Bank Of America: The Positive Implications Of The Fine Imposed

Aug.12.14 | About: Bank of (BAC)

Summary

Final penalty announced: $16 billion; where more than 50% of the fine will be paid in cash and the remaining balance will be directed for consumer assistance.

Foreign earnings can be used to settle this penalty, which will ultimately reduce the foreign profit base on which double taxation is applied upon repatriation.

The portion of consumer relief will be tax-deductible and will derive cash savings of $1.26 billion.

The bank has increased its quarterly dividend by a staggering 400% to 5 cents per share.

The scrip is undervalued based on P/TBV valuation, the most suitable measure for banks.

The final verdict by the Department of Justice "DOJ" has marked an end to the series of penalties charged for the wrong acquisition picks by Bank of America Corporation (NYSE:BAC). The bank has already paid out $60 billion to clear up the mess and repurchase mortgage-backed securities. The final amount has been settled at $16 billion, where more than 50% of the fine will be paid in cash and the remaining balance will be directed for consumer assistance.

Let's take a look at the impact this penalty will have on Bank of America's financial position.

Part 1: The Cash Component

The financial giant has agreed to pay $9 billion in cash to the US Federal Government. The penalty will not be tax-deductible. The company's cash balance stood at $152.9 billion as at June 30, 2014. Following the payment of the fine, it will plunge to $143.9 billion. Consequently, the bank's cash ratio will trim down to 0.085 from 0.09.

On the contrary, the bank can use this penalty to its advantage. It has approximately 264 subsidiaries operating in different parts of the world for tax reasons. Under normal circumstances, repatriations of profits from these subsidiaries to the US will generate a huge tax liability for the bank. Since in any case the profits earned and the fine both do not provide tax benefits, the foreign earnings can be used to settle this penalty. This will ultimately reduce the foreign profit base on which double taxation is applied upon repatriation and elevate the bank's bottom line.

According to James Hines, an expert on corporate taxation and a professor of law and economics at the University of Michigan's law school, "If B of A has to make a potentially non-deductible fine payment to the U.S. government, it will prefer to have the obligation formally the responsibility of an affiliate in a foreign country".

Part 2: Future Relief To Borrowers

The remaining chunk of the total penalty pie, i.e. $7 billion, will take the form of consumer assistance for house owners, where either their loans will be completely or partially written off or given discounts. The positive news for the bank is that this $7 billion will be treated like an ordinary business expense and will be tax-deductible, which is expected to translate into cash savings. With constant regulatory whips that the bank continues to bear, this can be a sort of relief for the bank and will decrease the bottom line effect of the penalty charged.

According to Robert Willens, a tax and accounting expert in New York, "There's no question they will get this deduction and that it will help them".

Based on the 18% tax rate charged in the second quarter of fiscal year 2014, the company will be able to derive cash savings of $1.26 billion. On a per share basis, this will reduce the impact of the fine from 152 cents to 140 cents.

All's Well That Ends Well

While Bank of America is no longer pursuing its share repurchase plan, the bank has increased its dividend by a staggering 400%! The bank will now be paying 5 cents per share on a quarterly basis, up from 1 cent per share, after it received the green signal from the Federal Reserve. Caught up in the mortgage mess created by Countrywide and Merrill Lynch, the bank was completely strangled in the litigation issues. The dividend increase has finally been authorized and announced after seven years.

Being the most heavily penalized financial institution in the US for selling faulty mortgages, Bank of America has seen the balance of its deferred tax assets rise to nearly $30 billion in the post-financial crisis period. While the bank cannot encash this asset, it has benefitted by getting its increment in dividend approved without generating an ordinary tax bill.

Apart from Citigroup (NYSE:C), who failed to get its dividend raise approved by Fed two times in a row, Bank of America is still a lot behind its peers. JPMorgan & Chase (NYSE:JPM) has succeeded in raising its dividend from 30 cents to 40 cents per share, whereas Wells Fargo & Company (NYSE:WFC) has also increased its dividend by 108%, from 12 cents to 25 cents, in the previous two years.

Final Call

As the bank pays off its last blow of penalty, the gradually improving performance of the company will finally be highlighted by the analysts in front of the investors, which had been suppressed by the litigation clouds hovering over this stock until now.

From an investment standpoint, this can be a blessing in disguise as of now, and in fact, an attractive entry point. I have utilized P/TBV valuation to support my opinion. Since a majority of the assets on Bank of America's statement of financial position are highly liquid and have an active market for them, valuation based on tangible book value is an apposite measure. Based on the most recent quarterly results, the company's P/TBV is 1.01, as compared to the industry average of 3.03. This reaffirms the current undervaluation of the stock.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.