Bank of America Analysis
Board: Value Hounds
Bank of America is currently trading at about half book value, bringing to mind the value investor phrase, "buy banks at half of book value, sell at twice book value." Big-name value investors like Bruce Berkowitz, David Tepper, and John Paulson have large percentages of their portfolios invested in the bank. Morningstar has a 4 star rating on the stock with a valuation of around $18.00 and Valueline has a 3-5 year price target of between $20 and $35.
This was enough for me to want to take a closer look at BAC. Wading through the financial statements of a big money center bank is not easy though. They're about twice as long as the typical company's, more complex and more opaque. You have to rely on probabilities more often and at more levels in the valuation.
The classic way to value a bank is off its return on equity but that's been tricky to do accurately with BAC over the last couple of years. The returns are being affected both short term by one-time charges and long term by the changing bank regulation landscape. The equity is either getting hacked away by one-time charges or greatly expanded by new equity issuances. Add on top of this the worry over BAC's exposure to future mortgage putbacks and questions over its exposure to Europe. What you end up with is a very complex company to both value and keep track of quarter to quarter. Of course, this complexity coupled with the worry over both future returns and future equity writedowns is what makes BAC's stock so cheap these days, at least relative to historical measures.
Bank of America (BAC)
Headquarters: Charlotte, North Carolina
Market Cap: $103.3 billion
P/E: N/A ttm
Dividend Yield: 0.4%
Return on Equity: N/A ttm (11.8% 10 year average)
Recent Price: $10.20
Intrinsic Value Estimate: $17.00
Bank of America traces its roots back over 100 years to 1904, when Amadeo Giannini founded the Bank of Italy in San Francisco to cater to immigrants who were denied service by other banks. When the 1906 San Francisco earthquake struck, Giannini was able to get all of the deposits out of the bank and away from the fires while almost every other bank was destroyed in the disaster. Giannini was able to use the rescued funds to start lending to people looking to rebuild. Deposits rose quickly from $8,750 to over $700,000 in the first year of operation.
Mergers and acquisitions are nothing new in the banking space and Giannini made his first in 1918, buying Banca dell'Italia Meridionale to form Bank of America and Italy. In 1928 Giannini acquired Bank of America, Los Angeles and renamed the entire company Bank of America. What followed over the next century showcases the cyclical nature of the banking industry, where rapid growth was followed by either disaster or regulation to curb that growth, and disaster was of course followed by yet more regulation to curb future disasters, followed by recovery.
Regulation in the 50's forced BAC to spin off their insurance business, forming Transamerica in the process. More regulation forced them to spin off their domestic banks, creating First Interstate Bankcorp. Also in the 50's BAC created what would later become the Visa card, later setting the segment up as a separate entity in the 70's. Changes in regulations in the late 60's allowed BAC to once again own out-of-state banks if it was restructured as a bank holding company, and so BAC set out to again expand across the United States in the 70's and early 80's.
BAC's overexposure to Third World Debt hammered them in the late 80's and the company survived only by selling off large parts of itself. By the early 90's the company had recovered and started on one of its biggest acquisition and expansion sprees ever until disaster struck once again in 1998 with the Russian bond default, and Bank of America had to be acquired to be saved. Though NationsBank acquired Bank of America in 1999, NationsBank decided to keep the Bank of America name for the merged company. The merged company started out to yet again grow through acquisition, reaching mammoth proportions in the 2000's as it acquired FleetBoston, MBNA, LaSalle Bank Corporation, US Trust Corporation, and others under the leadership of CEO Ken Lewis.
That brings us to BAC's current financial crisis which, as we can see, is only one of many in the company's history. The stage for disaster was set with two acquisitions. Bank of America acquired Countrywide in 2007 for $4.1 billion, making BAC the largest mortgage originator and servicer in the US, controlling 25% of the market. Then in 2008 Bank of America bought Merrill Lynch in an all-stock deal for $50 billion. The rest is history. Shortly after both acquisitions it was revealed that both Countrywide and Merrill were suffering from massive losses, requiring large writedowns and the infusion of large amounts of new capital. BAC's stock price plummeted from the pre-crisis $50 range to $3.14 a share in March 2009. The stock has since recovered to only the $10-$11 range.
BAC is comprised of 6 operating segments. In order of 2010 revenue percentage they are:
Global Banking and Markets (25.9% of 2010 revenue)
This is the investment banking arm of BAC and provides clients (loosely defined as companies with annual sales greater than $2 billion) with financial products, advisory services, financing, securities clearing, and settlement and custody services. This is also the segment that engages in proprietary trading, securitization, and credit default swaps. The Volcker Rule as well as the new Basel III standard will limit BAC's proprietary trading activities in the future. Q1 2011 revenue was down 18.6% quarter over quarter due primarily to lower trading revenue as compared to last year. Net income was actually up though due to higher investment banking fees and lower provision for credit losses.
Global Card Services (23% of 2010 revenue)
Global Card Services provides credit and debit cards to U.S. and international consumers and businesses. This is a high margin cash cow for BAC and makes up almost a quarter of revenue. The problem here is not the business, but the regulation. The CARD Act of 2009 limited companies' ability to raise interest rates, charge penalties and fees, market to teenagers and college students, among other things. Adding to the regulation pain, the recent Durbin Amendment has put a cap on the amount that can be charged for a debit card transaction, cutting the average fee per transaction in about half from 44 cents to 21 cents. The Durbin Amendment caused BAC to take a $10.4 billion goodwill impairment in 2010. Going forward non-interest income in this segment is going to be lower due to lower fees charged. Revenue was down 18% quarter over quarter due to a decline in net interest income from lower average loans and yields as well as a decline in noninterest income due to the impact of the CARD Act as the provisions became effective throughout 2010. Net income was again up due to lower provisions for credit losses due to fewer delinquencies and bankruptcies, and lower credit costs.
Global Wealth and Investment Management (15.1% of 2010 revenue)
GWIM consists of three primary businesses: Merrill Lynch Global Wealth Management, U.S. Trust, and Bank of America Private Wealth Management and Retirement Services. These are the businesses that cater to high net worth investors, with separate businesses within the segment catering to people of different net worth tiers, starting at $250,000 in assets and going up from there. Revenue was up 11% for the quarter year over year. Net income was up 22%, boosted by a greatly reduced loan loss provision.
Deposits (12% of 2010 revenue)
Down in fourth place is the segment most people would tend to first identify with BAC due to its ubiquitous brick and mortar presence across the US. BAC serves approximately 57 million consumers and small businesses in the US through a system that stretches coast to coast through 32 states with a network of approximately 5,900 banking centers and 18,000 ATMs. Revenue was down 14.2% quarter over quarter, mainly due to lower noninterest income from the impact of overdraft policy changes. Net income was also down. Unlike the other segments, there was no reduced loan loss provision to make up for any reduction in revenue in this segment.
Global Commercial Banking (9.9% of 2010 revenue)
Clients here are generally defined as companies with annual sales up to $2 billion, and include business banking and middle-market companies, commercial real estate firms and governments. Revenue here was down 14.2% due to lower net interest income and lower loan balances but net income was again up due to lower loan loss provisions.
Consumer Real Estate Services (9.7% of 2010 revenue)
This is the only segment that had a net loss in Q1 2011. Revenue was down 40% quarter over quarter due largely to a decrease in mortgage banking income driven by an increase in representations and warranties provision. This segment is still getting hit with repurchase requests from investors who own securitizations of mortgages generated by this segment, mainly from legacy Countrywide mortgages though some from BAC itself. BAC has largely settled with Fannie Mae and Freddie Mac, but there are still about $222 billion worth of securitizations sold to non-government agencies that are either 180 days past due or in default as of the last 10Q. Legacy Countrywide mortgages account for $171 million of that. This is what BAC and the investors are in the process of arguing over and settling with these days.
If you look at that $222 billion number as a BAC investor it’s scary since that amount is essentially equal to the entire equity of the company. Some of that $222 billion will be eaten by the company as settlements, mortgage putbacks, etc. continue to occur over the next few years. For example, on June 29 BAC announced that it had reached an agreement to resolve nearly all of the legacy Countrywide-issued first-lien residential mortgage-backed securitization (RMBS) repurchase exposure, representing 530 trusts with original principal balance of $424 billion. If you look at the breakdown of non-agency securitizations on page 47 of the 2011 Q1 10Q you can see that this represents about 60% of the $716 billion in original principal balance Countrywide loans that led to the $171 billion in Countrywide delinquent mortgages.
Also, mortgages cannot be put back simply because they drop in market value. In order to be put back it has to be shown that BAC misrepresented the warranty, title, appraisal, or some other aspect of the mortgage. Simply because the value of the real estate that backed the mortgage went down does not in and of itself dictate a mortgage repurchase. Drops in market value are part of the risk an investor takes when buying a securitized mortgage.
The bank's bank capital ratios are in good shape:
*The Tier 1 capital ratio is at 11.32% (current minimum Tier 1 capital ratio is 4% and 6% to be considered well-capitalized)
*The total capital ratio (Tier 1 plus Tier 2) is 15.98% (current minimum here is 8% and 10% to be considered well-capitalized)
*The Tier 1 leverage ratio stands at 7.25% (current minimum is 3%, 5% to be considered well-capitalized)
All ratios have been on a steady climb over the last several years, with large losses overpowered by even larger dilutive equity sales:
[See Post for Tables]
That said, the $14 billion in cash settlements and added loss reserves BAC is paying out to settle 60% of the Countrywide delinquent mortgages will put a dent in Tier 1 capital going forward as will any possible additional future payouts. Also, the Basel III standards as they stand now will require more capital, on average 2-3% higher on all of the ratios. While BAC looks to be above those new minimums, certain types of assets, such as deferred tax assets and trust preferred securities are currently being considered to be either disallowed or deducted from Tier 1 capital. Additionally, the company has no interest in flirting with the minimum standards to be considered well-capitalized. They plan to increase their capital base over the next two years though the phase-in period for the new rules runs between 2013 and 2019. Considering all the capital building BAC will need to do in the next 2-3 years it’s unlikely that there would be much breathing room to restore the dividend any time soon.
Loan Loss Provisions and Charge-offs
Loan loss provisions and net charge-offs have just recently turned a corner and are now on a decline after two years of increases. The reduction in provisions and releases of reserves have been a boost to net income even when revenue is down year-over-year. CEO Brian Moynihan reported in the last conference call that delinquencies are down in all portfolios.
[See Post for Tables]
BAC’s efficiency ratio (non-interest expense divided by revenue) got trashed as loan loss provisions and writeoffs soared. Moynihan stressed that the goal is to get the efficiency ratio back in the 55% range over the next couple of years. In quarters where there isn’t a writedown the efficiency ratio is already there in the mid 50’s, so achieving this shouldn’t be too difficult as long as writeoffs continue to tail off.
[See Post for Tables]
Revenue generation was never a major problem throughout the crisis. Revenue actually climbed all the way through fiscal 2009, only to dip 8% in 2010. Compare that to the 80% drop in stock price! The problem with BAC was the balance sheet, not the income statement. When net income did turn negative it was primarily due to writedowns, charge-offs, and increases in loan loss provisions, not problems on the top line.
When you value a non-financial company you usually model what the free cash flow will look like. You start with revenue, estimate an operating margin, add back in depreciation and amortization, subtract out working capital needs and capex, grow the resulting free cash flow estimate out into the future by an estimated growth rate, and then subtract out the debt. This doesn't work too well with financial firms though. Capex and d&a charges are minimal with respect to operating income and working capital isn't all that relevant since cash, short term investments, and customer deposits aren't money tied up in the business, it is the business. Similarly, the debt on the balance sheet is the raw material with which the bank uses to make money, loaning this money (mainly deposits but there's also issued debt there) out at higher rates in order to generate a positive net return. If you assume that all of this debt is put to use earning returns higher than the cost of the debt you can value the business based on this return as compared to the equity invested in the business: i.e. how much return are we getting vs. the amount we as owners have to invest. This is only easy when we know what the value of the equity is and what the return will be. In BAC's case both ROE and the equity base per share have swung around pretty markedly in the last few years. Let's see if we can get a handle on both.
BAC's current shareholder equity is $230.8 billion. I'm going to reduce this number by a few things though. We know shareholder equity has been hit in the recent past by various writedowns and we are almost certainly not done yet.
First, I'm going to deal with the nonperforminng and defaulted mortgages. I'm going to start with the $222 billion in nonperforming/defaulted mortgages from the Q1 2011 10-Q and subtract 60% of the $171 million in bad Countrywide loans covered in the June settlement to arrive at $120 billion in remaining bad mortgages. BAC estimates the future liability will be somewhere between $7 to $10 billion, or 7% of the total figure. Current claims are about $13.7 billion, or about 11.4%. Loan losses here are stabilizing but I'm going to go with 15% of the remaining $120 billion, or an $18 billion haircut to equity.
Second, BAC has $681 million in net PIIGS sovereign debt exposure. I'm subtracting all of this, assuming total loss. In addition, BAC has $13.78 billion in net PIIGS non-sovereign debt exposure. I'm subtracting 50% of this ($6.9 billion), assuming loss here as well.
Third, I'm subtracting the Q2 2011 forecast of a $2.6 billion goodwill impairment, $8.5 billion in settlement claims and $5.5 billion in new reserves, all related to more mortgage settlements. This is the expense BAC incurred to absolve itself of 60% of the legacy Countrywide problem loans we dealt with in Step 1.
BAC has $13.1 billion in credit risk on its credit default swap portfolio. This credit risk represents the loss to the company if the counterparty in the swap fails to deliver if BAC is in a gain position on the swap. I didn’t have any particular reason to think this was going to pose a problem so I didn’t handicap equity here.
Subtracting all of these things gives me an adjusted equity base of about $185 billion. Would the equity ever actually get this low? No. A bank needs to maintain certain capital ratios to remain a bank and most of these ratios are based on equity. If things got bad BAC would issue more equity. In fact, if you look at shareholder equity through the financial crisis it has risen steadily each year. The thing that has changed drastically though is the share count. So though the equity amount on the balance sheet wouldn't go much lower than it is now you as a current shareholder would indeed get impacted since per share value of equity would get diluted as new equity is raised. Estimating what the share count would be in such a case is tricky though so for now I'm just treating these assumed future charges as a reduced equity value for the purposes of the valuation.
BAC's 10 year average ROE is almost 12%, reaching as far as the high teens between 2002 and 2006 and as low as -2.2% recently. These days it's either negative or in the very low double digits depending on whether or not the quarter had a writedown. So what's it going to be in the future?
It's a pretty good bet that it will be lower on average. The new Basel III standards require large banks like BAC to hold on average 2-3% more equity in relation to assets than before and the Durbin Amendment limiting interchange fees will take a bite out of BAC's lucrative debit card revenue. Also, Basel III and The Volcker Rule require that banks like BAC wind down their proprietary trading line of business which, when it works, can generated very high returns on equity. On top of all that, the next couple of years will almost doubtless have more writedowns and goodwill impairments. Offsetting some of this is BAC's focus on creating a lean operation going forward, reducing staff, closing certain branches, and consolidating deposit platforms across its various operating segments. So with this in mind I estimate an ROE of 5% next year, 7% the year after, and 10% after that for years 2-10. I estimate 3% terminal growth.
Putting the Two Together
I use an excess returns model for the basic valuation. In this model, I start with the equity base for year 1 and calculate the return off of that equity. I add that equity return to the equity base for year 2. The excess return for year 1 is calculated as the equity base for year 1 times (return on equity - cost of equity). Here's how it looks using simpler numbers, assuming two years of explicit growth with year three being the terminal value. In the example my return on equity is 10% and cost of equity is 9%:
[See Post for Tables]
Adding it up we get:
Equity Base: $1,000.00
Excess Return Year 1: $9.10
Excess Return Year 2: $9.10
Terminal Value: $129.87
Total Value: $1,148.07
That's the valuation model using simple numbers. Now if you look at BAC, my cost of equity is 10% and my return on equity never rises above 10%. I get zero excess return for years 2-10 where my cost of equity and return on equity are both 10% and a negative excess return in the first two years where my return on equity is below 10%. Any positive value I reach for the equity is based solely on the book value of the equity on the balance sheet handicapped by my estimate of future impairments.
While I don't subtract debt I did subtract the $427 million in unfunded pension obligations. Stock option dilution isn't currently an issue since they're all underwater with an average exercise price of of around $50 a share. If we get to $20 a share we're going to be plenty happy at the current price, let alone $50.
Putting it all together I get a value for BAC of around $17.00 a share.
The big risk is the balance sheet. It's not the income statement, ROE, efficiency ratio, or anything else. We're making an educated guess that loan losses and charge-offs will continue to go down, that BAC's liability on nonperforming mortgages will be limited only to a minority of mortgages that pass the putback hurdles, the economy will continue to slowly improve, that BAC's exposure to Greece and the other dicey European economies is truly what they say it is, and that BAC's $2 trillion in credit default swaps are as perfectly hedged as it says they are.
BAC has had a history of downplaying the severity of its losses. For example, BAC announced that the mortgage putbacks from Fannie Mae and Freddie Mac were done with in January, but then recorded a half billion dollar charge in the first quarter of 2011. While you could just attribute this to downplaying, BAC also just doesn't have much experience in this situation. The size of the housing downturn and amount and complexity of the mortgage securitizations were something that few at the company have any experience with. When BAC puts out a loss estimate going forward, it would be wise to pad it. This is not a company that has made the greatest of decisions when it comes to risk in the recent past.
Regulation can change the game quickly. Just recently we had The CARD Act, the Volcker Rule, the Durbin Amendment, and Basel III. When banks managing trillions of dollars in assets either screw up or get too big too fast people sit up and take notice. A valuation under one set of rules would have to be modified under a different set of rules.
The bank is currently a potpourri after the Countrywide and Merrill acquisitions. It will take time to assimilate these companies cleanly. Moynihan has said that going into the future BAC will not be doing large acquisitions but instead be focused on pruning non-core businesses and integrating what they want to keep. Hopefully they'll stay focused here.
It's hard to say precisely how badly the mortgage putbacks, European debt, and regulatory landscape will affect BAC but the current price is already factoring in a pretty dire scenario. To reach the current price (while maintaining all other inputs such as discount rate and return on equity) I'd have to assume there will be $113 billion in additional writedowns. This is equal to almost all of the remaining nonperforming/defaulted mortgages, and I don’t think this level of impairment going forward is likely. I think BAC's shares offer more upside than downside at the $10-11 range.