Fear Not The Street: Bank Of America More Than Prepared For Upcoming Fine

| About: Bank of (BAC)
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Retail and institutional investors are panicking over whether or not Bofa will be able to sustain the DOJ's upcoming fine.

Investors are failing to see how much cash Bofa is actually generating and how large their asset base is.

Despite the upcoming lawsuit/settlement with the DOJ, Bofa has not fundamentally changed.

Last week, Bank of America (NYSE:BAC) sold off about 5% after the Department of Justice rejected its $12 billion settlement offer. The DOJ has demanded $17 billion from Bofa for illicit mortgage practices. There has been much speculation about how severely Bofa's financial health will be effected in the event that they are fined this monumental sum. Through cash flow and revenue analysis, I will determine if a $17 billion fine (assuming worst case scenario) will drastically impair the financial health of Bofa and hurt shareholders.

In 2013, Bank of America generated about $11.5 billion in net income. As you can see from the graph below, their 2013 net income was substantially greater than prior years, indicating a turnaround. Decreasing interest, non-interest, and loan-loss expenses, combined with increasing non-interest income, contributed to Bofa's large gain in net income. They returned an impressive 90 cents to shareholders in 2013 compared to 25 cents in 2012. Despite 2013's net income advancement to pre-crisis levels, 2013 EPS is not in line with the increased net income. The relative increase discrepancy between net income and EPS is attributable to the dilution of common stock during the financial crisis. Higher liquidity demands during the crisis, driven largely by Bofa's acquisition of CountryWide Financial and Merril Lynch, prompted the bank to issue more stock. Below, I have graphed Bofa's EPS, net income, and shares outstanding. If the Fed approves Bofa's new capital plan in August, which will allow the board to initiate a new share repurchase plan, shareholders could see massive EPS growth.

Earnings Per Share

Img. source: Factset

Net Income

Img. source: Factset

Shares Outstanding

Img. source: Factset

So the question remains: What effect, if any, will a $17 billion fine have on Bofa's shareholders? That question is hard to answer due to a large number of factors that may come into play. By the time the lawsuit with the DOJ is settled, Bofa may be well into their share repurchase program. In this case, the fine felt by shareholders will be mitigated as the number of shares outstanding could be greatly reduced. On the other hand, the Fed may not find Bofa's capital levels sufficient to initiate a share repurchase and dividend increase. In this case, unless Bofa can naturally expand their net income through revenue growth, a $17 billion fine could drastically hurt shareholders. However, based on the fact that Bofa grew their net income by about 65% in 2013 despite continuing fines and low interest margins, I would be surprised if the $17 billion drastically impaired EPS growth.

While net income is useful for calculating profits directly available to shareholders, free cash flow is a better metric to determine how much actual cash is generated and available to bolster shareholder value. Since the financial crisis, Bofa has strengthened its free cash flows largely on behalf of asset purchases by the Federal Reserve. The step-by-step breakdown to calculate free cash flow is long and intricate. For that reason, I just want to walk through the major steps. Funds from Operations (all graphs shown below) is the baseline of free cash flow for financial institutions. Funds from Operations is essentially calculated by adding back non-cash deductions to net income. Amortization of intangibles, deprecation, and provision for credit losses are some of the major non-cash metrics added back in to calculate FFO. Below the FFO graph, I included a graph showing Bofa's non-cash provision, or their subjective budget allocation for loan defaults. As expected, Bofa wrote off a large pile of cash during the crisis, which was designated to deal with loan defaults. Loan-loss provision has diminished as fewer people are defaulting on their loans, so FFO is beginning to more closely match net income. Jumping down to Change in Working Capital, it is evident that Bofa is generating additional cash largely through the sale of securities to the Fed, as I mentioned earlier. ∆Working Capital in 2009 indicates that Bofa generated a shocking $60 billion in cash from the sale of credit instruments (largely comprised of MBS) to the Fed. Also included in the calculation of FCF are capital expenditures, issuance/reduction of additional debt, and sales of fixed assets among many. Since the financial crisis, Bofa has generated positive FCF in all but one year. From positive FCFs, Bofa has accumulated a staggering $130 billion in cash, which is waiting to be lent out to borrowers, spent on business investments, or returned to shareholders. Using FCF is a better metric than net income to gauge a financial institution's overall cash generation. Net income deducts non-cash expenses such as, in this case, amortization of intangibles and loan-loss provisions, and it also neglects cash generated through the liquidation of assets, the build up of current liabilities, and cash flows from investment activities. So while some may argue that shareholders are unprepared for such a massive fine, as Bofa's 2013 net income alone does not even come close to the sum of the fine, they are wrong. Bofa is more than prepared for this fine through their large cash reserves and their continued generation of FCFs.

Funds from Operations

Img. source: Factset

Loan Loss Provision

Img. source: Factset

Change in Working Capital

Img. source: Factset

∆Working Capital 2009

Img. source: Factset

Free Cash Flow

Img. source: Factset

Cash & Due From Banks

Img. source: Factset

The bottom line is that Bank of America is financially stable and in a good position to grow. While $17 billion may in fact temporarily hurt earnings, Moynihan has plenty of free cash sitting in his vault to give a few bucks back to shareholders. All who have stock in Bank of America fear not. Let the traders and shorts bash Bofa. I do not doubt that in the near term, the stock may continue to be pushed down by negative news. However, think twice before you sell your Bank of America stock. Net income is up, Merrill Lynch is compensating Bofa's weak commercial side through exposure to booming capital markets, net interest margins will rise as interest rates increase, as the economy turns around consumer lending will pick up, and Bofa's mortgage-related troubles should come to a close with the DOJ settlement. This is only the beginning of the turnaround. Stay long!

Disclosure: The author is long BAC. 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.