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Summary

  • The stock appears to be fundamentally undervalued but is going to have a difficult time moving up until it can determine the full impact of ongoing litigation and non-performing loans.
  • The $1.27B settlement related to Countrywide's "Hustle" program is a step in the right direction but there will likely be more fines on the way.
  • Legal issues have spilled over to the company's bottom line further limiting any short term upside in the stock.
  • Short term investors may want to consider a big bank alternative like Citigroup in the meantime.

Bank of America (NYSE:BAC) has been a company all over the news the last few years but mostly for the wrong reasons. The company continues to be weighed down by the fallout of the financial crisis including billions of dollars in toxic loans that were underwritten as well as the less than ethical pre-crisis behavior by Countrywide Financial.

The latest is the $1.27 billion settlement for the bad loans issued through Countrywide's "Hustle" program. Bank of America is attempting to move past all of its legal issues but appeals (B of A is supposedly deciding whether or not to appeal the "Hustle" verdict), settlement negotiations (still ongoing with the Department of Justice and the two sides remain billions apart) and litigation that may yet be on the horizon. While Bank of America has managed to settle several legal issues there's still no real end in sight.

And it's a bit of a shame too because if you look at the fundamentals you could make an argument that this is a much undervalued stock. Bank of America stock currently trades at about a 30% discount to its book value. While the stock hasn't traded anywhere near its book value since the financial crisis hit it does demonstrate that the stock has room to run once Bank of America can be traded like a normal company.

Similarly, the stock's price to sales ratio remains far below competitors. Bank of America's ratio has been steadily climbing for the last two years but its current ratio of 1.85 is far below those of Citigroup (NYSE:C) (2.14), JPMorgan (NYSE:JPM) (2.31) and Wells Fargo (NYSE:WFC) (3.23). Throw in a forward P/E ratio of around 10 and you could see why value investors may be interested on fundamentals alone.

But there are just too many headwinds and other issues at play before Bank of America stock can widely be considered a buy right now. The black cloud of past and ongoing litigation risk is continuing to affect the company across the board.

On the earnings front, Bank of America has missed analyst forecasts badly over the last two quarters. Consensus estimates call for full year 2014 earnings to come in at $0.79 per share. That would be down from 2013's $0.90 per share. As a result, analyst estimates for future quarters and for full year 2015 have been dropping as well.

Revenue growth has been a problem for Bank of America as well. 2014 revenue has been flat when compared to 2013. 2015 revenue is only expected to rise by 3% over 2014. ROE and ROA figures also significantly trail those of Citigroup, JPMorgan and Wells Fargo.

In order for Bank of America's stock to become a more attractive investment, I'd look for a few of the following circumstances to take place:

Rise in interest rates

Interest rates have remained very low for a long time fueled in part by the Fed's quantitative easing program. But the Fed has already begun dialing back on QE and is getting prepared to let the economy fly on its own. Last week, the market dropped significantly on positive economic data that suggested the Fed may be ready to raise interest rates soon.

The implication is that the time is drawing near for interest rates to rise. Rising rates will boost the company's interest income and that will help lead the recovery.

Reduced cost cutting

This sounds a little counterintuitive, so let me explain.

I'm not suggesting that Bank of America's recent cost cutting efforts have been a bad idea. In fact, it's the opposite. Through layoffs and other measures, the company is expected to net itself around $2 billion in savings. This will undoubtedly be used as a cushion for litigation expenses.

But cost cutting is often a short-term fix, not a long-term solution. It can be used as a buoy in tough times but costs can only be cut so far before the company ultimately has to perform again. Reduced cost cutting measures would be an indication that the company has built a solid base and is ready to grow organically.

Improved net interest income

This sort of ties the first two points together but provides a more all-inclusive view. Bank of America's net interest income figures have been trending lower over the last couple of quarters and seeing that trend reverse will signal a stronger bank.

Improved interest income through higher rates and better credit quality, lower interest expense through cost reduction and a better overall balance sheet quality through the reduction or elimination of non-performing loans will ultimately drive company income higher.

Settlement of legal issues

Yes, this is painfully obvious but the company needs to put its legal issues behind it. Some argue that the lawsuits are already priced into the stock but how can they be if you can't yet understand the full extent?

In the meantime, investors may want to consider parking their cash in another banking giant that's already moved past their legal troubles - Citigroup.

Citigroup is a solid value play in its own right. It carries a forward P/E ratio of just 9, its price/sales ratio is roughly 20% below the industry average and it sells at about a 25% discount to its book value. The big bank just reported solid earnings for the latest quarter and is forecast to grow EPS almost 40% in 2015. Perhaps most importantly, Citigroup just settled with the government regarding its role in the financial crisis for $7 billion - a number lower than it could have been. This helps eliminate the cloud of uncertainty that is still floating above Bank of America.

Conclusion

On a fundamental basis alone, Bank of America stock looks like it could be a solid value play but there's just too much other stuff going on right now. The company really can't do anything right now until it's able to ascertain the full impact of its bad loan activity. Not only that but Bank of America needs to continue to address non-performing loans that are still on the company's books.

The company's fortunes should be able to turn once the outstanding litigation issues are settled but there's just no telling when that will be. Bank of America is sitting a mountain of cash which could easily be used to complete the stock buyback or raise the dividend but they can't really do that until they know how much capital will need to be dedicated to legal settlements.

Long term shareholders may want to hang on and ride things out but in the short term investors may want to consider an alternative like Citigroup because there's little reason to think that Bank of America stock will be anything but range bound.

Source: Bank Of America: Short-Term Obstacles Outweigh Long-Term Value