Bank of America: Now Things Are Getting Interesting

Summary:

• Bank of America stock has taken a beating this year, falling 9.95% in the last month and 23% for the year.
• The stock has been affected by concerns about treasury yields and unrealized losses.
• BAC has a large amount of unrealized treasury losses, but its liquidity is still superior to that of the other Big Four banks–including JP Morgan.
• If you adjust Bank of America’s treasuries down to fair value they still cover 56.9% of deposits.
• The bank’s depressed valuation provides an additional margin of safety on top of its robust financials.

Bank of America (NYSE:BAC) stock has been beaten down severely in recent weeks. Over the last month, it has fallen 9.95%, capping a 23% decline for the whole year. The stock appears to have been the victim of some treasury-related concerns that came up in the first week of October. This week, long-term treasury yields spiked, leading to many investors selling off stocks. In a world where 5% yields on treasuries are obtainable, dividend stocks look less appealing. Such stocks were among those hardest hit in the first week of October-tech stocks fared comparatively well.

Bank of America faces two treasury related risks, one of them quite distinct from most stocks that sold off this week:

First, like most stocks, it pays a dividend, and that dividend looks less and less appealing as risk-free treasury yields rise. BAC’s dividend today is only 3.6%, which is not much compared to what the 1 year treasury offers.

Second – this is the more unique factor – Bank of America has by far the most unrealized treasury losses of any bank in America. Sitting at around $100 billion, BAC’s treasury losses dwarf those of its fellow banks-they made up 17.5% of the total unrealized losses at U.S. banks collectively!

Unrealized losses are problematic for banks because they affect banks’ liquidity. Earlier this year, the world watched as Silicon Valley Bank and First Republic Collapsed due to not having enough liquidity to pay off their depositors. Thanks to rising treasury yields, customers took their money out of those banks to invest them in treasuries, which offered more return than those banks’ savings accounts did. Unfortunately, the same yields that enticed the banks’ depositors also reduced their own liquidity: when treasury yields go up, treasury prices go down. Because of this phenomenon, SVB and FRB lacked the liquidity needed to pay off depositors during their bank runs and collapsed.

Many investors are worried about Bank of America today because it has a large amount of unrealized losses on its books. $100 billion certainly sounds like a lot of money. However, what’s often ignored is the fact that Bank of America’s liquidity is superior to that of many of its peers even after you write down the bank’s bonds to fair value. As I will show shortly, Bank of America has enough cash and bonds combined to cover 56.9% of its deposits, and a 119% liquidity coverage ratio. This makes BAC more liquid, and more able to withstand a crisis, than many of its peers.

When I last wrote about Bank of America, I rated it a “buy” on the basis of the fact that it was cheap and growing rapidly. Today, I still harbor the same feelings about the company itself, only the stock is now 11% cheaper. Accordingly, I am upgrading my rating to ‘strong buy.’ In this article I will explain my reasons for the newly higher rating.

The Bear Case and Why It’s Wrong

The main issue that bears have with Bank of America stock is the fact that the company supposedly has severe liquidity issues brought on by unrealized securities losses. It is true that the Bank is sitting on large amounts of unrealized losses, but it’s not true that these losses present an immediate threat to the company. Even after you adjust the values of BAC’s bonds down to fair value (i.e. subtract the unrealized losses from them), you still get more liquidity than most banks have.

In the most recent quarter, Bank of America had:

• $373 billion in cash.

• $800 billion in securities held at amortized cost.

• $697 billion in securities measured at fair value.

• $1.88 trillion in deposits.

$697 billion is what’s left of Bank of America’s bonds once you subtract its unrealized losses. Add the cash to that and you’ve got $1,070 trillion in liquidity. 1,070 divided by 1,880 is 56.9%. So, even after writing down the value of BAC’s held to maturity securities, you’re still left with enough liquidity to cover more than half of deposits.

Is that good?

We can answer that question by looking at the same percentages for BAC’s closest competitors: JPMorgan (JPM), Citigroup (C) and Wells Fargo (WFC).

	JP Morgan	Citigroup	Wells Fargo
Cash	$485.1B	$283.9B	$154.9B
Securities at amortized cost	$612.2B	$513.9B	$406.6B
Securities at fair value (“FV”)	$611.4B	$486B	$365B
Deposits	$2.3T	$1.32T	$1.34T
FV securities/deposits	47.6%	37%	39%

Click to enlarge

As you can see, Bank of America is the most liquid of its peer group, even though its shares have been beaten down far more than most of the others this year. This fact is further confirmed by the bank’s liquidity coverage ratio. According to BAC’s most recent quarterly information supplement, it had a 119% liquidity coverage ratio, which is 19% higher than what regulators require (100%). Overall, Bank of America’s liquidity picture appears quite good. Even if the recent spike in treasury yields results in the company’s bonds declining further in value, it will still have a lot of liquidity. A full $373 billion of it-or 20% of deposits-is held in cash!

Bank of America – the Bull Case

Having established that Bank of America’s liquidity issues are not insurmountable, thus refuting the main bear case on the bank, we can now move on to the bull case. If Bank of America isn’t really suffering from severe liquidity issues, then it’s possible that the company’s profitability, growth and valuation make it a buy.

First, let’s take a look at profitability.

In its most recent quarter, BAC had:

• $25.2 billion in revenue, up 11%.

• $7.4 billion in net income, up 19%.

• An 11.2% return on equity.

• A 15% return on tangible book value.

The returns on equity and tangible book value are satisfactory. The revenue and earnings figures give us a 29.3% net margin, which is very high. Seeking Alpha’s numbers for the entire trailing 12-month (“TTM”) period are similar. So, Bank of America is a very profitable company.

It’s a similar story with growth. According to Seeking Alpha Quant, BAC grew at the following rates in the TTM period:

• Revenue: 5.6%.

• EPS: 8.8%.

• Return on equity: 5.11% growth.

Overall, Bank of America achieved satisfactory growth in the TTM period. The five year CAGR growth rates were even better:

• Revenue: 2.5%.

• Net income: 6.5%.

• EPS: 12.8%.

• Equity: 1.2%.

Again, these growth figures are strong. With BAC’s current 7.5 P/E ratio, we have a 0.585 PEG ratio, which is below the level usually considered to make a stock worth the investment.

Finally, we can look at BAC’s valuation. At today’s prices, it trades at:

• 7.5 times earnings.

• 2.17 times sales.

• 0.81 times book value.

• 4.6 times operating cash flow.

On the whole, these are rock bottom multiples. The only caveat is that if you calculate book value using fair values instead of amortized costs, then the price/book ratio rises. Seeking Alpha Quant reports $254 billion in book value for BAC in the TTM period. Subtract $100 billion from that and you’re down to $154 billion in book value at fair value. Divide that by 9.6 billion shares outstanding, and we’re at $19.83 in book value per share. Divide the current stock price by that sum and we’re at a 1.3 price/book ratio. Certainly not high by the standards of the markets these days, but not as low as it appears to be at first glance.

The Bottom Line

The bottom line of Bank of America is that it’s among the most liquid and well-run of the Big Four banks, yet is among the cheapest of the lot. BAC has more liquidity as a percentage of deposits than JPMorgan does, yet it is trading as though it’s going to collapse. It seems clear that investors are looking at BAC’s unrealized losses and assuming that, in and of themselves, they present a major liquidity issue. In fact, they don’t. BAC remains highly liquid even after you adjust its securities down to fair value. The markets aren’t valuing Bank of America based on its overall risk and return profile, but rather taking ‘unrealized losses’ as the be-all and end-all of risk. This has created a mispricing that makes BAC shares very attractive today.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of BAC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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