Why Bank Of America Should Trade For $22 In 2015

Summary

• BAC's terrific balance sheet has positioned the company well for higher credit demand.
• Rising interest rates should bolster returns from the portfolio.
• A conservative multiple on BAC's rising earnings - if I'm right - would mean $22 is very possible in 12 months' time.

I've written extensively here on SA about my bullishness for Bank of America (NYSE:BAC), a stock that I think still has some legs despite its huge move up recently. The stock has been a battleground for investors to say the least as the company has had several multi-billion dollar legal headaches that have sucked investors dry over the past few years. Whether all of the penalties were deserved or not is really moot at this point because the fact is the money has been paid (or reserved) and it's done. But that means investors can move ahead and value BAC like a bank instead of valuing it based on the whims of the Justice Department's next suit against it. I called for BAC to hit $20 in 2015 a few months ago on the back of the company being on track to earn $1.75 in 2015 and in this article, I'll take a look at those predictions and assess BAC's value after rallying to $18 late in 2014.

(click to enlarge)

To do this, I'll use a DCF-type model you can read more about here. The model includes inputs such as earnings estimates, sourced from Yahoo!, dividends, which I've set to grow at 10 cents next year and 20 cents per year after, and a discount rate, which I've set at the 10 year Treasury rate plus a risk premium of 5.75%.

		2014	2015	2016	2017	2018	2019
Earnings Forecast
Prior Year earnings per share		$0.90	$0.44	$1.47	$1.59	$1.72	$1.85
x(1+Forecasted earnings growth)		-51.10%	234.10%	8.00%	8.00%	8.00%	8.00%
=Forecasted earnings per share		$0.44	$1.47	$1.59	$1.72	$1.85	$2.00
Equity Book Value Forecasts
Equity book value at beginning of year		$26.45	$26.69	$27.86	$28.95	$29.96	$30.92
Earnings per share		$0.44	$1.47	$1.59	$1.72	$1.85	$2.00
-Dividends per share		$0.20	$0.30	$0.50	$0.70	$0.90	$1.10
=Equity book value at EOY	$26.45	$26.69	$27.86	$28.95	$29.96	$30.92	$31.82
Abnormal earnings
Equity book value at begin of year		$26.45	$26.69	$27.86	$28.95	$29.96	$30.92
x Equity cost of capital	8.00%	8.00%	8.00%	8.00%	8.00%	8.00%	8.00%
=Normal earnings		$2.12	$2.14	$2.23	$2.32	$2.40	$2.47
Forecasted EPS		$0.44	$1.47	$1.59	$1.72	$1.85	$2.00
-Normal earnings		$2.12	$2.14	$2.23	$2.32	$2.40	$2.47
=Abnormal earnings		-$1.68	-$0.66	-$0.64	-$0.60	-$0.54	-$0.47
Valuation
Future abnormal earnings		-$1.68	-$0.66	-$0.64	-$0.60	-$0.54	-$0.47
x discount factor(0.08)		0.926	0.857	0.794	0.735	0.681	0.630
=Abnormal earnings disc to present		-$1.55	-$0.57	-$0.51	-$0.44	-$0.37	-$0.30
Abnormal earnings in year +6							-$0.47
Assumed long-term growth rate							3.00%
Value of terminal year							-$9.46
Estimated share price
Sum of discounted AE over horizon		-$3.44
+PV of terminal year AE		-$5.96
=PV of all AE		-$9.40
+Current equity book value		$26.45
=Estimated current share price		$17.05

We can see the model produced a fair value of $17, one dollar below where shares are currently trading. That means the model is saying BAC is more than fairly valued and should probably be sold. But what does the model do? The intention is to provide investors with a price at which a margin of safety can be achieved; with BAC trading over the fair value price no margin of safety is implied. But the model is currently using analyst consensus estimates and I believe those estimates are too conservative.

My bullishness on BAC has always been predicated on the company being able to return to 'normal' levels of earnings on its ample asset base. BAC has been an interesting study in the past decade or so in a bank that went from being just a bank to one that attempted to become a financial services juggernaut, only to be humbled by the financial crisis, terrible decisions and expensive acquisitions. The thing that has become clear about the last few years with Bank of America is that it is not simply a bank; it is a full service money center bank that attempts to touch consumers at every point of their financial lives. This sounds great in theory but poor management from prior regimes has left BAC with a tangled web of huge losses and a bad reputation, a condition that has been getting better with time.

Strategically I think BAC is certainly on the right path to hitting my $1.75 EPS estimate for next year although consensus is still down at $1.47, right where estimates have been for the past several months. The company continues to downsize its physical presence in retail banking as that segment of the industry appears to be going the way of the dodo. It's certainly important to have a physical location consumers can walk into but having more than 5,000 is unnecessary. BAC is saving a lot of money by downsizing its branch network and I'm wholeheartedly behind this continued effort.

BAC is also continuing to work through its legacy servicing unit's problems. This is the unit that is housing all of the disasters from the Countrywide acquisition, easily one of the worst purchases in the history of business. Losses are still enormous but pale in comparison to the losses sustained in recent years. With the legacy servicing business getting ever closer to breaking even, a huge lift to EPS will be provided by way of the anchor that is legacy servicing becoming a little lighter. And I know the current management team is determined for this type of unit never to be needed again as prudent lending practices have prevailed over the willy nilly, wild west style lending that pervaded the financial crisis era Bank of America; I think this problem will be put to bed for good in the next year or so.

BAC's portfolio has also seen its gross yields driven down steadily in recent years, a condition which cannot persist. This has been the result of rock bottom interest rates and cautious lending practices combined with somewhat weak demand for credit in the industry. Only one of those factors - cautious lending - is within BAC's control and one thing I've been very pleased to see from management is a lack of motivation to relax credit standards in order to create demand. A bank doesn't operate like a normal business that can lower prices to stimulate demand - prices are largely fixed when lending - but it can relax the standards it requires for a customer to achieve a line of credit in order to stimulate demand but BAC has resisted. That means no more crisis-style blow ups in the balance sheet, no more $17 billion lawsuits and no more need for legacy servicing units. Yes, demand has been weak but it is for the long-term health of this company and I'll take weak demand over tens of billions in losses any day.

The Fed has made it very clear the target date for beginning the process of raising rates is June. The Fed has come off of its unprecedented accommodation in monetary policy but has a long way to go to fully reverse its position. Raising short-term rates in June would be a huge step forward for banks as it would mark the beginning of the process for the normalization of credit rates. That would mean an end to the trough rates BAC and others have been charging for credit and it would also make lending more attractive as higher rates can be achieved. It is this that will lead to top line growth for BAC and with its substantial margins on interest income, much of that will turn into profit.

I think BAC will surprise investors with its 2015. The company is extremely well positioned with its balance sheet, lending practices and top notch management. The wildcards in this case are rates rising - when and by how much - and the Fed; the regulator still needs to approve BAC's capital return plans each year, an affliction that all of the largest banks suffer from. That means my dividend forecast is subject to enormous changes and it could still be a while before BAC is an income stock again.

If BAC can hit $1.75 next year on higher rates and utilization of its lending capacity, analyst estimates will be ratcheted up and we'd see the stock into the $20s. Once investors catch on that BAC is a coiled spring, which I've long argued it is, higher estimates will lead to a higher earnings multiple and we'll see the stock move up. While BAC isn't overly cheap at $18, it's still cheap enough that I want to continue to hold it because I think there is still more left in it. After a wave of euphoria sent shares skyrocketing from the low teens, sentiment has cooled a bit. But BAC has been quietly building its business for higher rates and credit utilization and I want to be there when it starts to work. My prediction for BAC shares is $22 by the end of 2015 as EPS moves over $1.75 next year and estimates for the out years are moved up. Growth is hard to come by in the mega banking space and if BAC can produce growth, it will earn a premium multiple over its competitors. But once $2 in EPS becomes a reality, $22 will prove to be conservative as that represents only 11 times earnings; the future looks bright indeed.

By Josh Arnold

Source:http://seekingalpha.com/article/2782605-why-bank-of-america-should-trade-for-22-in-2015