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Bank of America: Still a Speculative Stock

March 27, 2012 | About:

It is common knowledge that the most recent financial crisis enormously damaged U.S. banks. Banks invest in financial instruments and are therefore largely subjected to economic risk. Many banks, such as Bank of America (NYSE:BAC), invested heavily in mortgage-backed securities and other risky assets prior to the financial meltdown. They also issue credit to small businesses and individuals. This financial crisis forced many small businesses to shut down and for many individuals to lose their jobs. With no capital inflow, it is difficult for individuals and institutions to pay obligations. This creates significant credit risk for banks. This article discusses how Bank of America was affected by this meltdown, its current position, its plans for the future and whether it is selling at a reasonable price.

Bank of America serves three customer groups: people, businesses and institutional investors; and provides unique services for each. For people, it provides secured and unsecured lending and deposit, checking and savings accounts. For businesses, it provides assistance managing cash, accessing equity and debt markets, and risk management in terms of currency risk and interest rate volatility. For institutional investors, it provides research that helps identify investing opportunities.

In moving forward, Bank of America believes that it has the resources and capabilities to reach its goal of becoming the “world’s finest financial services company.” It has several characteristics and goals that it believes will drive the company forward. Some of these goals include becoming a customer-driven company, building a stronger balance sheet, managing risk well, to repair legacy issues relating primarily to the mortgage business, and becoming the best place for people to work.

2010 resulted in a $2.2 billion loss for Bank of America. However, this loss was largely due to two non-cash, non-tax deductible goodwill impairment charges. If these expenses had not been recognized, it would have reported a profit of $10.2 billion. In 2010, credit costs fell and resulted in a 42% decrease in its provision expense from 2009. In 2011, Bank of America reported a net income of roughly $1.5 billion. Although this is an improvement from the net loss in 2010, it does not compare to the income levels several years ago. For comparability, the average net income from the relatively strong years of 2004-2007 was about $16.7 billion. However, if 2010 was in fact a year of restructuring and net income continues to trend upwards in the coming years, Bank of America might be a good investment at its current price.

Bank of America competes in a vigorous business environment. It is structured as a universal bank which has not altogether been proven favorable. Bank of America competes largely with Citigroup (NYSE:C) and JPMorgan Chase (NYSE:JPM). Both competitors are similar in that they offer a diverse set of businesses to a diverse customer base.

Citigroup has three core businesses. These are Securities and Banking, Global Transaction Services (GTS), and Regional Consumer Banking. Securities and Banking provides revenue from trading, foreign exchange, advisory and other services. The GTS franchise is said to be one of the most attractive businesses in Citi’s industry because of stable revenue and low capital usage. The Regional Consumer Banking business is strategically geared toward appealing to affluent consumers in the top 150 international cities.

JPMorgan also offers a wide range of banking services. Businesses include Investment Banking, Retail Financial Services, Card Services, Commercial Banking, Treasury and Securities Services, and Asset Management.

While both Bank of America and Citi reported losses recently, JPMorgan maintained profitability. Although it did recognize a sizable decrease in earnings in 2008, its current profit levels are substantially greater than in the early 2000’s. Citi reported a significant $26.6 billion loss in 2008 and a much lesser loss of $1.6 billion in 2009. In 2010 and 2011, it reported profits of about $10.6 billion and $11 billion, respectively. Again, Bank of America reported its loss in 2010 of $2.2 billion and reported unimpressive earnings in 2011 of about $1.5 billion. In 2011, Bank of America, Citigroup, and JPMorgan reported net margins of 0.9%, 14.12%, and 18.07%, respectively.

Quantitatively speaking, Bank of America does not stack up well to some of its main competition. In fact, when considering earnings, Bank of America is selling at a nonsensical level. Citi and JPMorgan are both selling at just above 9 times earnings while Bank of America is selling at a multiple of 813. So logically, to avoid a drastic drop in share price, it will have to significantly increase earnings in the near future.

Recently, Bank of America discovered that a U.S. appeals court ruled that the proposed $8.5 billion settlement with investors in mortgage-backed securities should be reviewed in New York state court. This is a positive alternative to the federal court. These liabilities arise from the 2008 acquisition of Countrywide Financial Corp. The benefit that this will have is that it will reduce the settlement’s scope of review which will increase the chance for the settlement to remain in the proposed $8.5 billion range. More investors purchased Bank of America stock upon this news, resulting in moderate share price appreciation.

However, regardless of the decision, this settlement will put a significant strain on Bank of America’s near-term bottom line. To maintain its goal of strengthening its balance sheet, it would not be wise to fund this expense with a majority of debt. It is possible that management will decide to issue more shares. This will further dilute an already miniscule earnings per share.

Regardless of modest upsides, Bank of America should be seen as very risky investment at its current price. It understandably reported a loss in 2010 but was unable to report earnings close to that of its competition in 2011. The fact that it is selling at over 800 times earnings is a huge warning sign. It has peers with strong balance sheets and positive prospects that are selling for far less. This enormous price to earnings shows that investors anticipate huge earnings growth. There just doesn’t seem to be any substantial evidence supporting this theory. I would only recommend this stock for the speculative investor. Although there is a big upside potential in share price, massive uncertainty exists.

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