BANK OF AMERICA CORP BAC
June 16, 2011 - 10:14pm EST by
sag301
2011 2012
Price: 10.60 EPS $1.04 $1.50
Shares Out. (in M): 10,132 P/E 10.2x 7.0x
Market Cap (in $M): 107,409 P/FCF nm nm
Net Debt (in $M): 1 EBIT 1 1
TEV ($): 1 TEV/EBIT nm nm

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Description

 

At $10.5 per share, BAC trades at roughly 80% of Tangible book and 4-5x the company's estimate of normalized earnings power.

            For comparison - regional banks trade at roughly 1.5x tangible book and 10-12x earnings power. BAC's franchise is stronger than the typical regional bank - with a wonderful deposit franchise. Compared to most regional banks, BAC has stronger deposit share, greater product offering, better tech/systems and the company owns the ML brokerage and banking business, which provides asset light earnings (brokerage) and a better growth profile (capital markets/I banking).

 

A number of issues weigh on BAC's stock -

  • - Inability to Demonstrate normalized earnings power
  • - Elevated credit costs
  • - Uncertain risk associated with legacy mortgage business (reps & warranties, lender fraud, etc)
  • - Timing of operating cost normalization
  • - Basel III rules and US implementation of SIFI buffer
  • - Economic Environment (NIM, credit losses, loan demand), US goes Japan (extended period of low rates, low loan demand, pressure NIM)

Inability to Demonstrate normalized earnings power

            There are a number of ways to get at normalized earnings - look at the historic results of the firms that make up today's BAC, or look at Q1 adjusted annualized earnings or 2010 adjusted, or apply reasonable ROA metrics to BAC's asset base.  Whatever you use, you will find that $45-50bn is a reasonable PPNR number. Normal credit costs can be understood by examining the realized loss results in different lines of business over the past 20 years. You'll find that $10-15bn is a reasonable range.  Deduct taxes and preferred divided and you'll find that BAC has $1.8-2.5 of normalized earnings power.  Given this level of normalized earnings, I'll argue if/when the other issues are resolved, that BAC is worth $20-30 per share in a normalized environment. A reasonable upside from the current stock price is around $15.

 

            But, BAC is a leveraged financial company, so things could disrupt current shareholders ability to benefit from the company's normalized earnings power. Many things that could prevent current shareholders from owning the upside are currently in the news (rep/warranty, servicer fraud, government insolvency, Basel III/SIFI rules).  Nobody knows how these risks will play out.

 

Is BAC adequately Capitalized?

It depends on how things play out, but statistically the company's leverage ratios are down 30-50% from the 2006/07 period and provisions cover NPA to the tune of 135%, so in the least, it is better capitalized than it was 5 years ago. 

 

What about uncertainty and risk associated with legacy mortgage business (reps & warranties, lender fraud etc.)?  I have seen estimates that legacy issues/litigation could be a $20bn cost (pre-tax) and easily covered by PPNR (which seems reasonable).  But, you'll have to make your own estimate. (don't forget FHA and PCI 1st mortgage book).

What about Basel III rules and US implementation of SIFI buffer, I don't know, but it seems they are going to have until 2019 to get up to a 7% T1C level + (3%?) SIFI.  If they have until 2019, no problem.  If they need to get there by 2012, they are going to need to sell businesses or raise capital.  Unfortunately, we will all find out this answer at the same time.  It might be bad news, it might not matter much - we'll see.  

Under reasonable scenarios, it seems that BAC will muddle through in 2011 and 2012, mitigate legacy issues with PPNR and build Basel III/SIFI capital with retained earnings. 

It takes about 2 years or so to liquidate bad mortgages (also not a bad time line for mtg litigation, and AG settlement - we'll defiantly know the outcome on BASEL III/SIFI by then), so by YE 2013, BAC could be demonstrating normalized earnings power.  In that case, we could possible get a $20-30 stock.  Average out to $15 per share upside.

Unfortunately, the various risks facing BAC might not work out so well from BAC's perspective, so, lets look at a miserable scenario: Weak PPNR, high credit costs, 3x street estimates for rep/warranty, more than the AGs are asking (mk share adjusted) for servicer fraud, and $11bn of misc. costs (for god know what).  In a horrible scenario, BAC will need to raise capital, see below.

 

BAC

     

 ($ in millions)

     

Tier I Common (3/31/11)

   

 $                    123,882

2 year roll forward

     

Pre-tax Pre-Provision

   

 $                      70,000

Credit Costs

   

32,000

Rep & Warranty

   

60,000

Robo -signing

   

7,000

Elevated Costs

   

8,000

Other legal

   

3,000

Pre Tax

   

(40,000)

Tax

 

35%

(14,000)

After Tax Earnings

   

(26,000)

Preferred dividend

   

2,480

T + 2, Tier 1 Common

   

 $                      95,402

Basel III impact

   

14,500

T + 2, Basel III Tier 1 Common

 

 $                      80,902

Sale of CCB

   

10,000

Basel III Tier I Capital

   

 $                      90,902

       

Basel III Assets

   

1,800,000

       

T1C Ratio (Basel III at T +2)

 

5.1%

Level Required

   

10.0%

Capital Needed

   

4.9%

$ amount of Capital Needed

 

 $                      89,098

       

Share Price

$9.00

 

9,900

Old Shares

   

10,133

Total Shares Outstanding

 

20,033

       

2013 Earnings

     

T+2 PTPP

   

 $                      40,000

Credit costs

   

15,000

Pre-tax earnings

   

 $                      25,000

Tax

 

35%

8,750

After Tax Earnings

   

16,250

Preferred

   

1,250

After Tax Earnings

   

15,000

Per-share Earnings

 

 

 $                        0.75

       

Multiple

7.00 x

 

 $                          5.24

 

8.50 x

 

 $                          6.36

 

10.00 x

 

 $                          7.49

 

11.50 x

 

 $                          8.61

 

 

 

In the above, we've assumed everything goes poorly - earnings are 70% of normalized earnings power for the next 2 years and then 80% in the out year.  Credit losses remain high, rep/warranty is 3x street estimates, robo-signing litigation is settled at high end of AG ask, and I've thrown in $4bn a year of elevated costs and $3bn of legal costs (for unknown future issues). For good measure, I've assumed a 10% T1C Basel III/SIFI level, that must be met immediately.

 

In this miserable outcome, BAC is going to have to dilute current shareholders, and the stock will be worth less than today's stock price. I'd guess $2-5 less (but you'll have to make your own est. on BAC trading multiple and share issuance price)

 

            In the scenario presented, the downside works out to $5 per share.  Make your own assumptions, but it seems reasonable to say that BAC has $3 per share of upside for every $1 of downside.  One can get more interesting upside/downside ratios by examining the LEAPS or Gov. Warrants associated with BAC. Give that the downside is less than certain, BAC is interestingly priced.

 

Catalyst

resolution of - rep/warranty, AG litigation, basel III/SIFI, normalization of credit costs 
    sort by    

    Description

     

    At $10.5 per share, BAC trades at roughly 80% of Tangible book and 4-5x the company's estimate of normalized earnings power.

                For comparison - regional banks trade at roughly 1.5x tangible book and 10-12x earnings power. BAC's franchise is stronger than the typical regional bank - with a wonderful deposit franchise. Compared to most regional banks, BAC has stronger deposit share, greater product offering, better tech/systems and the company owns the ML brokerage and banking business, which provides asset light earnings (brokerage) and a better growth profile (capital markets/I banking).

     

    A number of issues weigh on BAC's stock -

    Inability to Demonstrate normalized earnings power

                There are a number of ways to get at normalized earnings - look at the historic results of the firms that make up today's BAC, or look at Q1 adjusted annualized earnings or 2010 adjusted, or apply reasonable ROA metrics to BAC's asset base.  Whatever you use, you will find that $45-50bn is a reasonable PPNR number. Normal credit costs can be understood by examining the realized loss results in different lines of business over the past 20 years. You'll find that $10-15bn is a reasonable range.  Deduct taxes and preferred divided and you'll find that BAC has $1.8-2.5 of normalized earnings power.  Given this level of normalized earnings, I'll argue if/when the other issues are resolved, that BAC is worth $20-30 per share in a normalized environment. A reasonable upside from the current stock price is around $15.

     

                But, BAC is a leveraged financial company, so things could disrupt current shareholders ability to benefit from the company's normalized earnings power. Many things that could prevent current shareholders from owning the upside are currently in the news (rep/warranty, servicer fraud, government insolvency, Basel III/SIFI rules).  Nobody knows how these risks will play out.

     

    Is BAC adequately Capitalized?

    It depends on how things play out, but statistically the company's leverage ratios are down 30-50% from the 2006/07 period and provisions cover NPA to the tune of 135%, so in the least, it is better capitalized than it was 5 years ago. 

     

    What about uncertainty and risk associated with legacy mortgage business (reps & warranties, lender fraud etc.)?  I have seen estimates that legacy issues/litigation could be a $20bn cost (pre-tax) and easily covered by PPNR (which seems reasonable).  But, you'll have to make your own estimate. (don't forget FHA and PCI 1st mortgage book).

    What about Basel III rules and US implementation of SIFI buffer, I don't know, but it seems they are going to have until 2019 to get up to a 7% T1C level + (3%?) SIFI.  If they have until 2019, no problem.  If they need to get there by 2012, they are going to need to sell businesses or raise capital.  Unfortunately, we will all find out this answer at the same time.  It might be bad news, it might not matter much - we'll see.  

    Under reasonable scenarios, it seems that BAC will muddle through in 2011 and 2012, mitigate legacy issues with PPNR and build Basel III/SIFI capital with retained earnings. 

    It takes about 2 years or so to liquidate bad mortgages (also not a bad time line for mtg litigation, and AG settlement - we'll defiantly know the outcome on BASEL III/SIFI by then), so by YE 2013, BAC could be demonstrating normalized earnings power.  In that case, we could possible get a $20-30 stock.  Average out to $15 per share upside.

    Unfortunately, the various risks facing BAC might not work out so well from BAC's perspective, so, lets look at a miserable scenario: Weak PPNR, high credit costs, 3x street estimates for rep/warranty, more than the AGs are asking (mk share adjusted) for servicer fraud, and $11bn of misc. costs (for god know what).  In a horrible scenario, BAC will need to raise capital, see below.

     

    BAC

         

     ($ in millions)

         

    Tier I Common (3/31/11)

       

     $                    123,882

    2 year roll forward

         

    Pre-tax Pre-Provision

       

     $                      70,000

    Credit Costs

       

    32,000

    Rep & Warranty

       

    60,000

    Robo -signing

       

    7,000

    Elevated Costs

       

    8,000

    Other legal

       

    3,000

    Pre Tax

       

    (40,000)

    Tax

     

    35%

    (14,000)

    After Tax Earnings

       

    (26,000)

    Preferred dividend

       

    2,480

    T + 2, Tier 1 Common

       

     $                      95,402

    Basel III impact

       

    14,500

    T + 2, Basel III Tier 1 Common

     

     $                      80,902

    Sale of CCB

       

    10,000

    Basel III Tier I Capital

       

     $                      90,902

           

    Basel III Assets

       

    1,800,000

           

    T1C Ratio (Basel III at T +2)

     

    5.1%

    Level Required

       

    10.0%

    Capital Needed

       

    4.9%

    $ amount of Capital Needed

     

     $                      89,098

           

    Share Price

    $9.00

     

    9,900

    Old Shares

       

    10,133

    Total Shares Outstanding

     

    20,033

           

    2013 Earnings

         

    T+2 PTPP

       

     $                      40,000

    Credit costs

       

    15,000

    Pre-tax earnings

       

     $                      25,000

    Tax

     

    35%

    8,750

    After Tax Earnings

       

    16,250

    Preferred

       

    1,250

    After Tax Earnings

       

    15,000

    Per-share Earnings

     

     

     $                        0.75

           

    Multiple

    7.00 x

     

     $                          5.24

     

    8.50 x

     

     $                          6.36

     

    10.00 x

     

     $                          7.49

     

    11.50 x

     

     $                          8.61

     

     

     

    In the above, we've assumed everything goes poorly - earnings are 70% of normalized earnings power for the next 2 years and then 80% in the out year.  Credit losses remain high, rep/warranty is 3x street estimates, robo-signing litigation is settled at high end of AG ask, and I've thrown in $4bn a year of elevated costs and $3bn of legal costs (for unknown future issues). For good measure, I've assumed a 10% T1C Basel III/SIFI level, that must be met immediately.

     

    In this miserable outcome, BAC is going to have to dilute current shareholders, and the stock will be worth less than today's stock price. I'd guess $2-5 less (but you'll have to make your own est. on BAC trading multiple and share issuance price)

     

                In the scenario presented, the downside works out to $5 per share.  Make your own assumptions, but it seems reasonable to say that BAC has $3 per share of upside for every $1 of downside.  One can get more interesting upside/downside ratios by examining the LEAPS or Gov. Warrants associated with BAC. Give that the downside is less than certain, BAC is interestingly priced.

     

    Catalyst

    resolution of - rep/warranty, AG litigation, basel III/SIFI, normalization of credit costs 

    Messages


    Subjectcombo of the worst merger ever
    Entry06/21/2011 12:04 PM
    Memberskyhawk887
    Maybe TimeWarner AOL was worse, but this company is the combination of BofA, which itself was a series of poor acquisitions, Countrywide, which is a less than worthless, and Merrill, which has a weak, also-ran investment banking franchise and a decent wealth management business, but one that has reputational issues, conflicts of interest, and losing share to RIAs. Its international operations are minimal--it is almost exclusively dependent on the US consumer/residential market.
    Additionally, Brian Moynihan is a lawyer by training. Lawyers rarely make good, dynamic managers, even ones that get their degrees from Notre Dame. The turf wars and in-fighting and silo-like operations currently going on at BAC would probably make Citigroup under Chuck Prince look like a paragon of efficiency and effectiveness.
    Maybe this is all fluffy, non-quantitative color, but I bet we will continue to see a series of missteps, charges, and management turnover from BAC for years to come.

    SubjectRE: combo of the worst merger ever
    Entry06/21/2011 12:54 PM
    Membersnarfy
    I'm sure the biggest banks would fight against forced breakups like a bunch of cornered animals,
    but would the broken up pieces wind up being collectively more valuable than if they remained together?
    I'm wondering if the experience of Standard Oil and AT&T is relevant.

    SubjectRE: RE: RE: combo of the worst merger ever
    Entry06/21/2011 03:22 PM
    Membersnarfy
    Really interesting that someone like JPM would be worth more just on multiples alone given the funding advantage. 
     
    I'm just a casual observer when it comes to banks, but I always wondered if a break up would lead to value creation because of the traits that helped shareholders of the broken up oil and telephone companies - more localized decision making/strategic thinking, adapting to change faster, better productivity as employees identify more closely with local leadership rather than bristling at edicts handed down from a central overlord in a faraway land.  That last one probably speaks to the silo issues Skyhawk raises.
     
    Of course, you lose the funding advantage as you say, but apparently that isn't worth much, at least for the moment.

    Subjectupdate?
    Entry08/23/2011 07:11 PM
    Membermpk391
    sag-  I really liked the simplicity of your analysis (i.e. the 2 year roll forward).  Hoping you wouldn't mind updating your numbers for recent settlements & divestitures.
     
    thanks!
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