On April 19, Bank of America Corp (BAC) released first quarter earnings with a lot of moving parts to them, but that were quite strong when you get past the noise. Every business reflected improved profitability versus the fourth quarter of 2011 due to better market conditions, and improved execution.
As written about before in my articles on Citigroup Inc. (C), and American International Group Inc. (AIG), there is a huge disconnect between business values and stock market values in the financial sector. Bank of America offers an extremely compelling risk reward opportunity, trading at just over 4 times normalized earnings, and with a balance sheet that is among the strongest in the bank's history. For investors looking to double their money while obtaining a strong dividend yield over the next 3-5 years, there are few better opportunities than this out of favor gem.
The bear argument against Bank of America is primarily predicated on unjustified concerns on its accounting. I say that the concerns are unjustified because banks have never been under closer scrutiny than they are currently, and banks financial statements are always most transparent after a financial crisis as loan disclosures are improved dramatically. Activities such as the stress test and the overly ambitious Dodd-Frank have created an arguably overly capitalized banking sector, as opposed to the hideously leveraged monster that existed pre-Lehman.
The second bear argument revolves around risks pertaining to Bank of America's HELOC and rep and warranty exposures. A basic understanding of credit cycles tells the investor that the majority of loan losses and provisions have been taken long ago; as homeowners still paying on their mortgage, whether it is underwater or not, are doing everything in their power to stay current. Bank of America has reserves of 3.6% of loans and leases outstanding which equates to 2 times the current level of annualized credit losses. Whether its credit cards, 1st lien mortgages, or HELOCs, banks have shown 10-12 consecutive quarters of improving credit metrics. During that time these banks have continued originating solidly underwritten loans with attractive yields.
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BAC in the first quarter was due to new guidance effecting all of the banks on the accounting of Home Equity NPAs ($1.85b), but excluding that nonperforming loan trends continued to improve. Bank of America has $15.8 billion reserved for reps and warranties with the primary growth driver being requests from the GSE's. The $3.1 billion and $4.9 billion in reserves for the Monolines and Private Mortgage purchases should be adequate to cover future costs including a likely settlement with MBIA Inc. (MBI), and even if we assume an unlikely 50% increase in GSE liability we are only talking about $4 billion pretax as it has $8.1 billion reserved. That is hardly a game changer for a company with a tangible net worth of $139 billion or $12.87 a share.
At a price of $8.77 BAC trades at a 31% discount to tangible book, and a 55% discount to book value of $19.83. CEO Brian Moynihan has done an extraordinary job building capital with a Tier 1 common equity ratio of 10.78%, up 2.5% just since the 2nd quarter of 2011. The company has $406 billion of global excess liquidity, which hurts net interest margins when combined with low interest rates. Moynihan has expenses dropping 5.6% since 4Q 2011, but this story will get drastically better as currently the bank has $3 billion in quarterly costs tied to mortgage servicing in excess of what would be needed on a normalized basis. These costs should go down sequentially on a quarterly basis over the next couple of years as assets are worked out or disposed of.
Bank of America's earnings power is explosive with the addition of Merrill Lynch. $35-40 billion of pre-tax, pre-provision income is realistic as net interest margins improve over the next couple of years, and with Merrill's higher margin businesses I believe that a 15% return on tangible book value is certainly within reach. This would equate to $1.90-$2.00 of normalized earnings power and a simple 50% dividend payout ratio at some point in the future would bring $1.00 per share per year, or 11.4% at current prices. The math gets even sillier when you factor in potential share buybacks if the stock continues to trade below tangible book value. I believe the banks offer a simple time-arbitrage in that either the stock will go up to tangible book at the least, or eventually they will buyback stock aggressively boosting the stock value substantially higher than what could be achieved without the buyback.
Capital markets still have plenty of room for improvement and Merrill is perfectly situated to benefit. I expect to see mortgage refinancing and originations pick up, as investors and lagging home buyers come to realize that these record low mortgage rates, combined with low priced home values aren't going to last forever. Moynihan is a welcome reprieve from the disastrous and imperialistic prior regime, because he has conveyed a clear and concise plan and is executing on the core businesses.
For investors looking for revenue growth, reduced expenses, increasing margins, and a soon to be fast-growing dividend payout, Bank of America offers one of the most compelling opportunities available. For investors seeking additional leverage to the upside, the warrants are an attractive option. There will always be naysayers and conspiracy theorists, but as Buffett says, "if you wait for the robins, spring will be over."
