It has been over four years since the subprime lending crisis that transformed into the Global Financial Crisis (GFC) and shook the global financial system to its core. It saw many high profile global financial institutions collapse or reach the brink of collapse and require government bailouts to prevent their collapse. One of the largest and most high profile of these institutions is Bank of America (BAC). Unlike many of its peers, Bank of America continues to shuffle along, lurching from one crisis to the next, with market pundits split between whether it represents a deep value long-term investment play or is a stock to avoid.
Prior to the GFC, Bank of America had an extensive Latin American franchise, which formed a key plank in its non-domestic growth strategy. As a result, when analyzing the performance of Latin American banks across the region, I have frequently used Bank of America as an indicative point of comparison. This has meant that I have been reviewing the bank's performance on a regular basis, which has led to the emergence of this article. Subsequently, in this article, I am going to attempt to determine the true value of Bank of America in order to find an indicative fair value and deduce whether it is a deep value investment for the long-term investor.
Improving Financial performance continues to be challenging
The next question was where to start conducting this analysis given that Bank of America, for want of better words, is a complex beast to analyze. On this basis, I thought the best approach was to get back to basics, review the bank's recent financial performance, and, in particular, whether it is improving.
For the third quarter 2012 in comparison to the second quarter (QoQ), revenue fell 7% to $20.4 billion, while net income fell by 86% to $340 million. This also represents a significant fall in both revenue and net income over the last year, as the chart below illustrates. This pattern is particularly concerning when the two trendlines tracking revenue and net income since the end of 2010 are observed.
The reason for this concern is that over the same period, the U.S. economy grew by 2% in the third quarter, and since the end of 2010, has grown by 2.5%. Yet over the same period, Bank of America's revenue has declined by almost 9%. This is obviously having a significant impact on the bank's profitability and investor confidence, and is one reason why the bank is trading at a significant discount to its tangible book value.
While many of Bank of America's peers [including the three other U.S. domiciled banking majors JP Morgan (JPM), Wells Fargo (WFC) and Citigroup (C)] have been able to grow the value of their loan portfolios since the end of 2010, Bank of America's has shrunk. As the chart below illustrates, its loan portfolio over this period has fallen by 5% in value, to a current value of $893 billion.
Source data: Bank of America, JP Morgan, Wells Fargo, Citigroup Financial Statements First Quarter 2011 to Third Quarter 2012 & Federal Reserve Bank of St Louis.
This indicates that Bank of America is having problems generating new business in its core franchise of lending, and obviously, a shrinking loan portfolio affects the bank's ability to grow its revenue. I believe this is one reason why the bank is continuing to experience falling revenue, despite reporting a significant drop in loan loss provisions as a result of the improving quality of its loan portfolio. This improvement in quality is evidenced in the 65% fall in loan loss provisions since the end of 2010 to now be at a post-GFC low of $1.8 billion, which I believe to be a remarkable achievement, given the state of Bank of America's loan portfolio.
But disappointingly, not only is Bank of America's loan portfolio shrinking at a time when many of its competitors are expanding, but its deposit base is growing significantly more slowly. Since the end of 2010 the bank's total deposits have only grown by 5% to $1 trillion, with this rate well below the growth rates seen by its main competitors as the chart below illustrates.
This rate of growth is almost half of Citigroup's 9%, almost a third of Wells Fargo's 14% and less than a quarter of JP Morgan's 22.5% for the same period. Normally this would indicate an increasing reliance upon more costly wholesale funding and short-term borrowings to fund its loan. But more positively, given that the total loan portfolio value is decreasing, it indicates that the bank is deleveraging and increasing liquidity.
Deleveraging is improving the funding mix and increasing liquidity
The ongoing quarterly decreases in the bank's long-term debt is further evidenced by a deleveraging process, in which long-term debt has fallen by 28% since the third quarter 2011 (YoY) as the chart below shows.
Source: Bank of America 3Q12 Financial Results.
By engaging in this deleveraging process, Bank of America is actively improving its funding mix and reducing its dependence on wholesale and short-term credit markets. This should help to improve the bank's profitability and reduce the impact of short-term interest rate movements while improving liquidity. In fact, the change in funding mix and focus on deleveraging has seen the bank significantly improve its liquidity, with its loan-to-deposit ratio falling by just over 7% since the first quarter 2011 to 84% as the chart illustrates.Source data: Bank of America, JP Morgan, Wells Fargo, Citigroup Financial Statements First Quarter 2011 to Third Quarter 2012.
While this loan-to-deposit ratio is higher than the bank's major U.S. domiciled peers, it is well within acceptable parameters and is below what is seen as the optimal range of 95% to 105%. This is regarded as the optimal range because it allows a bank to generate the maximum benefit from its deposit base, while ensuring sufficient liquidity to cope with extraordinary or unplanned events. However, given Bank of America's previous history and ongoing issues relating to litigation and lack of investor and customer confidence, which will be discussed in further detail later in this analysis, a higher degree of liquidity is preferable.
Growing capital adequacy indicates a greater awareness of risk
Bank of America has also focused on increasing its capital adequacy as part of the deleveraging process, primarily for two reasons. Firstly, in response to the U.S market risk rules and Basel III requirements and secondly, as a means of improving investor confidence by better equipping the bank to deal with any further adverse events. As a result, as the chart below illustrates, the bank has worked towards boosting its tier one common capital ratio, with it increasing by almost three full percentage points to 11.4% since the third quarter 2011.
Source: Bank of America 3Q12 Financial Results.
It is important to note that this is the bank's tier common capital ratio, which is its tier capital ratio excluding preferred stock, trust preferred securities, hybrid securities and minority interest, divided by risk-weighted assets. Bank of America's tier one common ratio, with the exception of Citigroup, is superior to its main U.S. peers as the chart below shows.Source data: Bank of America, JP Morgan, Wells Fargo, Citigroup Financial Statements First Quarter 2011 to Third Quarter 2012.
All of this indicates that Bank of America is well on its way to meeting the Basel III capital requirements, along with the additional capital requirements required for an institution defined as being a globally systemically important institution. It also indicates that Bank of America's deleveraging plan is progressing well, with capital adequacy and liquidity being boosted. This has seen all of the keys risk measures moving well within acceptable levels.
Accordingly, liquidity, funding mix or capital adequacy, are not the reasons for the bank's ongoing poor performance nor do they explain the poor sentiment among investors towards the institution. This leaves asset quality as the next major indicator to be examined in order to ascertain why the bank continues to underperform.
Asset quality is improving along with lower charge-offs and loan-loss provisions
It was the bank's extremely poor asset quality and overexposure to substandard loans that almost saw it collapse during the subprime lending crisis and require the injection of federal government bailout funds. This also sits at the heart of many of the bank's legal and regulatory issues. Currently, Bank of America's asset or loan portfolio quality as represented by its non-performing loan (NPL) ratio at 2.6% is higher than its major competitors but lower than the U.S. national NPL ratio of 3.7% as the chart below illustrates.
It should also be noted that its NPL ratio is well within acceptable parameters, being almost half of the 5% marker, which is considered to be the point at which a loan portfolio's quality becomes questionable. Furthermore, as mentioned earlier, Bank of America's loan loss provisions have fallen significantly further, indicating that the quality and profitability of its loan portfolio has increased significantly.
As the table below shows, loan loss provisions on an adjusted basis for the last year have fallen to $1.4 billion, while for the same period net chargeoffs have decreased by 37% to $3.2 billion.
All of this indicates that the profitability of Bank of America's loan portfolio is improving along with its quality, particularly when it is considered that the economic cost associated with loan loss provisions has been reduced.
However, Bank of America's NPL coverage ratio, while adequate at 112%, is lower than its peers as the chart below indicates.
The coverage ratio is representative of the degree of risk within a bank and in the case of Bank of America, the low coverage ratio, which is substantially lower than the other U.S. majors, indicates that it is carrying greater risk. But at 112%, Bank of America's coverage ratio is within acceptable parameters.
Another concern is that by keeping its coverage ratio low, particularly in comparison to its peers, Bank of America is able to boost its profits by utilizing those funds that should be allocated to its loan loss reserves for revenue generating activities. This is particularly concerning, because, as this article will illustrate, Bank of America's profitability is particularly poor and those funds are artificially boosting profitability.
Efficiency and profitability remain poor and will do so for the foreseeable future
Despite Bank of America's risk, capital adequacy and liquidity indicators all being within acceptable parameters, it continues to trade at a substantial discount to its book value per share. Currently Bank of America is trading at around a 51% discount to its book value per share of $20.40, but this falls to a discount of around 34% when compared to its tangible book value per share of $15. This indicates that the bank is facing a considerable number of pressures affecting its profitability, considerable risks and an image problem among investors, in order to be trading at such a substantial discount.
First among these issues is the bank's poor operational efficiency, with it currently operating with an efficiency ratio of just under 85%. This is essentially a measure of how efficiently a bank is operating, and how cost effectively it is able to generate revenue for every dollar of expenses incurred. Generally, the lower the ratio, the more cost efficiently and productive a bank is at generating revenue, with a ratio of 50% or better seen as being optimal.
But investors should recognize that the U.S. is a higher cost environment, with higher demands from customers for better service and greater degree of bank infrastructure, which increases their operational costs. This particularly so in comparison to the Latin American banks that I normally analyze, which generally have efficiency ratios of well under 50%.
However, despite this, Bank of America's efficiency ratio is still particularly high and indicates, with the exception of Citibank, that it is a highly inefficient bank in comparison to the other major U.S. banks. As the chart below shows, JPMorgan's efficiency ratio for the last quarter was an acceptable 61% and Wells Fargo's an impressive 57%.
Interestingly, it is Bank of America and Citigroup that have had to manage the greatest amount of fallout from the subprime crisis, combined with poorly thought out acquisitions, the financial and reputational impact of regulatory investigations, as well as costly litigation.
Added to this situation, both banks are incurring additional costs for managing large books of subprime loans, legacy assets and other non-accrual loans that have been quarantined from their balance sheets. The ongoing management of these assets comes with a considerable economic cost, because not only are accounting and administration costs incurred, but Bank of America is unable to redirect those funds to activities that are likely to produce revenue and enhance profitability.
As at the end of the third quarter 2012, Bank of America's least efficient business was its Consumer Real Estate Service, which had an efficiency ratio of 136% as the chart below illustrates. However, this is understandable because this business segment is responsible for the manufacturing and administration of the bank's mortgage products, as well as its legacy assets.
However, the efficiency ratio for the bank's consumer and commercial banking divisions, both domestically and globally, are delivering solid efficiency ratios of around 57% and 49% respectively. These are well in line with the efficiency ratio of its U.S and global banking peers. Furthermore, the higher efficiency ratios of the bank's global markets and wealth management segments are to be expected because these are higher cost qualitative focused businesses, with higher potential margins.
It is clear though, when analyzing Bank of America's profitability by way of its return-on-equity, that the bank is suffering and is currently incapable of delivering value for shareholders. At the end of the third quarter 2012 Bank of America reported a return-on-equity of 0.30% and a seven quarter average of just over 3%. This, as the chart below illustrates, compares poorly with the other major U.S. banks and is even significantly worse than Citigroup, which reported a third quarter return-on-equity of 1%.
When the bank's return-on-equity is analyzed by business segment, it is possible to see that again it is the Consumer Real Estate segment that is significantly detracting from the bank's profitability. For the third quarter this segment reported a return-on-equity of -6.6%. As the chart below illustrates, each of Bank of America's other main business segments are producing returns-on-equity that are well within an acceptable range, given the difficult operating environment.
Clearly, the bank's profitability will not improve until it is able to reduce the costs associated with its legacy assets and remove the litigation and regulatory burden it is now carrying. It would also appear that it will take some time for the bank to be able to wind down its legacy assets pool and this will continue to impact its profitability for the foreseeable future. Accordingly, I do not expect to see Bank of America's return-on-equity to improve for the long-term.
A poor net-interest-margin continues to hinder profitability
This pressure on the bank's profitability becomes even more acute when it is considered that Bank of America has a net-interest-margin (NIM) of 2.3%, which is the lowest NIM of the four major U.S. banks as the chart below shows.
Such a low NIM is obviously affecting the bank's profitability, and I do not expect to see it improve any time soon. I have taken this view because the bank is still expending considerable costs on managing its non-productive legacy assets, and operating in a low interest rate environment that is continuing to squeeze this margin. On top of this, there are additional costs being imposed by the bank's ongoing legal and regulatory issues that are also placing pressure on its margins.
Legal and regulatory risks continue to create significant uncertainty
Since the subprime crisis and its acquisition of Merrill Lynch and Countrywide, Bank of America has found itself caught in a legal maelstrom and found itself being the focus of attention of regulators. These legal and regulatory issues have come to dominate the risks faced by the bank, and have taken a considerable toll on the bank both financially and reputationally.
It was only in April this year that the bank agreed to settle an investor class action suit concerning its acquisition of Merrill Lynch, during the global financial crisis for $2.4 billion. Prior to this, Bank of America paid out $11.8 billion for its mishandling of troubled mortgage borrowers and foreclosures and has agreed to pay out around $8.5 billion to investors who demanded it buy back virtually worthless mortgage bonds issued by Countrywide. Yet this final issue has yet to be formally settled and may still blow up in the bank's face and cost it even more to finally settle. It has also agreed to reduce the collective balance of its mortgagors by around $4.75 billion as part of its obligations under the federal assistance package that it was granted as a result of the GFC.
Besides the direct financial impact of these suits, the ongoing costs of managing this litigation have been tremendous, having both a direct and consequential impact on profitability. For the third quarter alone, Bank of America reported that it had recorded $1.6 billion in legal costs, which is obviously directly affecting the bank's efficiency and profitability. On top of this there is the economic cost, with the funds used to pay these expenses being diverted from revenue producing activities. This is clearly affecting the bank's profitability and is one of the reasons its return-on-equity continues to fall.
Then there is not only the financial impact that comes from managing all of this significant litigation, but also the reputational impact. To date, it has had a significant impact on the bank's reputation across all stakeholders, including customers, the communities in which it operates investors and regulators. This I believe is having a significant impact on both the bank's profitability and share price and will continue to do so for some time.
Of even further concern, particularly for investors and the markets, is that the U.S. Department of Justice has filed a civil fraud action against the bank for $1 billion as a result of mortgage loans sold to Fannie Mae and Freddie Mac. Bank of America is also facing a money laundering probe with regard to allegations that it failed to appropriately monitor a series of transactions that allowed organized groups to launder funds. This certainly does not bode well for any improvement in the bank's efficiency and will more than likely see significant legal costs incurred for some time.
All of this creates considerable uncertainty for investors in Bank of America and does not bode well for the bank to be able to improve either its operational efficiency or return-on-equity until these matters are finally resolved. It also keeps the bank in the media and regulatory spotlight, further damaging its already significantly tarnished reputation. This makes it extremely difficult to ascertain the indicative fair value of the bank or be confident that there are no more legal or regulatory surprises in store. All of this contributes to the reasons for the bank to be trading at a considerable discount to its book value.
Excess return valuation signifies that it is fairly valued by the market
With all of these factors in mind, I have set out to value Bank of America using an excess return valuation, based upon the bank's tangible book value as the starting point. To arrive at the tangible book value, I deducted the bank's liabilities from its assets and then stripped out both intangible assets and goodwill to arrive at a tangible book value of $161.6 billion. This equates to a tangible book value per share of almost $15.
I have then, using Bank of America's payout ratio, projected return on equity, cost of equity and future growth prospects, applied a discount methodology to determine the present value of its future retained earnings over the next ten years. When determining these assumptions, particularly with regard to the bank's return-on-equity, I have calculated some conservative estimations in light of the ongoing issues discussed above. Using this data I have calculated an indicative value per share of around $11 as shown by the chart below.
In order to calculate Bank of America's return-on-equity, I have averaged out its reported return-on-equity for the last seven quarters, and then applied that for the full duration of the valuation period. I have also applied a discount rate that equals the weighted average cost of capital (WACC) calculated for Bank of America of around 7%. Finally, I have factored in a moderate rate of growth for the duration of the valuation of 2%. This is lower than the historical average of the U.S. economy of 3.4%, but allows for the economic headwinds currently being experienced, which I believe will continue for some time.
With Bank of America trading at around $10 at the time of writing, this indicative valuation represents a 15% upside for investors. Obviously, this does not allow for even a moderate margin of error for investors, leading me to conclude that at this time, Bank of America is fairly valued by the market. Furthermore, should the worst case scenarios eventuate for each of the bank's current legal matters, then this valuation will decrease in my estimation to around $9 per share.
Overall, as illustrated by this article, Bank of America continues to make considerable improvements across its business, particularly with regard to its capital adequacy, liquidity and funding mix. Much of this is being achieved by an aggressive deleveraging program, which is improving the bank's cost base and reducing its dependence on wholesale funding. This should ultimately lift profitability over the long term, although with the bank reporting a return-on-equity of less than 1% for the third quarter, it is clear there is still a considerable way to go.
As a result, I do not expect this program to benefit investors any time soon, and in fact, I believe it may take up to a decade for Bank of America to emerge from the quagmire in which it has found itself. This is because the bank is dealing with a range of complex issues that are increasing costs, reducing operational efficiency, and pushing down profitability. Key among these issues are the financial burdens caused by the ongoing management of its legacy assets, legal costs both direct and consequential, and the inability to effectively grow its core business of loans and deposits.
Furthermore, the bank is still wrestling with the impacts of significant reputational damage, which include decreased ability to generate new business and maintain market share. In all likelihood, it will take some time for the bank to overcome this particular issue. All of this is leaving the bank with a substandard efficiency ratio in a highly competitive and costly industry, along with a poor return-on-equity that on average for the last seven quarters has been less than the bank's own borrowing costs. It is also currently paying a nominal dividend that amounts to an annualized yield of around 0.4%, which is certainly not a particularly compelling yield for investors and unlikely to increase anytime soon.
It is for these reasons that Bank of America continues to trade at a significant discount to its book value and will continue to do so for the foreseeable future. When taking all of these factors into account the excess return valuation gives an indicative fair value of around $11, which only represents a 15% upside on the bank's share price at the time of writing. This is a particularly slim margin of safety, particularly for such a complex and troubled institution. When this is considered in combination with the other significant issues analyzed, I believe that it denotes that the Bank of America is currently fairly valued by the market. In turn, this leads me to conclude that those investors seeking exposure to banks in general and the U.S. banking sector in particular, would be better to avoid Bank of America for the time being and consider other opportunities among its national and international peers.