Bank of America (NYSE:BAC) has been the best performer in the sector over the past twelve months - the stock is up over 57% and still going strong. The economy is making steady recovery and with it, the financial sector of the economy. I believe the company is well positioned to continue its recovery over the next twelve months, in fact, I believe the prospects are even better for the company over the next two-three years. I will explain my optimism in the following paragraphs.
Getting Rid of the Demons of the Past?
Bank of America has paid over $40 billion in legal costs and claim settlements since the crisis of 2008. However, the most recent payment of $404 million to Freddie Mac has settled the remaining claims between the two organizations. The payment will resolve the dispute on defaulted mortgages which were sold to Freddie Mac between the period of 2000 and 2009. The payment will be made from the reserves of the bank. This might just be the last of the skeletons in Bank of America's Closet. Countrywide Financial was a hot property at the boom of the housing industry - however, the most attractive asset turned into the weakest link in the chain for the company after the crisis of 2008, and it will still take some time for the company to get rid of these demons. Furthermore, the bank has offered to pay $8.5 billion to the investors who bought mortgage bonds issued by Countrywide Financial; however, there has not been any decision on this settlement offer yet.
In addition, the bank is trying to improve the position of its segments, especially the asset management arm. Recently, the company moved its own pension fund to Merrill Lynch and the decision by Wal-Mart (NYSE:WMT) to stay with Bank of America to handle its 401k program with $18 billion in assets has further enhanced the position of the company. Although this deal is not likely to have big impact as a standalone; it enhances the position of the bank among its competitors and puts it as a preferred choice for large businesses to manage their assets.
Getting Down to the Solid Facts.
Aside from the news and its short-term effects, let us understand that the banking industry runs on a business cycle parallel to the economic cycle. Since the financial crisis has passed the US economy is on its way to recovery, and the solid performance of the company has shown how it is benefiting from the improving economic conditions. Bank of America has a tangible book value per share of $13.62 and a total book value of $20.50. Tangible book value calculates the book value of the assets of a company without the intangible assets (Goodwill etc) - it gives an idea as to what investors can expect to get if the business is liquidated. Book value measure is especially appropriate for banks and financial institutions as non-cash expenses such as depreciation are usually not present on the books of the company. As a result, it is typically difficult to temper with the book value of assets of a bank and these assets will most likely fetch the value mentioned on the books.
The current tangible book value of the Bank of America stock indicates that the share is trading at a discount of 23% to total book value and at 16% premium to tangible book value. Since we are looking at the bank as a going concern, a premium of just 16% on the liquidation value is on the lower side in my opinion. As a result, Bank of America has a handsome margin of safety which not only makes it a safer investment but it also has a significant potential to grow especially when the economy gets in the flow. Also the price to book value of Bank of America is 1.2 while the industry's Price to Book value is 1.7. Furthermore, the reduction in the gearing of the Bank but also allows the company to have free cash flow which would have been taken up by the interest cost. Also, it will improve the net profit margin and there will likely be more funds available for dividends if and when the company decides to increase dividends.
Bank of America settling the claim with Freddie Mac takes the uncertainty out of the picture and reduces the gearing of the company since this deal is going to act as a shield for further such claims in the future. On the other hand, the long-term prospects of the bank look promising - if the company is able to settle its remaining mortgage issues soon, then it will have a solid platform to build on and fewer bumps on the road to recovery. As I have mentioned above, the stock is trading at a small premium to its liquidation value despite a large increase over the past twelve months. I believe there is a lot more to come from Bank of America in the next two-three years.