December 8, 2007

BofA: Value idea?

What attracted me to investigate Bank of America (BAC) is its dividend yield. A blue chip company that is yielding around 5.8% is rare. Well, that is not saying much, Citi's yield is almost 7%. Well, Citi and BAC are in two different categories of value. BAC is a good company with good management but is under pressure due to macro economic factors beyond its control. Citi is under the same pressures but it also has internal process problems and that's what concerns me. There is a lot of uncertainties facing both banks but with BAC I can assign some probabilities to the risks it faces, while Citi there are some uncertainties that are simply unknown. For example, the huge exposure to SIVs, extent of the problems with its assets and their quality, its leadership position, risk management processes...etc. Therefore I choose to pick BAC that has an extensive retail operations with little investment banking exposure compared to its rivals.

In this post I will go over the following:

  1. BAC Overview
  2. BAC economics and Competitive Advantages
  3. Management Quality
  4. Financial Quality
  5. Dividend Quality

Bank of America (BAC) overview:

Bank of America is one of the world's largest financial institutions, serving
individual consumers, small and middle market businesses and large corporations
with a full range of banking, investing, asset management and other financial
and risk-management products and services. The company provides unmatched
convenience in the United States, serving more than 55 million consumer and
small business relationships with more than 5,700 retail banking offices, nearly
17,000 ATMs and award-winning online banking with more than 20 million active
users. Bank of America is the No. 1 overall Small Business Administration (SBA)
lender in the United States and the No. 1 SBA lender to minority-owned small
businesses. The company serves clients in 175 countries and has relationships
with 98 percent of the U.S. Fortune 500 companies and 80 percent of the Global
Fortune 500. Bank of America Corporation stock (NYSE: BAC) is listed on the New
York Stock Exchange. (Source BAC web site)

Forbes magazine has selected BAC as the best big company in the banking sector outclassing JP Morgan and Wells Fargo. For more on their ranking read here. The bank boosts the highest 5 year total return, sales and net income amongst its peers.

Name5-Year Total Return %Sales ($bil)Net Income ($mil)
Bank of America15.8 108.6 19,451
BOK Financial13.6 1.3 211
Colonial BancGroup15.5 1.6 261
Commerce Bancorp14.7 2.7 283
Compass Bancshares19.2 2.6 444
Hudson City Bancorp30.7 1.5 294
IndyMac Bancorp17.8 2.4 343
JPMorgan Chase7.2 93.0 12,616
KeyCorp13.7 7.5 1,200
M&T Bank12.1 4.2 831
Marshall & Ilsley10.4 4.5 815
PNC Financial Services7.9 10.9 2,574
Regions Financial13.3 6.8 1,246
Synovus Financial7.1 3.9 579
US Bancorp17.4 18.6 4,700
Wachovia15.5 41.9 7,197
Wells Fargo13.6 46.3 8,231
Zions Bancorp12.4 3.1 565

BAC economics and Competitive Advantage:

The major core value for BAC is its retail network. BAC is the only bank to have a significant presence nationally, while Wells Fargo is mainly a west cost bank and JP Morgan, which its retail network inherited from Chase Bank, is heavily concentrated in the north east. The retail network is a strong and defendable competitive advantage for BAC. The bank is large and well run, it has huge deposit base making its capital less expensive than others. The bank's economies of scale due to its size combined with cheap capital base makes BAC a cost leader earning above average returns.

Market Share leader: BAC earns more per quarter than others, see schedule above, and it is first in deposits, credit and debit card transactions, small business banking, Internet banking and, with the recent acquisition of US Trust from Charles Schwab, private banking as well. It has a top 4 ranking in market share of deposits in each states it operates in. (table courtesy of Forbes)

BAC enjoys economies of scale compared to its rivals. In addition to its large ATM network, it has the largest network of retail branches among its peers. Blanketing the nation, the bank has more domestic outlets (5,700) than its two largest competitors--five times as many as Citi and twice as many as JPMorgan Chase. BAC would rather conquer middle America rather than increase its investment banking operations. BAC gets 56% of its revenue from consumer banking, Citi and Chase more like 40%.The large size translate into less customer acquisitions and advertising expense as the bank able to leverage national advertising campaigns into all of its locations and areas more effectively, while others have to duplicate efforts in more than one market to acquire an additional customer.

BAC capital base has lower cost than others due to its large number of retail deposits, ATM machines, and branch network. BAC is the US leader in market share of US deposits close to the federal level cap of 10% followed by JP Morgan Chase with 7%. Deposits boost a bank liquidity and capital base at much lower cost than borrowing on the open market or from the FED discount window. Banks typically pay lower rate of interest on deposits than on borrowed funds. For example, A $20,000 savings balance yields maybe 0.2% interest; a $20,000 car loan yields 7.2%. Branches bring in mortgages, home equity lines of credit, auto loans, small-business borrowings, certificates of deposit, credit cards--all products with fairly predictable income streams. The same cannot be said of hedge fund operations and investment banking. BAC has by far the lower cost of capital compared to other banks. This is a huge competitive advantage that enhances returns and create shareholder's value in the long run.

Not satisfied by being just the biggest, BAC spends on IT and Data processing to ensure it continues to operate efficiently. BAC average capital expenditure over the last 5 years was 1.17% of revenue in addition to annual expenses on IT in the tune of 3.4%. The branches are stuffed with the latest banking technology designed to aid customers. Under a new system being rolled out, you feed checks into an ATM and the deposit receipt comes back with photo images of them. However, BAC trails JP Morgan in this department, which invests heavily in its infrastructure as it spends 5.9% (latest financials) on Technology and communications. However in absolute level BAC investment is much higher.

BAC is a cost leader in the industry due to its back office efficiencies and its enormous economies of scale. Despite its retail focus and its pampering of customers, BAC does not have high operating costs. They eat up 49 cents of its net interest dollar, 61 for Chase and 64 for Citi, according to SNL Financial. Indeed a quick comparison between BAC and other banks in its return on revenue, assets and equities shows that its competitive advantages translates to solid margins. BAC's returns are consistent over the last 5 years history of solid performance and strong competitive position.

Operating Margin (TTM)41.1233.997.8734.6734.7
Operating Margin - 5 Yr. Avg.41.7322.7332.2235.0550.09
Pre-Tax Margin (TTM)41.1233.9926.7234.6733.42
Pre-Tax Margin - 5 Yr. Avg.41.7322.7332.2235.0542.47
Net Profit Margin (TTM)27.6823.2319.2523.2824.18
Net Profit Margin - 5 Yr. Avg.28.1315.6622.523.0328.8
Return On Assets (TTM)1.321.160.921.741.33
Return On Assets - 5 Yr. Avg.1.480.71.311.721.34
Return On Equity (TTM)14.813.9615.219.415.81
Return On Equity - 5 Yr. Avg.18.349.1217.4219.516.38

Management Quality:
While BAC's counterparts at Citi and Chase struggle to bring order to the dissonant pieces of their empires, BAC lifer Lewis, 60, has learned, through years of integrating new acquisitions, how to make operations run smoothly. "I grew up in the bank," he says. A quality is of great importance to have the bank leader grow through the ranks of the organization.

Management is skilled at buying smaller organization and integrating them efficiently and quickly. Management have been careful to buy assets opportunistically at good prices in easily digested doses rather than massive ones that can interrupt operations and take from management focus on running the bank.

BAC management concentrate on customer service and providing quality product. A recent survey has customer satisfaction of customers improve from 43% to 50% in 2007. The continuous investment in technology and ATM to enhance users experience is testament to management focus on operations rather than empire building.

The bank is light on mortgages and out of any business related to subprime. The management saw the potential threats of the subprime lending and got out of the business altogether. BAC is absent from the top 20 subprime lenders in 2007, 2006 and 2005 (source: inside Mortgages rankings).

Today's credit and mortgage crises lead to the implosion of 200 major lending operations in the US. It leaves the better capitalized, liquid and much stronger BAC to earn more business in the future and expands its market share, once things return to normalcy (I do not know when will this happen, but someday it will). BAC is not big in mortgages but it has been aggressively boosting its mortgage business, taking up market share as many other non-bank lenders have disappeared or cut back, hurt by problems with subprime and other risky mortgage debt. First mortgage originations were up 27%. Its investment in Country wide may lead to a joint venture or a buyout if Country wide is on the verge of bankruptcy!

Financial Quality:

BAC capital, liquidity and reserves against possible credit losses are better compared to other banks. Its Tier 1 capital ratio, which measures a bank's core financial strength, was 8.22% at the end of the second quarter, compared with 7.32% for Citigroup (C) and 8.42% at JP Morgan Chase. Its Level 3 Assets, consisting of illiquid holdings -- including private-equity and subprime mortgages that are marked to model, rather than marked to market -- are 1% to 2% of total assets, versus 6% at Citi and 4% at JP Morgan chase.

Another plus for the bank is the lack of any exposure to the troubled Special Investment Vehicles (SIVs), unlike Citi's $80 billion and HSBC's $45 billion exposure of low rated entities and assets.

Dividend Quality:

BAC has a dividend yield 5.64% higher than the industry average of 4.72%. Also Dividends have been growing at a steady rate, the 5 year average of dividend growth of 13.21% is consistent with the 10 year growth average of 13%. Cash flows and earnings have kept pace as well. Cash flow growth rate has been 8.16% over the last 10 years. and it increases to 11.2% over the last 5 years. So cash flow growth has kept up pace with the dividends. In addition the payout ratio at 50% is not high to strain the bank's flexibility to invest in operations or to increase the payout even higher.

Dividend Yield5.643.296.293.814.68
Dividend Yield - 5 Year Avg.--3.822.942.823.34
Dividend 5 Year Growth Rate13.210.0126.7116.6513.36
Payout Ratio (TTM)50.7731.0156.3143.0447.09

Investment Conclusion:
BAC have a solid advantage and business operations compared to other banks. BAC have unparalleled retail network that gives the bank cheap capital and allow it to be a market share leader in sales to consumers. The business revenue stream is not as volatile as other banks as it is light on investment banking and heavy on the more predictable retail. Although the bank may suffer in an economic downturn, but its advantages, good management and low cost base will prevail in the long run.

The recent sell off in the banks makes a good buying opportunity in BAC. The bank expected return is 11% going forward (earning yield plus dividend yield) higher than the industry average. As a result of my analysis I purchased BAC few weeks earlier at $44 a share and I figure that there is a 25% upside potential to fair value.

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