Bank of America: Prepare for a Medium Term Rally

Anindya is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Charlotte, North Carolina-based Bank of America (NYSE: BAC), the second largest U.S. bank, reported its Q3 earnings last month, which were in line with analysts’ expectations. Earnings were essentially flat compared with a $3.1 billion profit in the second quarter, but were much better than a $1.8 billion loss in Q3 2011.

The net interest margin (NIM) expanded 11 basis points (bps) to 2.31%, benefiting from lower parent company debt and sequentially lower market-related premium amortization and hedge ineffectiveness. Lower securities yields and subdued new loan demand continued to constrain margins.

In this article I will share why I expect the bank to improve its earnings in the coming six to eight quarters, despite the short term bottlenecks the bank is facing and the negative outlook on the U.S. economy. I will also share why I expect the stock to rally in the near term, based on its impressive financial performance.

Balance Sheet Strengthened

  • Capital building exercise remained impressive: The bank registered impressive progress on the capital front, with the estimated Basel III Tier 1 common ratio (including the terms of the Fed's proposals) rising 102 bps to 8.97%, partially because of accumulated other income gains (which added 18 bps) and partially because of risk-weighted asset declines (which added 40 bps). With these gains, management has turned their attention to driving core earnings.
  • Asset quality continued to improve: Asset quality continued to improve, with the net charge-off ratio declining 19 bps sequentially (excluding new regulatory guidance on Chapter 7 bankruptcy treatment), and the nonperforming assets ratio declining 6 bps to 2.64%. It is expected that asset quality will continue to strengthen, though at a slower pace, led by improvements in commercial loans.

Earnings to Increase in 2013

  • Net interest income to register modest growth: The management’s guidance of net interest income for Q4 is in line with Q3 levels as liability actions being taken by management could offset low rate pressure. However, according to Standard & Poor's Ratings Services, the full impact of the roll-off of parent company debt and recent redemptions of high-cost trust preferred securities and subordinated debt ($6.2 billion in third-quarter 2012 and $5.1 billion announced for fourth-quarter 2012) should help propelling net interest income modestly higher in 2013.
  • Interest expenses are close to a tipping point: Long term debt declined to $287 billion at the end of the third quarter of 2012, from $302 billion at the end of the prior quarter, and $399 billion at Sept. 30, 2011. As a result, interest expenses softened and will continue to moderate.

Risks Associated with Bank of America

Although visible progress is being made on capital building and cost reduction, the following risks could dampen Bank of America’s earnings potential in the quarters to come:

  • Elevated litigation risks
  • Fragile housing market
  • Representation and warranty claims
  • New legislation (particularly the Volcker Rule)

Stock Price Attractively Valued based on PTBV

A stock's price to tangible book value per share, or PTBV, represents the amount of money an investor would receive for each share if a company were to cease operations and liquidate all of its assets at the value recorded on the company's accounting books. As a rule of thumb, stocks that trade at higher price to tangible book value ratios have the potential to leave investors with greater share price losses than those that trade at lower ratios, since the tangible book value per share can reasonably be viewed as about the lowest price a stock could realistically be expected to trade at.

<img src="" />

BAC Price / Tangible Book Value data by YCharts

As one can see in the chart presented above, only Citigroup (NYSE: C) has a better price / tangible book ratio than Bank of America. Both JPMorgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC) are more expensive than Bank of America in terms of PTBV. 

A Rally Just in the Cards

With a tangible book value per share of $13.48 as of Sept. 30, 2012, and a price / tangible book ratio of 0.78, the stock looks reasonably attractive just below $10. The positive outcomes with respect to the bank's latest financial performance, as described above, are not yet discounted in the stock's price. This is clear from the range bound activity of the stock just below the $10 level after earnings. The stock took nice support above $9 during the recent corrective phase in the stock market and prepared ground for a sustained move above $10 in the weeks to come. 

Anindya7 has a position in Bank of America. The Motley Fool owns shares of Bank of America, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus