-meaningless penny per quarter dividend has left a lot to be desired for BAC shareholders. Indeed, what once was a solid income stock has become a vehicle for speculators betting on the housing market and macro economy. With the release of the Fed's stress test and capital return plan approval, however, I believe BAC shares could be on their way to resuming the strong uptrend that has been in place for over a year now.

I will have to disagree with RBC that Bank of America is a poorly capitalized bank; it does not necessarily possess the strength of Wells Fargo (NYSE:WFC) or JPMorgan (NYSE:JPM), but the company has made significant strides to build up its capital base. Indeed, in 2012 alone, BAC reduced its long-term debt load by almost $100 billion. In addition, Basel 1 capital is now up to 11.06% and Basel 3 tier one capital improved YoY from 8.97% to 9.25%. Clearly, the bank is investing in stability for the future and the results can be seen quite visibly.

In terms of capital returns to shareholders, BAC currently spends four cents per share annually returning capital to common stock shareholders. In terms of 2012 earnings, this represents a 16% payout ratio. Also, share repurchases were shelved during the financial crisis, at the Fed's hastening, but those will once again be on the table once the stress test results are confirmed.

If RBC's conservative estimates are correct, BAC will be able to return between 10 cents and 30 cents of capital to common stock shareholders this year. BAC is expected to earn $1.00 per share in 2013 which would make for a current payout ratio of only 4% with the current penny per quarter distribution. I think BAC will forego share repurchases this year in favor of reinstituting a respectable dividend. For instance, if BAC increases its dividend to seven cents per quarter, which is well within the range of possibilities, shares would yield nearly 2.5%. BAC would become an income stock once again, besting the S&P 500's current yield.

BAC could increase its dividend gradually, perhaps targeting three cents for the second quarter, five cents for the third quarter and seven cents for the fourth quarter of 2013. Management probably will not want to use up the good publicity that comes from raising the dividend all at one time with a massive increase in the distribution this quarter. However, once BAC begins to raise the payout, increases will likely come quickly and steadily as BAC's profitability continues to improve at a rapid rate.

BAC doesn't really need to raise significant additional capital as the bank's efforts since the financial crisis have already paid off. This leaves the door open for earnings to once again be distributed to shareholders in the form of buybacks and dividends. Even if BAC distributes seven cents per quarter, that is still only a 28% payout ratio on its projected $1.00 in earnings for 2013. This leaves significant room in the future to increase the payout. Finally, with BAC slated to grow earnings by another 25% or so next year, we could see the dividend reach nine cents per quarter, for a yield of greater than 3% at the current price without even increasing the payout ratio.

The bottom line is, if you are considering a long position in BAC, take a hard look now before the CCAR results are released and BAC reveals its capital return plans. Once the company starts to raise the dividend, I think shares will begin to appreciably increase in value to reflect the fact that BAC has put the financial crisis behind it and is focused on returning capital to shareholders once more.

Disclosure: I am long BAC. 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.