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If you can look beyond the serious problems facing the banking industry, this may be a terrific time to buy Bank of America (NYSE:BAC), one of the world’s strongest banks, at a steep discount to its true value and with a terrific dividend. That said, a purchase bears significant risk, as no one truly knows how the mortgage/credit crisis will play out or when.

Company/Stock Type: Large, mature growth company. Business = Domestic and international retail and commercial banking. Normally, this would be a stable business. But the banking and finance sector is beset with problems stemming from the still-ongoing sub-prime mortgage fiasco and general credit crisis.

Company Story and Quality: Bank of America (BAC) is one of the largest banks in the world, second in the USA to Citigroup. It is the nation’s largest consumer bank. Its geographic reach is coast-to-coast, covering 80 % of the population. BAC enjoys significant advantages of scale, which it uses well to hold down costs. It has stated its aspiration to become "the country's top retailer of financial services, with the size and scale to drive distribution and marketing efficiencies."

BAC has about 5700 offices (almost twice as many as anyone else), plus 17,000 ATMs, serving 59 million consumer and small business accounts. It is the largest Small Business Administration lender in the US. Outside the US, BAC serves clients in 175 countries. Altogether, the bank has a massive deposit base (almost $800 B), giving it a stable and low-cost source of funding. BAC’s retail orientation normally provides steadier business results than many other banks. In 2007, the consumer and small-business segment accounted for 63% of net income.

Of course, along with the whole financial sector, its results have become unsteady in the past year due to the mortgage and credit crises. BAC recently acquired troubled mortgage originator Countrywide Financial (CFC), which makes it the largest mortgage lender in the country.

At the moment, that may not be a great place to be, but long-term, with the imposition of sensible lending standards, the acquisition should become a positive for the bank. The original “bargain” price for Countrywide now seems questionable, because of the risk that many losses are still hidden in Countrywide’s assets. BAC posted unexpectedly good results in Q2 2008, with record net revenues, enough profits to cover its dividend for the first time in two quarters, and credit-related write-downs halved from the previous quarter. It had very good results in its commercial segment. BAC’s core business, retail banking, appeared to remain relatively strong, with deposits increasing and the company tightening its lending standards.

That said, BAC still probably has more mark-to-market write-downs in its future, although we can expect them to go down quarter-to-quarter. Most notably in its Q2 results, BAC did not cut its Q3 dividend, whereas many pundits thought it was a foregone conclusion that it would have to cut the dividend.

This fact alone, along with statements accompanying its Q2 report, suggest that BAC’s balance sheet may not require extraordinary steps to raise capital. The bank had displayed steady earnings increases for many years before being hurt in mid-2007 by sub-prime mortgage and similar credit-related write-downs. Its profitability has sunk to 8% ROE after many years of being in excess of 15%. BAC has paid dividends since 1903 and increased them for 30 consecutive years through 2007. An increase this year is probably not in the cards. Because of severe price declines in 2007 (-19%) and so far in 2008 (-26%), BAC is presently paying a rich 8.7% dividend.

Using my Easy-Rate™ scoring system for company quality, I rate Bank of America as “Good.” Of course, in the short term, any evaluation of BAC has high risk attached, and it ultimately depends on your views of the problems facing the whole financial sector. (More on this below.)

Valuation: At a recent price of $29.58, I rate BAC “Good+” in valuation, meaning that it is significantly undervalued. Its P/E ratio is 13, its Forward P/E ratio is 9, its P/CF (price to cashflow) ratio is extremely low at 5, and its P/B (price to book value) ratio is less than 1. Again, whether these are good valuation numbers or glaring red flags depends largely on your outlook for the sector.

Investment Thesis and Conclusion: Under normal circumstances, BAC would be a solid “Buy.” This is a stock that one would normally purchase for slow but steady growth, combined with a good dividend yield. Some investors would buy it mainly for its dividend, and right now that dividend is a sky-high 8.7%. Its valuation is attractive by almost any measure.

But these are not normal times for banks, and opinions differ widely on whether financials are great deals or value traps at this time. Analyst James B. Stewart, in a recent article in The Wall Street Journal, stated that "The current indiscriminate selloff in the financial sector makes no sense... This simply isn't rational." He thinks bank stocks like BAC are a raging “Buy.”

Since Stewart’s article, the SEC made it much tougher to short beaten-down financial stocks. And over the weekend, Congress passed a sweeping Housing Act. Its overall goals are to help homeowners stay out of foreclosure and keep mortgage giants Fannie Mae and Freddie Mac (which own or guarantee nearly half of the nation’s mortgages) from insolvency.

Will these steps be enough? There are very legitimate questions to ask about banks:

  • Will the earnings hold up?
  • Is the book value valid or illusory?
  • Will the dividend be maintained?
  • When will the housing decline end, and how?

Whatever your beliefs about banks as a whole, in my estimation, the balance tilts in favor of the Bank of America. It stands out among banks. Its Q2 results are heartening. While its 30-year string of dividend increases is probably over, Q2 would have been the time to cut its dividend. It did not see the need to do that. And I have faith that the banking industry will rebound—probably not short-term, but certainly over some longer time frame. If you hold BAC stock, I would certainly hold onto it. And if you do not own it, this may a chance to purchase shares in what will turn out to be one of the strongest banks in the world at a deep discount and get a great dividend in the process.

Disclosure: Author holds a long position in BAC

Source: The Long Case for Bank of America