Bank of America reported a 13% decline in mortgage revenues in 1Q 2013, which is consistent with the experience (if not the magnitude thereof) of its competitors such as JPMorgan (JPM) and Wells Fargo (WFC). One positive development is that the recent mortgage bankers survey suggests that second-quarter mortgage activity is improving at a 12% annualized pace, which should enable money center banks to recover lost ground.
Indeed, Bank of America is expected to see earnings of 97 cents this year, though that may be adjusted down to 87 cents following the MBIA settlement. Even using the lower figure, however, its annual earnings improvement would be in the magnitude of 248%. This earnings recovery is expected to persist into 2014: earnings per share are expected to rise to $1.27, an improvement of between 31 and 46% over 2013's expected number.
Including 2014, earnings per share are expected to grow by an average of 23.4% over the next five years - an impressive turnaround from the average contraction of 21.4% in the previous five years. This compares favorably to the 8.5% growth expected from the banking industry as a whole for the same period, which also trails the 9.4% earnings growth rate anticipated for the S&P 500.
Ostensibly, Bank of America will gain traction not only from the continued recovery of the mortgage market but also through a combination of the expansion of its investment banking activities, in which it is currently ranked second in terms of global investment banking fees, and wealth management, where its revenues are at their highest since Bank of America acquired Merrill Lynch.
At the risk of overstating things, this is why Bank of America's settlement with MBIA and other legacy claimants is important: management can focus on the more substantive (to shareholders, anyway) parts of managing its business of banking rather than dealing with regulators or aggrieved parties.
Related to this renewed focus, Bank of America has already moved forward with its "New BAC" project, which it now expects will save it $8 billion a year by 2015. In our view, the biggest danger for Bank of America going forward is not litigation so much as execution: it cannot afford any further bungles such as imposing a $5 surcharge on debit card transactions.
Valuation and Fundamentals
On the face of it, Bank of America is currently expensive. After adjusting for the MBIA settlement, its stock is now trading at 61x its trailing 12-month earnings. Yet Bank of America's earnings are impaired by its legacy costs and up-front restructuring charges, which have taken a huge amount away from its bottom line. By the less-cluttered measure of its price-to-sales, Bank of America is actually trading at a discount: 1.45x to 1.8x for its industry.
The same relationship holds on a price-to-book value basis: Bank of America is trading at 0.66x compared with 0.98x. Considering that the typical rule-of-thumb valuation for a financial entity is 2x book value, it is evident that the market is still wary of financial institutions in general and of Bank of America in particular. In that sense, and coupled with its future earnings prospects, it can be said that there is a much better company hidden beneath the uncertainty of litigation.
Moreover, Bank of America shareholders can take comfort in the fact that certain of its key metrics are trending in the right direction: its current net income margin is now at 5.7%, better than a four-fold improvement over its performance over the past five years - and far better than its industry's 0.12% margin. At the same time, its return on investment should improve further if its bet on MBIA proves correct - something that it could use given its break-even ROI over the past five years.
Conclusion
Bank of America is making significant progress in working its way out of the hole that its previous leadership had dug it into. Its restructuring efforts and the wave of settlements it's made over the years, of which the MBIA transaction is the latest, demonstrates that management is committed to moving away from the company's legacy and focused instead on bringing Bank of America back to its historic levels of profitability. Meanwhile, the recovering mortgage market and the fertile capital markets augur well for the company's earnings going forward.
Given these factors, we believe that Bank of America will not trail the S&P 500 for long and could see its shares above $18.50 by year's end.
