Bank of America is back with a BANG!

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

2013 will be an interesting year for the banking industry. With a reviving economy, declining jobless claims and an improving housing market, well-known analyst Dick Bove believes bank earnings could hit a record $38 billion in the fourth quarter. Clearly, the industry is poised to have a solid 2013. My favorite stock to play the banking boom is Bank of America (NYSE: BAC). The company’s shares have more than doubled off of their 2012 lows on the back of greatly improving fundamentals and overall market bullishness. I believe there’s still a lot of upside for the bank. Let’s assess why.

Cost cutting and restructuring

The bank has its focus on capital efficiency, so it’s adopting reconstruction by asset sale and cost-cutting strategies to strengthen capital ratios. The 'project new BAC' is one such initiative, which has aimed to save around $5 billion every year since its launch in 2011. The company expects to reduce 30,000 positions on consumer business & technology and operations this year, saving $5 billion in 2013.

The bright future of the mortgage industry

Now, nearly six years after the crash, the dust has finally cleared and we have a true picture of the new housing landscape.

The housing market recovery picked up steam in the final three months of last year, with prices rising at an annual rate of 7.3%, according to S&P Case-Shiller. Loan originations totaled $1.75 trillion in 2012, the highest since 2009, according to the Mortgage Bankers Association.

Wells Fargo (NYSE: WFC) has been the biggest beneficiary of a robust mortgage market. The largest U.S. home lender originated nearly 1 in 3 mortgages as of Sep. and reported a 24% rise in fourth-quarter profit in Jan. 2011 and net gains on origination totaled $2.8 billion. In all of 2012, the firm recorded about $11.6 billion in mortgage banking income.

Bank of America had booked almost $40 billion in costs since 2007, including refunds and litigation tied to defective home loans and improper foreclosures. These settlements have impacted earnings results in recent quarters, and the company still has pending litigation. However, investors seem to be increasingly focused on "normalized" earnings, which is what analysts expect the company can earn under normal conditions once the litigation and related housing crisis losses are over. Countrywide's mortgage business will eventually become a strong source of profitability for Bank of America.

Hedge funds like Bank of America

Europe's largest hedge fund, Lansdowne, purchased 26.5 million shares in the fourth quarter, according to regulatory filings. Both Adage Capital Management and Arrowstreet Capital purchased 14.7 million more shares. It's also important to note that these purchases came after the stock rose 55% in the first three quarters of 2012. Buffett continues to hold his own Bank of America investment. This shows the hedge funds’ faith in the company and their expectations of the massive profits which haven't shown up yet, but could be on the way in 2013 and beyond.

Attractive valuations

Bank of America's capital position at the end of 2012 was very strong:

1. Basel 1 Tier 1 Common Capital Ratio of 11.06%

2. Basel 3 Tier 1 Common Capital Ratio of 9.25%

3. Long-term debt decreased by $96.7 billion in 2012

Analysts, on average, are estimating an EPS of $0.23, with revenue of $23.34 billion for the current quarter ending March 2013. For 2013, analysts are projecting an EPS of $1.00, with revenue of $90.64 billion, which is 5% higher than 2012. Analysts are projecting 18.70% growth for the next 5 years (per annum), which is higher than the industry average estimate of 8.65%.

There are a few positive factors for BAC:

  • Lower P/B and P/S of 0.6 and 1.6 (vs. the industry average of 1.0 and 2.2)
  • Lower Forward P/E of 9.3 (vs. the S&P 500's average of 13.9)
  • BAC trades 60% below its book value of $20.24
  • BAC currently offers an annual dividend yield of 0.33%

Bank of America also has a leading investment and commercial bank, Merrill Lynch, which has produced nearly $30 billion in earnings alone  since it was acquired.

Improving net interest margin

Bank of America’s net interest margin fell from 3.5% in 2003 to 2.3% in the last quarter of 2012. This was mainly due to lower interest rates resulting from the Fed's QE efforts to boost the economy. The Fed’s QE will be coming to an end very soon, which will result in an increase in interest rates, thus helping the bank raise its net interest margin to the pre-crisis level of 3%. This should produce around $10 billion annually in extra interest income, assuming that no growth occurs in the interest-bearing asset base. In addition, extra net interest margin doesn't really add incremental cost, so operating leverage is enormous in this situation. In other words, any increase in net interest margin will largely flow directly into operating income.

Share buyback

The Fed approved Bank of America’s buyback application, worth $5 billion in common stock and $5.5 billion in preferred share redemptions for 2013. This shows Bank of America has grown and become smarter as a financial company. The company is going to retire $5.5 billion worth of preferred debt that's yielding over 8%. This move alone will save the company $450 million annually in interest expense and reduce the number of outstanding shares, thus showing positive signs for EPS growth prospects.

JPMorgan Chase (NYSE: JPM) was one of four banks that did not receive the thumbs up from the Federal Reserve for their 2013 capital adequacy plan. Shortly after the Fed announcement, JPMorgan announced plans to raise the quarterly dividend from $0.30 to $0.38 per share and repurchase up to $6 billion in shares over the course of the next year. The $6 billion number comes in well short of the planned $15 billion share repurchase, but in response to the Fed's report, as well as a desire to improve capital ratios, this seems like an appropriate response.

Foolish Takeaway

Bank of America's huge improvement from the previous year's results clearly shows that the CEO's, Brian Moynihan, efforts have started paying off well. The company has a fortress balance sheet. The Fed’s stress test showed that the bank is well positioned enough to sustain any financial crisis similar to that of 2008. An improving housing market, attractive valuations, share buybacks and expected improvements in net interest margins show that the turnaround is in full effect at Bank of America, and the company's worst days are behind it.

 


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