Bank of America (BAC) stock has come roaring back from the brink, and over the past 12 months is up 65%, substantially outpacing both the S&P 500 and most bank stocks as well over the same time period. Many analysts also have a buy rating on the stock. Is the stock cheap here, or will it pause to consolidate it gains?
Cheap Based on Forward P/E?
Bank of America currently trades at 10.0x consensus projected 2014 earnings per share. While this is cheaper than the S&P 500, BAC trades is more expensive on a forward P/E basis than both JPMorgan Chase (JPM), Citigroup (C), and trades about in line with Wells Fargo (WFC). I pick this peer group because these four banks are far and away the largest banks in the U.S., each has a national footprint, and combined they control over 60% of all deposits held in U.S. banks.
So, is this premium for BAC justified? As I argue below, its forward earnings power is dependent upon a number of factors. Also, recall that both JPM and WFC both pay a hefty dividend.
Cheap on a Book Value Basis?
When looking at how a bank is valued versus book value, it is always important to look at Tangible Book Value, which deducts goodwill, intangibles and certain other assets from common equity to reach true "hard" book value that can be compared against other banks on an apples-to-apples basis. Goodwill and intangibles result from premiums (over book value) paid by the acquirer in an acquisition, and therefore should be deducted to get to true tangible book value. On a price to tangible book value multiple, BAC stacks up well against its competition on a valuation basis, and trades at a bigger discount to tangible book value than all but Citi. When looking at Price to Tangible Book Value multiples, you have to ask yourself, what are the risks that Tangible Book Value Per Share is overstated. As discussed below, BAC has some risk that its reserves for rep & warranty put back liabilities and its reserves for litigation liabilities are not sufficient to cover future losses, which might cause Tangible Book Value to be modestly overstated. So, take this ratio with a grain of salt.
What are the wild cards that could affect BAC's earnings the next two years? BAC is in the process of doing three main things:
1. New BAC - Through a program called New BAC phases I & II, they are trying to cut their operating costs by a total of $8 billion from the inception through 2015. While New BAC sounds fancy, it is really a euphemism for layoffs, consolidations and improving processes to make the Company run more efficiently with fewer employees. It is also a reality that BAC needs to cut expenses to match revenues, as lower service charges on checking accounts and low interest rates have cut into profitability. This process is already under way, and according to management, will be completed by 2015.
2. Reducing Legacy Assets and Liability Exposure from Countrywide - BAC has a massive hangover from the Countrywide acquisition, in the form of (1) massive unknown liabilities resulting from rep & warranty buyback demands from various buyers of mortgage loans originated by Countrywide, and to a lesser extent Merrill and BAC, (2) huge servicing costs that result from modifying, servicing or foreclosing on legacy Countrywide mortgages, and (3) extensive litigation exposure from AIG, the Federal Housing Finance Administration, private MBS holders, and many others resulting from Countrywide's alleged mortgage activities.
Over the past three years, management has settled a number of outstanding claims against the company, especially with the GSE's. At the same time, they have consistently underestimated the costs of settling these claims, which has resulted in large charges against earnings. The company's Q1 2013 earnings report states that reserves for rep & warranty put backs could be understated by as much as $4 billion. I think it will be more, and management is likely under reserved for both future mortgage settlements and mortgage litigation, and will have to take additional charges that will impact reported earnings and growth in tangible book value per share.
Management expects total operating cost savings from a reduction in Legacy Asset Servicing to reach approximately $10 billion per year by 2015.
3. Growing Revenues - Now that management has raised capital, increased liquidity and sold non-core assets, they say they are focused on growing revenues across all lines of business. If the first quarter is any indication they have a long way to go. The Company fell short of analysts earnings projections as both its mortgage origination and fixed income trading (FICC) operations in the first quarter of 2013. Also, it is not at all clear that they are maintaining their market share in many lines of business, and that they are not damaging their revenue generating and customer service abilities by cutting so much staff in Project New BAC.
Other Reasons BAC Might Miss Projected Earnings
All banks have to set aside a reserve called the Allowance for Loan Losses ("ALL") that is used to absorb loan losses that occur in the normal course of making loans to consumers and businesses. The Allowance for Loan Losses is reduced by Net Charge Offs whenever a bank determines all or part of a loan is not collectible. Banks rebuild this "ALL" reserve account from quarter to quarter and the amounts added are management's best guestimates of future losses. It is an inexact science at best. The Provision for Loan Losses runs through the income statement, affecting reported earnings. A little complicated, but here is how it works:
Beginning Allowance for Loan Losses
Less: Net Charge Offs during Quarter
Plus: Provision for Loan Losses during Quarter (charged against expenses)
Ending Allowance for Loan Losses
How much in reserves should a bank have in its "Allowance for Loan Losses"?
A general rule is that banks should keep about 2 year's worth of Net Charge Offs in its Allowance for Loan Losses. BAC is not carrying as much coverage in its Allowance for Loan Loss Reserve as its peers. I have used two sets of numbers for BAC - as they reported their numbers for Q1 2013, and also after subtracting out a portion of their loan loss reserves for a special basket of loans called PCI or purchased credit impaired loans. See table below:
If you dig deep enough in the bowels of the recent 10-Q, you can discover that within the Allowance for Loan Losses there is an esoteric designation, "purchased credit impaired loans" or PCI. This is loan portfolios previously purchased from outside institutions (many are from the Countrywide debacle) that BAC knew were impaired when they were purchased. These loans were written down at acquisition, but lo and behold, now four or five years later, there is realization that the original markdown was insufficient so this extra PCI reserve is a loan loss reserve for these assets that have gone from bad to worse. This creation of a PCI is a practice perfectly within GAAP guidelines and the three other large banks avail themselves as well. In my opinion, just because it's legal doesn't mean it gives an investor an accurate financial picture of a bank's risk profile. So to get an accurate picture of the four major "too big to fail" bank's loan risk profile, we must first subtract out the PCI reserve to get a net dollar amount that BAC and the other banks actually have reserved against their loan portfolios. The chart below compares, BAC, to JPM, WFC, and C on equal footings after adjusting all of their allowance for loan losses and backing out the PCI reserve.
When you compare BAC against its peer group, it is carrying fewer reserves as compared to its Net Charge Offs than any of its peers after making this adjustment.
This is important to investors in BAC stock because banks have been improving their earnings over the past year by putting (expensing) less money into their Allowance for Loan Losses than they have been charging off in bad loans. This is called "Releasing Reserves" into earnings. There is nothing wrong with the practice of releasing reserves into earnings, but it is a low quality source of earnings that cannot go on indefinitely. At some point your reserves cannot or should not go much lower. From the table below, you can see that Reserves Released into earnings was a large chunk of BAC's earnings in 2012 and Q1 2013.
And, for the current fiscal year, some analysts are projecting that BAC will release between $1.8 to $2.7 billion of reserves into earnings. This would account for about 10-20% of BAC's pre-tax earnings for 2013.
Based on consensus 2014 estimated EPS, BAC currently trades at a premium P/E multiple to JPM and C, and in-line with WFC. Also, BAC has a smaller Allowance for Loan Losses than its peers, meaning that it will have fewer reserves that it can release into earnings, increasing the chance that it misses analysts projected earnings targets. Add to all of this the fact that BAC's projected earnings depend upon its proper execution of its cost savings program called New BAC, reducing its legacy mortgage servicing costs, and its management team correctly estimating the costs of future mortgage and litigation settlements. Finally, management has not proven that it can grow revenues and maintain its market share. For all the risks attendant to BAC hitting its earnings estimates, it should be trading at a bigger discount to its peers. At this price, I think it is fairly valued.
Additional disclosure: We are engaged in a lawsuit against BAC regarding the Merrill Lynch acquisition.