The Grind Goes On For Bank Of America

By Stephen D. Simpson, CFA | July 14, 2011 AAA

Bank of America (NYSE:BAC) seems locked into a dance of "two steps forward, two steps back." While the company got itself into a huge mess with poor underwriting and acquisition decisions, the company continues making mistakes like taking shortcuts in its foreclosure process. The conundrum for investors is that Bank of America has an invaluable branch network and strong positions in key states like California, Texas and Florida, but that network will never get full value absent evidence that B of A can run itself effectively and earn its cost of capital.

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Another Bank with Swampy Second Quarter Results
Like Citigroup (NYSE:C), and indeed most large banks, Bank of America's second quarter earnings are complicated by all manner of charges, gains and items. At the bottom-most bottom line, though, the company delivered on its guidance and produced earnings of 33 cents after those items. Of course, reserve release is still a big part of the story, and Bank of America saw $2.4 billion in earnings from this line item, while tangible book value fell about 4%.

Operating performance was still weak, however. Revenue fell 8% from the year-ago period and 6% from the first quarter. Net interest income dropped 13% and 7% over those time periods as the net interest margin declined and assets dropped about 1%. There is little sign of momentum in loans (consumer loans were flat) and fee income fell due in part to a large decline in trading - a common issue this quarter at other companies like Citigroup and Goldman Sachs (NYSE:GS).

Can Bank of America Run Its Own Assets?
Banks like PNC (NYSE:PNC) are paying quite a lot of money to get access to attractive markets like Florida, and it wasn't so long ago that the same was true of California and Texas. That suggests there is some real value in BOA's retail operations - this is the number-one bank in Florida, the number-two bank in Texas, and the number-one bank in California by a wide margin.

What's more, these market shares are going to be difficult to surmount. Wells Fargo (NYSE:WFC) and Citi are leading competitors in these markets and will not be able to expand share through acquisition. Likewise, BBVA (Nasdaq:BBVA) and BNP Paribas (which own Compass and Bank of the West, respectively) have bigger issues today than ongoing U.S. expansion. The bigger risk, then, may be that regional players like Regions (NYSE:RF) get bids from would-be national rivals, but that is an expensive proposition.

The question, though, is whether or not Bank of America can run this business effectively. The deals for Countrywide and Merrill Lynch have clearly not worked out as intended, but Bank of America has had plenty of its own mistakes to account for recently. If Bank of America can deliver a clean return on equity in excess of 10% (and this company used to routine do better than that), its discount to tangible book will disappear and it will be a good bank to hold. But at this point that is still very much an "if".

The Bottom Line
Unlike Citigroup, though, Bank of America does not have an exciting ex-U.S. banking franchise, nor a great non-bank fee business like US Bancorp (NYSE:USB). That leaves it with a great deal of exposure to the U.S. banking industry - an industry that has a much higher regulatory burden today and one whose growth prospects are modest.

That said, Bank of America does look like a reasonable holding for aggressive investors willing to bet that current management will either hit that ROE target or the board will find someone who can. It is not the best-run bank in the U.S., nor the one with the best long-term growth prospects, but in terms of discount to ongoing value, it may be at or near the top of its U.S. peers. (For additional reading, take a look at Analyzing A Bank's Financial Statements.)

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