After showing positive earnings along with the other major banks, what happened to Bank of America (BAC)? Here we have a large bank stock that possibly could double in value in a few years with a strong dividend building. Banks, after a period of intense scrutiny by the U.S. government, have never been more transparent. Common sense would tell the average investor 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.
JP Morgan, Morgan Stanley (MS), US Bancorp (UBS), Goldman Sachs (GS), and Capital One Financial (COF) have beaten EPS estimates by sizable margins, the post-earnings valuation multiples stand to be even more attractive.
However, CLSA analyst Mike Mayo downgraded his rating for BAC to a "Sell" from "Underperform" with an $8 price target. His position is that the bank's first quarter report is going to be as good as it gets for the year. It is true Bank of America reported adjusted earnings of 31 cents a share last Thursday morning, besting the Street's estimate of 11 cents a share by a significant margin. It joined JP Morgan, Morgan Stanley (MS), US Bancorp (UBS), Goldman Sachs (GS) and Capital One Financial (COF) by beating EPS estimates by sizable margins. However, Mr. Mayo believes the stock is expensive and does not believe it can reduce long term expenses anymore without hurting the company. Expenses have dropped 5.6% since the fourth quarter of 2011, but it isn't enough. And projecting the company's profits in 2013 will not be near what is expected of a company with (Bank of America + Merrill Lynch).
One of the key elements of this negative report is the Bank's Valuation Adjustment. A major part of Bank of America's accounting practices (and a regular for most banks) is the mention of the "Negative Valuation Adjustments of $4.8 Billion Pretax."
This means the bank took a $4.8 billion hit from an accounting adjustment. If a bank's debt securities are losing value, this means its liabilities (the amount it owes) are not worth anything. This is good for accounting. It can be put on the income statement as a gain. Some of the banks debt securities in the first quarter gained in value, which means those liabilities increased in value and produced a loss of $4.8 billion in earnings.
How does falling debt prices (a sign that investors do not trust the bank's credit) lead to a gain in profit? Are we supposed to ignore the loss when calculating core earnings? Its long term debt rose to 2.99% the first quarter of this year, up from 2.8% the last quarter of 2011. It appears debt markets may not like Bank of America after all.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.