“Bank of America is a strong, well‐led company...I am impressed with the profit‐generating abilities of this franchise, and that they are acting aggressively to put their challenges behind them.” - Warren Buffett August 25, 2011
Bank of America was on the brink of Bankruptcy just a few years ago. Under prior management, growth in assets was pursued at the expense of sound business practices. This combined with years of poor underwriting and the disastrous loans that came with the acquisitions of Countrywide Financial and Merrill Lynch caused huge damage to the franchise. To this day Bank of America remains one of the most shorted stocks on the NYSE.
However, the problems BAC has faced are temporary. Brian Moynihan became CEO in 2010 and has made it a priority create a “fortress” balance sheet and clean up their legacy issues. The underlying business is very high quality and is producing 13-15% ROTE. The high earnings power of the underlying business is being clouded by a very high expense rate, high litigation costs, mortgage put backs, high cost long term debt, etc. These issues are quickly being resolved. I expect by 2014-2015, Bank of America will be mostly finished taking care of the financial crisis related issues.
Bank of America is currently one of the best capitalized banks in the United States. Their capital levels are already in excess of the Basel 3 requirements that come into full effect in 2019. Basel 3 requires them to be at a tier one common equity ratio of 8.5% by 2019. At the end of the 3rd quarter they were already at 8.97%.
At today’s price ($10) Bank of America is selling at one of the widest discounts to its tangible book value ($13.50) in its history. By 2015, I expect BAC to be earning in excess of $30 billion/ year pre-tax and potentially well in excess of this. At this level of earnings, Bank of America is worth at least $25 per share. In addition, in 2013 alone Bank of America could return up to $18 billion to shareholders based on Brian Moynihan’s statement during the 3rd quarter conference call where he indicated that nearly all capital going forward will be returned to shareholders.
Reason for Existing Discount:
*Expenses Are Far Above Normal
*High Cost Debt Has Built Up From Prior Overpriced Acquisitions And Is Being Repaid
*The Net Interest Margin Is At A Very Depressed Level
*Delinquencies Are Tying Up Capital That Could Be Employed Elsewhere And Is Costing The Company A Substantial Amount In Expenses
What Will Future Normalized Earnings Look Like:
2013--Earnings should come in at around $1 based on analyst expectations. In addition, a significant amount of capital could be returned to shareholders. Next year’s earnings plus the earnings from the 4th quarter will allow BAC to return up to $18 billion to shareholders. Moynihan said after BAC reaches Tier 1 cap ratio of 9% (currently at 8.97%), capital will be returned to shareholders on roughly a 1/3 for buybacks, 1/3 to dividends and 1/3 to grow the business
2014--Pre-tax earnings will grow significantly from a base of around $13.5 billion in 2013. In 2014, many of the initiatives aimed at reducing costs will be in place.
2015--In 2015, the majority of the litigation, representation and warranties expenses and other overhang from the financial crisis will be over.
Historically large money center banks have earned on average between .75-1.5% after tax earnings as a percent of assets. Given the increase capital ratios required going forward, I expect Bank of America to come in at the lower end of that range at around 1% once they have cleaned up the current mess. This would result in pre-tax earnings in excess of $30 billion per year.
Bank of America was on the edge of bankruptcy just a few years ago. Since new management led by Brian Moynihan took over in 2010, management has been working quickly to clean up the balance sheet and generate strong earnings.
Today the bank is generating very little earnings power. However, in just a few years time this will change as expenses are cut, litigation runs off, mortgage put backs decline, the net interest margin returns to normal, and long term debt is replaced by deposits. I expect Bank of America to reach at least $30 billion in normalized earnings by 2015.
The stock is worth around $25 per share or 2x book value. In addition, Bank of America has already completed raising all necessary capital to meet Basel 3 requirements. Even though they are not required to do so until 2019. This sets the stage for significant returns of capital to shareholders. I expect management to begin returning capital to shareholders in 2013.