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Summary

  • Analysts at Deutsche Bank have turned positive on Bank of Amerca.
  • While potential catalysts could push shares higher, I am still worried about further litigation risks and potential multi-billion dollar settlements.
  • As a potential dividend hike approval could be delayed again as the bank faces renewed investigations, upside is limited in my appeal.

Shares of Bank of America (NYSE:BAC) were a prominent gainer on Wednesday as analysts at Deutsche Bank turned positive on the prospects of the bank. Analysts see potential catalysts for the shares, as current issues and worries have been priced into the stock already.

I don't necessarily share the optimism, as more multi-billion dollar settlements could delay the Federal Reserve's approval of a potential dividend hike even further ahead in time.

Reasons Behind The Upgrade

The analyst team at Deutsche Bank led by Matt O'Connor upgraded its rating on the bank from hold to buy, citing that the negative catalysts regarding potential multi-billion settlements were fully priced into the stock.

O'Conner believes that the bank has potential catalysts which can push shares higher. This includes a potential improvement in capital market revenues, higher interest rates and an improving US economy. These factors apply to more large US banks, which furthermore benefit from stronger credit issuance and higher M&A activity, among others.

Despite the bullish call, O'Conner sees second-quarter earnings down by 5 to 10% compared to the year before for large US banks. Earnings are seen flat compared to the first quarter, as tapering effects of the Federal Reserve have continued to put pressure on fixed income desks.

A Bank Facing Troubles

Despite the solid performance of equity markets which are trading at all-time highs, it has not been easy for shares of Bank of America to participate in the year-to-date gains. The 2% gains in Wednesday's session mark the entire year-to-date gains, as shares were trading flat for the year on Tuesday.

Like many banks in today's world, it is not credit losses which are keeping investors up at night. The latest trend in the financial sector is the potential for multi-billion dollar fines related to mortgage settlements, price manipulations or the facilitation of criminal activities which limit appeal.

In the specific case of Bank of America, the continued overhang from legal issues are causing worries, with the bank still in talks to settle with prosecutors.

According to press reports, the bank is close to reaching a $12 billion settlement with the Department of Justice related to allegations of defrauding buyers of mortgage-backed securities during the financial crisis.

This potential settlement is another costly episode for shareholders in the bank, after paying $6.3 billion in settlements regarding lawsuits filed by the Federal Housing Finance Authority in March of this year. According to Reuters, total litigation costs have come in around $50 billion, which even excludes the latest potential settlement. More settlements might even be on the horizon regarding investigations in its foreign exchange trading activities.

Lack of Dividends

Before the financial crisis hit, Bank of America was a true dividend champion, paying quarterly dividends of $0.64 per share, which provided investors with a decent 5% dividend yield around $50 per share. Over the past few years, investors have received quarterly dividends of merely a penny, as the bank still does not have approval to repay a more attractive dividend again.

As the shareholder base has diluted from roughly 4.5 billion shares ahead of the crisis to about 10.5 billion shares at the moment, a comparable dividend would amount to roughly $0.28 per share. Even when the Federal Reserve would approve a dividend hike, it is unthinkable to see Bank of America being able to pay such steep dividends again.

Part of the reason for the decision by the Federal Reserve is, of course, the continued litigation risks. A shocking $4 billion accounting error regarding the bank's regulatory capital did not help either.

My Takeaway On The Bank's Prospects

Back in January, when the bank posted its fourth-quarter results, I last had a look at the prospects for Bank of America. I was pleased with the solid topline revenue growth of the bank at the time. I furthermore noted that the bank was reporting earnings of about $14 billion per annum, while it was making progress in cutting costs.

With shares trading around $17 per share at the time, which valued equity around $180 billion, I concluded that shares offered not much appeal at roughly 13 times potential earnings. To become interesting for me, earnings would have to improve further to levels above the $15-billion mark. At the time, it appeared to be a difficult task ahead in my eyes, as cost cuts could be offset by an increase in allowances for bad credit, which were at unsustainable levels.

Ever since, we have seen the accounting errors in the bank's capital levels, multi-billion mortgage-related settlements, poor trading conditions and relative softness in the mortgage origination market. News about new investigations related to FX markets have made investors more than ever aware of risks related to more potential settlements. As such, I believe settlement costs are more structural than I previously anticipated, requiring me to essentially discount earnings for years to come.

As such, I conclude to remain on the sidelines given the continued and significant risks related to tougher regulations and multi-billion dollar settlements. These issues, especially if the bank has to pay multi-billion dollar settlements, could delay the approval of a dividend hike for some time to come, limiting the appeal in my eyes at the moment.

Source: Bank Of America - As Deutsche Turns Bullish, I Remain Cautious