- The growth in the fundamentals has been strong and it is likely to continue over the next few quarters.
- BAC is trading at a slight premium to its tangible book value and a substantial discount to its book value.
- Litigation issues look to be coming to an end, which should allow the stock price to make a rally over the next few months.
The management of Bank of America (NYSE:BAC) has come under pressure due to some recent developments, especially the $4 billion accounting error - a lot has been said about the error, and it has caused the stock to lose substantial value over the last few days. An error of $4 billion might not look as big compared to the total assets of about $2 trillion for Bank of America; however, it does raise some questions about the competency and the ability of the management. Nonetheless, I believe the news has taken more than enough toll on the stock price and the surrounding negativity has brought the stock into oversold territory. In all the negativity, investors are ignoring some key positives for the bank, and these positives will prove to be catalysts in pushing the stock price up in the second half of the year, in my opinion. I will try to highlight these positives for the readers in this article.
First of all, let's talk about the growth in the fundamentals - Bank of America has been one of the best when it comes to the growth in earnings - the only negative for the bank has been the litigation costs (explained later). The growth in earnings has been splendid over the last few quarters. Bank of America has recently submitted its quarterly report and the investors' general meeting presentation - I would strongly recommend that BAC investors go through these documents. I will explain some parts of these documents in this article, but it is almost impossible to fit both of these important documents in just one article.
Source: Stockholders' annual meeting presentation
I have talked about the earnings of the bank in detail in a previous article, so I will not go into the segmented growth. I will only focus on three key points here. First of all, the growth in net income and EPS has been astonishing. We have seen net income go from $1.4 billion in 2011 to $11.4 billion - showing growth of over 714%. At the same time, EPS has gone up from a mere $0.01 to $0.90. The growth in the earnings has also converted into the appreciation in the stock price. The stock was trading at $5.56 per share in 2011 and went up three folds by the end of 2013 to $15.57. However, the rise in the stock price is still less than the growth in earnings. BAC stocks should have been trading close to $40 if the growth in earnings had translated into the stock price. Why have we not seen the growth in earnings translate into the same type of rise in the stock price? The answer is simple: litigation issues. The market has been putting a discount on BAC due to its litigation issues and the stock has lagged behind most of its industry peers. The majority of the banking sector stocks have regained more than Bank of America since May 2008 - The image below shows the stock price performance of five major banks since May 2008.
Only Citigroup (NYSE:C) is trading at a higher discount than BAC, while Wells Fargo (NYSE:WFC) has been the biggest gainer. JPMorgan (NYSE:JPM) is also trading at a premium compared to the price in May 2008. Litigation issues have weighed heavily on the valuation of the stock over the last few years.
The second key point is the growth in the book value of the stock - at the moment, BAC's book value is close to $21, considerably higher than the current market price of the stock. However, the tangible book value of the stock is close to $14 - based on the current stock price, the stock is trading at a slight premium to its tangible book value. Usually large banks trade at a considerable premium to the tangible book value, and at the moment, BAC's premium has been slashed substantially.
The third point is the decline in the loan losses - BAC has reported around 40% decline in the loan losses and provisions, and the bank stated in its 10-Q that further reductions are expected in the next few quarters. This shows that the quality of the assets is increasing and the growth in fundamentals should continue.
Let's now talk about the problems. The biggest problem has been the litigation issues related to the mortgage backed securities. Please follow this link to read about the FHFA settlement and rumored mortgage backed securities settlement with the authorities. These settlements will likely remove the shackles and the bank will get out of the Residential Mortgage-Backed Security (RMBS) litigation issues. Furthermore, the bank also discussed the FGIC settlement that should be completed by 27th May - BAC has paid $900 million and a further payment of $50 million will be made when the bank settles two remaining trusts. Another settlement was with the Consumer Financial Protection Bureau (CFPB) - BAC paid $45 million in civil penalties and the refunds to the affected customers will amount to $738 million, of which, a substantial amount has already been paid. With the RMBS litigation issues close to an end and the decision of the Bank of New York Mellon (NYSE:BK) case close; we can assume that the majority of the litigation issues will be over for Bank of America.
The key points are:
- The growth in the fundamentals remains strong and the litigation costs will likely impact the earnings in the short term, but the long-term outlook looks good.
- The litigation issues look to be coming to an end as the bank is close to settle all of its RMBS obligations - with these issues behind BAC I expect a strong rally in the stock price.
- The reversal of the dividend increase should not have a major impact on the valuation - if you are interested in dividend income then there are a lot of other, more attractive options available.
- The stock is trading below its book value and at a slight premium to its tangible book value. Once the litigation issues are over, BAC should trade at a substantial premium to its tangible book value.
Additional Disclosure: This article is for educational purposes only and it should not be taken as an investment recommendation. Investing in stock markets involves a number of risks and readers/investors are encouraged to do their own due diligence and familiarize themselves with the risks involved.