BAC Longs Already Know This

[Parsad]

Here's a pretty good group of charts showing a few different ratios for various financial institutions and their stock price.  You can pretty easily see that the only thing holding BAC's stock price back is fear over the overhanging lawsuits and continued doubts about loan loss provisions.  The current price has no real fundamental reason to be where it is based on the balance sheet.  Cheers!

 

  http://www.forbes.com/sites/ycharts/2012/03/10/bank-capital-tangible-common-equity-vs-wishful-thinking-ratios/

[Cardboard]

I don't know why they are not more agressive in settling some of their lawsuits. MBI seems like a good one, AIG another. It would certainly help me since I have positions in all three, but I think that lifting some of that uncertainty at BAC would do wonders.

 

I actually like the idea that someone mentioned about BAC buying MBIA. It is cheap and they could make money while resolving that issue at the same time. However, I will likely make more money longer term by them staying independent.

 

Cardboard

[ERICOPOLY]

The loan loss reserve is as large as 2.1x annualized losses.

 

Where do the doubts come from?

 

 

[racemize]

I think they are likely under-reserved for for reps and warranties, but I don't know how much.  I guess the other concern is collateral effects from a European melt-down.

[bmichaud]

The doubts arise from whether or not BAC has charged off enough and if the figure you cite, 2.1x charge offs, is actually indicative of BAC over reserving. Further, based on BAC's historical loss rate on repurchases  and the amount of loans still at less than 25 payments, there is a chance BAC could suffer further repurchases losses of greater than $15 billion. Right now BAC says "possible" losses are $5 billion - given that last year bac said possible losses were less than $10 billion and had to reserve for an additional $15 billion, IMO the market is right to question management on its assumptions.

 

However, while I believe the market is quite correct in discounting BAC for the above risks, I believe all of the above concerns are strongly mitigated by $30 billion of ptpp before accounting for "New BAC" cost cuts, and time (i.e. the more loans that reach greater than 25 pmts the lower the risk of repurchases).

 

If we have another recession, NPA will have to be written down even further, loans less than 180dpd will go bad at a faster rate and thus have to be written down to NRV, and the current loan portfolio will experience standard loss rates. So at risk of pointing out the obvious, BAC could languish for longer than expected, but the current price may provide reasonable compensation for such risks...

[ERICOPOLY]

(i.e. the more loans that reach greater than 25 pmts the lower the risk of repurchases).

 

I agree with that statement but the head-scratcher here is that another 12 months have passed -- in other words, if you look at the outstanding risk last year vs this year, it must have come down a whole lot just due to tacking on 12 months of additional payments to so many loans.  And so whatever estimates management have right now of their reserve adequacy is that much more accurate.

[bmichaud]

Agreed. I'm just saying that BAC was inaccurate in the recent past, thus Mr. market has that recent memory in mind when assigning an asking price to BAC.

 

Not that anyone cares, but this is how I look at it. Total potential repurchase losses are about $60 billion assuming all loans under 25 pmts are bought back and experience a 30% loss rate. Realistically let's say $30 billion instead. So over the next three years that works out to $10B per year in further losses. BAC generates roughly $30B PTPP before factoring in New BAC but assuming $300 million per quarter for LAS expenses. Let's say "core" provision is around $8 billion - in other words, what it takes to reserve against the "current" loan portfolio. So that leaves let's call it $20 billion to cover additional repurchase and loan losses. Over three years thats $60 billion of PTPP to cover $30 billion of repurchase losses and leaves $30 billion to write off anything 30 days or more past due over and above what is currently reserved for.

 

So by 2015, BAC could have all repurchases taken care off, all non-current loans written off and/or fully reserved for, New BAC fully implemented, a clean book value somewhere between $20 and $12 per share, and clean "though-the-cycle" EPS of around $1.50 per share. I say by FYE 2014 it trades for 12.5 times that EPS number, or $19 per share. Not a bad three year return.

 

Yes I have a position in BAC and yes it goes against my rhetoric of the last six months. However, I've learned from my mistakes, rolled up my sleeves and really dug into BAC's financials, and taken heed of Berkowitz's recent words of wisdom: "the world rarely comes to an end."

[ERICOPOLY]

Agreed. I'm just saying that BAC was inaccurate in the recent past, thus Mr. market has that recent memory in mind when assigning an asking price to BAC.

 

Not that anyone cares, but this is how I look at it. Total potential repurchase losses are about $60 billion assuming all loans under 25 pmts are bought back and experience a 30% loss rate. Realistically let's say $30 billion instead. So over the next three years that works out to $10B per year in further losses. BAC generates roughly $30B PTPP before factoring in new BAC but assuming $300 million per quarter for LAS expenses. Let's say "core" provision is around $8 billion - in other words, what it takes to reserve against the "current" loan portfolio. So that leaves let's call it $20 billion to cover additional repurchase and loan losses. Over three years thats $60 billion of PTPP to cover $30 billion of repurchase losses and leaves $30 billion to write off anything 30 days or more past due over and above what is currently reserved for.

 

So by 2015, BAC could have all repurchases taken care off, all non-current loans written off and/or fully reserved for, new BAC fully implemented, a clean book value somewhere between $20 and $12 per share, and clean "though-the-cycle" EPS of around $1.50 per share. I say by FYE 2014 it trades for 12.5 times that EPS number, or $19 per share. Not a bad three year return.

 

Yes I have a position in BAC and yes it goes against my rhetoric of the last six months. However, I've learned from my mistakes, rolled up my sleeves and really dug into BAC's financials, and taken heed of Berkowitz's recent words of wisdom: "the world rarely comes to an end."

 

I would be very very happy with that outcome.  Anyone paying $13 per share today would make 15% annualized until FYE 2014 under that scenario.

[Parsad]

Agreed. I'm just saying that BAC was inaccurate in the recent past, thus Mr. market has that recent memory in mind when assigning an asking price to BAC.

 

Not that anyone cares, but this is how I look at it. Total potential repurchase losses are about $60 billion assuming all loans under 25 pmts are bought back and experience a 30% loss rate. Realistically let's say $30 billion instead. So over the next three years that works out to $10B per year in further losses. BAC generates roughly $30B PTPP before factoring in new BAC but assuming $300 million per quarter for LAS expenses. Let's say "core" provision is around $8 billion - in other words, what it takes to reserve against the "current" loan portfolio. So that leaves let's call it $20 billion to cover additional repurchase and loan losses. Over three years thats $60 billion of PTPP to cover $30 billion of repurchase losses and leaves $30 billion to write off anything 30 days or more past due over and above what is currently reserved for.

 

So by 2015, BAC could have all repurchases taken care off, all non-current loans written off and/or fully reserved for, new BAC fully implemented, a clean book value somewhere between $20 and $12 per share, and clean "though-the-cycle" EPS of around $1.50 per share. I say by FYE 2014 it trades for 12.5 times that EPS number, or $19 per share. Not a bad three year return.

 

Yes I have a position in BAC and yes it goes against my rhetoric of the last six months. However, I've learned from my mistakes, rolled up my sleeves and really dug into BAC's financials, and taken heed of Berkowitz's recent words of wisdom: "the world rarely comes to an end."

 

I would be very very happy with that outcome.  Anyone paying $13 per share today would make 15% annualized until FYE 2014 under that scenario.

 

I paid a hell of a lot less than $13!  ;D  Also, there is one thing missing from your analysis Bmi (which I think is pretty accurate)...close to $10B in expense reductions over the next 3 years, and Moynihan's new goals of driving earnings forward.  So, your analysis is actually quite conservative...which is in line with what we estimated as well.  I don't plan on holding BAC or Wells for the next couple of years.  I plan on holding both for many years, reaping fat dividends from them over time.  Cheers! 

[ERICOPOLY]

I love the math.  We get another 62.5% rise in the stock by FYE 2012 to take us to $13.  Then from $13 we get yet another 20% annualized for two years to get to that $19 number.

 

[Parsad]

I love the math.  We get another 62.5% rise in the stock by FYE 2012 to take us to $13.  Then from $13 we get yet another 20% annualized for two years to get to that $19 number.

 

That's the conservative estimate based on the status quo for the U.S. economy.  If things deteriorate, the intrinsic value will continue to increase, but price may lag.  Like I said, tangible book by Christmas and book by mid-2014.  Cheers!

[bmichaud]

I was being conservative with $1.50 EPS by 2015. I can't quite get to $2 like BB, but I think $1.75 is quite doable after New BAC is fully implemented.

 

Parsad, I picture BAC being a low-return, high payout asset in a few years, thus not a great buy and hold investment once it reaches book value (let's say $20). What do you see that makes you want to hold over a super long time horizon? If it eventually earns its cost of equity, say 10% on a $20 BV, then it won't matter if it pays out 100% of earnings for a 10% yield or pays out 50% for a 5% yield and 5% growth. I guess it comes down to this - do you foresee more WFC-like returns on equity of 12 to 15%?

[ERICOPOLY]

I reason the dilemma would be the same.  You have high ROE at KO but don't expect much in annual returns holding it.  Reason:  the stock valuation is adjusted for the higher ROE and much of the earnings are not retained.

[bmichaud]

If I'm understanding you correctly, what you're saying is exactly what I'm saying - at some price, all investments are of equal attractiveness. The key is price.

 

So KO at 21 times earnings with 40% ROI for reinvested earnings, a 4% payout yield and 6% growth (6% growth achieved by retaining only 15% of $1 of earnings due to 40% ROI) is the exact same (assuming the economic prospects of KO and BAC don't deteriorate permanently going forward) as BAC at 10 times earnings with a 10% ROI for retained earnings, a 5% payout, and 5% growth (5% achieved by reinvesting 50% of $1 of earnings due to 10% ROI).

 

This is why I'm curious as to what Parsad sees in BAC long-term given the prospect of elevated capital ratios and correspondingly lower ROEs.

[ERICOPOLY]

I was being conservative with $1.50 EPS by 2015. I can't quite get to $2 like BB, but I think $1.75 is quite doable after New BAC is fully implemented.

 

Moynihan just told us last week that $35b-$40b pre-tax income is still doable in a normal environment (normal Fed interest rates, GDP growth of 3%, and planned cost cuts in place).

 

So $2.60 per share is possible if 11b shares and tax rate of 28%.  So a reason to hold the stock longer term is perhaps to wait to sell it into a stronger economy when full earnings power is realized.

 

He fields a question about it at the 21:30 mark (replay on BofA website).

 

 

[ERICOPOLY]

Over three years thats $60 billion of PTPP to cover $30 billion of repurchase losses

 

I get about 1/2 that amount.

 

I am thinking about $5b a year is the per-annum repurchase risk.

 

The calculation:

1)  $5b of repurchase requests per quarter (higher rate than last year) -- for $20b per year

2)  80% repurchase rate (same rate as AGO settlement)

3)  30% loss rate

 

$20b*.80*.30 = $4.8b

[bmichaud]

I like that calc better. If so, FYE 2014 BVPS is at least $1.25 higher than it would be otherwise.

[bmichaud]

I was being conservative with $1.50 EPS by 2015. I can't quite get to $2 like BB, but I think $1.75 is quite doable after New BAC is fully implemented.

 

Moynihan just told us last week that $35b-$40b pre-tax income is still doable in a normal environment (normal Fed interest rates, GDP growth of 3%, and planned cost cuts in place).

 

So $2.60 per share is possible if 11b shares and tax rate of 28%.  So a reason to hold the stock longer term is perhaps to wait to sell it into a stronger economy when full earnings power is realized.

 

He fields a question about it at the 21:30 mark (replay on BofA website).

 

I can't make it work with these calculations. $2.6 per share at 11b shares is $28.6b of net income. EBT is then $39.7b assuming a 28% tax rate, which implies nothing for loan loss reserves since ptpp is 35 to 40. Perhaps the $2.6 eps assumes a tax shelter? Even if so, 2.6 is not sustainable earnings usable for valuation purposes.

[ERICOPOLY]

I was being conservative with $1.50 EPS by 2015. I can't quite get to $2 like BB, but I think $1.75 is quite doable after New BAC is fully implemented.

 

Moynihan just told us last week that $35b-$40b pre-tax income is still doable in a normal environment (normal Fed interest rates, GDP growth of 3%, and planned cost cuts in place).

 

So $2.60 per share is possible if 11b shares and tax rate of 28%.  So a reason to hold the stock longer term is perhaps to wait to sell it into a stronger economy when full earnings power is realized.

 

He fields a question about it at the 21:30 mark (replay on BofA website).

 

I can't make it work with these calculations. $2.6 per share at 11b shares is $28.6b of net income. EBT is then $39.7b assuming a 28% tax rate, which implies nothing for loan loss reserves since ptpp is 35 to 40. Perhaps the $2.6 eps assumes a tax shelter? Even if so, 2.6 is not sustainable earnings usable for valuation purposes.

 

It's 35-40 of "income" before tax but AFTER provisioning for losses.

[bmichaud]

I was being conservative with $1.50 EPS by 2015. I can't quite get to $2 like BB, but I think $1.75 is quite doable after New BAC is fully implemented.

 

Moynihan just told us last week that $35b-$40b pre-tax income is still doable in a normal environment (normal Fed interest rates, GDP growth of 3%, and planned cost cuts in place).

 

So $2.60 per share is possible if 11b shares and tax rate of 28%.  So a reason to hold the stock longer term is perhaps to wait to sell it into a stronger economy when full earnings power is realized.

 

He fields a question about it at the 21:30 mark (replay on BofA website).

 

I can't make it work with these calculations. $2.6 per share at 11b shares is $28.6b of net income. EBT is then $39.7b assuming a 28% tax rate, which implies nothing for loan loss reserves since ptpp is 35 to 40. Perhaps the $2.6 eps assumes a tax shelter? Even if so, 2.6 is not sustainable earnings usable for valuation purposes.

 

It's 35-40 of "income" before tax but AFTER provisioning for losses.

 

Ah yes, didn't notice that. Dang that seems high for EBT. Would be sweet though.

[bmichaud]

your analysis seems to imply  bac trading at 10x normalized earnings and = to book value today.

 

This was precisely the reason for my question to Parsad. If we assume BAC earns no higher than its cost of equity, then once it reaches book value it is no longer a compelling long-term investment, regardless of the payout. If in fact normal EPS is $2.60 as Eric posited, BAC's cost of equity is 10% and it earns 10% on reinvested earnings, then BAC is no longer a compelling investment once it hits $26. If in fact ROE is 12% as you said, then BAC remains interesting even at an EPV of $26 since 50% of earnings reinvested at 12% equals a growth rate of 6% and a 4% dividend yield (required yield to reconcile 6% GR w/ 10% cost of equity) means a stock price of $32.50 (.5 x 2.6 / 4%).

 

Bottom line - I was curious what Parsad thought was "normal" ROE for BAC since that will largely determine the attractiveness of holding BAC for a long period of time.

[bmichaud]

I'm not comparing BAC and KO right now. I'm saying BAC at BV with a 10% ROE is the same as KO at 21 times earnings with a 40% ROE.

 

Parsad said he plans on holding BAC for much longer than two years. He also said he believes it will reach BV in two years, which implies he believes BAC is worth holding at BV, which further implies BAC will earn higher than its cost of equity. Thus I was curious what his thoughts were.

[ERICOPOLY]

[if in fact normal EPS is $2.60 as Eric posited, BAC's cost of equity is 10% and it earns 10% on reinvested earnings, then BAC is no longer a compelling investment once it hits $26. If in fact ROE is 12% as you said, then BAC remains interesting even at an EPV of $26 since 50% of earnings reinvested at 12% equals a growth rate of 6% and a 4% dividend yield (required yield to reconcile 6% GR w/ 10% cost of equity) means a stock price of $32.50 (.5 x 2.6 / 4%).

 

I believe tangible book per share will be somewhere around $18 to support those $2.60 in per share earnings -- this is when they are exceeding 9% Tier 1 capital ratio under fully phased in Basel III.

 

2.60 / 18 = 14.44%

 

So the return on reinvested capital would be 14.44%.  But I don't think they can reinvest 50% of their earnings -- where will the growth opportunities come from?

 

Or am I incorrect about that $18 per-share figure (using 11b share count).  I guess I'm using TCE of 9% as a proxy for Basel III of 9% (plus some cushion assuming TCE is more rigorous ratio than Basel III).

 

I believe Moynihan said about $18 billion of capital for every 100 bps of Basel III.  So with an 11 billion share count and a 9% target ratio the math is pretty easy --  about $18 per share.

[ERICOPOLY]

I think I overstated the necessary tangible book per share and therefore understated the return on retained earnings.  I think it's more like $16 per share and 16.25% return on retained earnings.

[Parsad]

I'm not comparing BAC and KO right now. I'm saying BAC at BV with a 10% ROE is the same as KO at 21 times earnings with a 40% ROE.

 

Parsad said he plans on holding BAC for much longer than two years. He also said he believes it will reach BV in two years, which implies he believes BAC is worth holding at BV, which further implies BAC will earn higher than its cost of equity. Thus I was curious what his thoughts were.

 

I think BAC's return on equity will be better than 10% after 2-3 years.  Why?  Because much of their earnings will be driven by a recovering housing market.  There is every reason to believe that once BAC gets their litigation issues out of the way, and their operating costs down to very efficient levels, they would entertain a price not much less than Wells Fargo relative to book. 

 

- Moynihan's model for BAC over the next five years is to copy the culture and customer-centric focus of Wells. 

- They have the deposit base and the mortgage business. 

- They also have a much more complete investment business than Wells. 

- The credit quality of their portfolio is improving every quarter. 

- Their operating efficiency should be on par with Wells over time.

 

When you have a CEO who truly puts his compensation aside to do the right thing for the business, you start to develop a culture that will permeate the ranks over time.  Compare Moynihan's compensation to Vikram Pandit's.  Look at what Moynihan had to work with and turnaround and look what Pundit had to work with...then compare their compensation.  That changes the way employees behave when the CEO does the stuff that no one else is willing to do.  I'm very keen on BAC, because I'm very keen on Moynihan...he's the intangible asset in the valuation that you guys aren't including in your calculations!  Cheers!