Avoid This Banking Giant

Bank of America Corp (NYSE:BAC)


Since the start of 2012, Bank of America Corp (NYSE: BAC) has rewarded investors with a near 50 percent return, as the stock has crawled out of its so-called ‘winter of discontent’ with shares currently trading above the $8 mark.  From Main Street to Wall Street, BAC has been a banking beaut, though the stock’s fundamentals tell a darker tale.  Coupled with oncoming clouds concerning the effectiveness of the company’s strategic direction and its lack of macroeconomic stability, it may be time to sell BAC and take the gains while they are green.

On the whole, high returns in the financial sector have been one of the biggest surprises of the year.  Specifically, average earnings growth has risen to 12.8 percent, up from 9.7 percent in 2011.  Interestingly, it seems that most of this boost can be attributed to lower loan loss provisions, which are expenses that banks set aside for loan defaults.  While it is partially justifiable that banks can expect lower rates of default, specifically in the housing market, it should be noted that student loan default rates have spiked to almost 16 percent in 2012 – up from 11 percent the previous year.  In BAC’s case, its student loan business brings in annual revenues of $8 billion.  While this is about one-fifth the size of its mortgage lending operation, any losses in this area will hurt the company’s bottom line.

Adding to this uncertainty, the financial sector has been one of the most ambiguous segments of the American marketplace in recent years.  Whether it was the global recession of 2008 or the ongoing European debt crisis, macro-level risks have lowered banks’ profits while increasing regulatory pressures through measures like the Dodd-Frank Act and Basel Accords.  Most importantly, a slower-than-expected economic recovery has muted consumer spending and job growth – two factors that directly suppress demand for bank loans.  Specifically, since 2009, BAC’s revenues have shrunk from $119.6 billion to $93.5 billion, a decline of 28 percent.  In this same time period competitors like JPMorgan Chase & Co (NYSE: JPM) at -3.2%, Wells Fargo & Co (NYSE: WFC) at -8.7%, Citigroup Inc (NYSE: C) at -2.4%, and US Bankcorp (NYSE: USB) at 14.7% all have revenue streams that are in better shape.

Over this same time period, BAC’s free cash flow dropped by 55.6 percent, which is worse than all of its competitors: JPM (-42.1%), WFC (-41.9%), C (130.1%), and USB (-42.4%).  While it is understandable that cash hoards were squeezed during the last recession, it is obviously not desirable to have some of the largest FCF losses in the entire sector.  It is also evident that BAC has looked to bolster some of these declines through the use of debt, which is beneficial in reasonable levels, but harmful if Debt-to-Equity ratios are too high.  In BAC’s case, its D/E ratio of 1.9 is higher than the industry average of 1.8 and its peers JPM (1.6), WFC (1.1) and USB (1.1).  Citigroup’s D/E ratio is similarly 1.9. This high leverage is one of the reasons of excessive volatility in BAC’s stock price. As if these factors weren’t enough, Forward Price-to-Earnings ratios – the price that investors are willing to pay for future earnings – show that shares of BAC are slightly overrated.  With a Forward P/E of 8.2X, BAC is overvalued compared to JPM (8.1X) and C (7.3X).  Yes, BAC’s recent earnings release of $0.31 per share was higher than analyst estimates, but it should be noted that both JPM and C also beat expectations by similar margins.

Adding one final straw to this proverbial camel’s back, there have been many questions about the strategic direction and economic preparedness of Bank of America.  Last year, its announcement to charge checking account customers a $5 monthly fee was met with heavy criticism, amongst protestors’ cries that the company had already been one of the biggest beneficiaries of the 2008 bailout.  In addition, bears have pointed out that the bank’s Tier 1 capital ratio – a measure of financial strength – is around 8 percent, and is the lowest out of the competitors previously mentioned.  Regulators are keeping an eye of this figure, as it is a key measure of whether a bank can withstand any financial crises in the future.  While it should be noted that BAC passed their most recent ‘stress test,’ it still remains in a weaker position than competitors like JPM, WFC and C.

It appears that the hedge fund industry has already begun to take note of these ‘sell’ signals surrounding Bank of America.  As of the end of last year, just 26 fund managers held at least 1 percent of their portfolios in BAC stock, compared to 51 at the end of 2010.  Some of the most prominent managers that reduced their long positions during this time were Mohnish Pabrai, the duo of Michael Platt and William Reeves, Sandy Nairn, and Jeffrey Tannenbaum.  Whether its BAC’s combination of shrinking revenues and cash, or the lack of stability surrounding the company in general, investors may be wise to follow the actions of these managers and get out of Bank of America (BAC) stock.