Description

At $10.5 per share, BAC trades at roughly 80% of Tangible book and 4-5x the company's estimate of normalized earnings power.

            For comparison - regional banks trade at roughly 1.5x tangible book and 10-12x earnings power. BAC's franchise is stronger than the typical regional bank - with a wonderful deposit franchise. Compared to most regional banks, BAC has stronger deposit share, greater product offering, better tech/systems and the company owns the ML brokerage and banking business, which provides asset light earnings (brokerage) and a better growth profile (capital markets/I banking).

A number of issues weigh on BAC's stock -

• - Inability to Demonstrate normalized earnings power
• - Elevated credit costs
• - Uncertain risk associated with legacy mortgage business (reps & warranties, lender fraud, etc)
• - Timing of operating cost normalization
• - Basel III rules and US implementation of SIFI buffer
• - Economic Environment (NIM, credit losses, loan demand), US goes Japan (extended period of low rates, low loan demand, pressure NIM)

Inability to Demonstrate normalized earnings power

            There are a number of ways to get at normalized earnings - look at the historic results of the firms that make up today's BAC, or look at Q1 adjusted annualized earnings or 2010 adjusted, or apply reasonable ROA metrics to BAC's asset base.  Whatever you use, you will find that $45-50bn is a reasonable PPNR number. Normal credit costs can be understood by examining the realized loss results in different lines of business over the past 20 years. You'll find that $10-15bn is a reasonable range.  Deduct taxes and preferred divided and you'll find that BAC has $1.8-2.5 of normalized earnings power.  Given this level of normalized earnings, I'll argue if/when the other issues are resolved, that BAC is worth $20-30 per share in a normalized environment. A reasonable upside from the current stock price is around $15.

            But, BAC is a leveraged financial company, so things could disrupt current shareholders ability to benefit from the company's normalized earnings power. Many things that could prevent current shareholders from owning the upside are currently in the news (rep/warranty, servicer fraud, government insolvency, Basel III/SIFI rules).  Nobody knows how these risks will play out.

Is BAC adequately Capitalized?

It depends on how things play out, but statistically the company's leverage ratios are down 30-50% from the 2006/07 period and provisions cover NPA to the tune of 135%, so in the least, it is better capitalized than it was 5 years ago. 

What about uncertainty and risk associated with legacy mortgage business (reps & warranties, lender fraud etc.)?  I have seen estimates that legacy issues/litigation could be a $20bn cost (pre-tax) and easily covered by PPNR (which seems reasonable).  But, you'll have to make your own estimate. (don't forget FHA and PCI 1^st mortgage book).

What about Basel III rules and US implementation of SIFI buffer, I don't know, but it seems they are going to have until 2019 to get up to a 7% T1C level + (3%?) SIFI.  If they have until 2019, no problem.  If they need to get there by 2012, they are going to need to sell businesses or raise capital.  Unfortunately, we will all find out this answer at the same time.  It might be bad news, it might not matter much - we'll see.  

Under reasonable scenarios, it seems that BAC will muddle through in 2011 and 2012, mitigate legacy issues with PPNR and build Basel III/SIFI capital with retained earnings. 

It takes about 2 years or so to liquidate bad mortgages (also not a bad time line for mtg litigation, and AG settlement - we'll defiantly know the outcome on BASEL III/SIFI by then), so by YE 2013, BAC could be demonstrating normalized earnings power.  In that case, we could possible get a $20-30 stock.  Average out to $15 per share upside.

Unfortunately, the various risks facing BAC might not work out so well from BAC's perspective, so, lets look at a miserable scenario: Weak PPNR, high credit costs, 3x street estimates for rep/warranty, more than the AGs are asking (mk share adjusted) for servicer fraud, and $11bn of misc. costs (for god know what).  In a horrible scenario, BAC will need to raise capital, see below.

In the above, we've assumed everything goes poorly - earnings are 70% of normalized earnings power for the next 2 years and then 80% in the out year.  Credit losses remain high, rep/warranty is 3x street estimates, robo-signing litigation is settled at high end of AG ask, and I've thrown in $4bn a year of elevated costs and $3bn of legal costs (for unknown future issues). For good measure, I've assumed a 10% T1C Basel III/SIFI level, that must be met immediately.

In this miserable outcome, BAC is going to have to dilute current shareholders, and the stock will be worth less than today's stock price. I'd guess $2-5 less (but you'll have to make your own est. on BAC trading multiple and share issuance price)

            In the scenario presented, the downside works out to $5 per share.  Make your own assumptions, but it seems reasonable to say that BAC has $3 per share of upside for every $1 of downside.  One can get more interesting upside/downside ratios by examining the LEAPS or Gov. Warrants associated with BAC. Give that the downside is less than certain, BAC is interestingly priced.

Catalyst