A New Kid On the Block? Bank of America Merrill Lynch

Bank of America Merrill Lynch (NYSE: BAC) (BofA) was America’s punching bag after the financial crisis.

In fact, it was one of the hardest hit stocks during the crisis. From 2007 through 2009, it lost over 90% of its value.   However, things changed in November since it is one of the President-Elect Donald Trump’s agendas to dismantle the Dodd-Frank act and de-shackle the banking industry.

Also, the beginning of a rising interest rate environment makes Bank of America deserving of your attention.

Like the kid who was bullied on the playground, BofA built itself up and is ready to be a real contender.

First, the company. Bank of America’s products and services are offered through 4,629 financial centers and 16,000 ATMs. It is the ninth largest bank in the world and second largest bank in the U.S. with $2.2 trillion in assets under management.

It is also the largest consumer depository in the U.S. with 25% of its revenue coming from consumer banking. Nearly 30% of its revenue comes from its Global Wealth & Investment Management Services segment where its enormous network of financial advisors connect customers with investment management, brokerage, banking, and retirement products. The remainder comes from Global Banking (18%), Global Markets (25%), and Legacy Asset Services (4%) segments.

Bank of America was hit harder than most because it had a string of extremely bad luck leading up to the financial crisis.  In January of 2008, BofA announced that it was going to acquire Countrywide Financial for $4.1 billion. Less than two months later, after the deal was complete, the FBI announced an investigation into Countrywide for possible fraud. To protect the parent organization, Countrywide was renamed and merged with an independent subsidiary. However, the damage was already done.

This streak continued throughout the year. In September of 2008, BofA purchased Merrill Lynch for $48.8 billion. This was literally days before the collapse. In fact, while the deal was still being negotiated, Merrill Lynch revealed a $21.5 billion fourth quarter operating loss. Ouch. Under pressure from the U.S. government, the deal went through.

Stephen King couldn’t come up with a scarier story.

In 2010, Bank of America finished licking its wounds and exited the wholesale and correspondent mortgage markets all together.  Instead, they decided to focus on direct-to-consumer home and auto lending and the move into digital banking. The acquisition of Merrill Lynch gave BofA an impressive competitive advantage in the wealth management business. This move helped them rake in a mountain of revenue from fees over the lower margins received from loans.

In 2008, fees accounted for 37% of total revenue. By 2015, fees were bringing in over 50% of their revenue. Another reason for this growth was that BofA lowered the capital requirements for its VIP-type benefits from $50,000 to $20,000. This strategy undercut its competitors, which worked. The segment’s revenue grew 2.5% over the last year and added 10.3% more in net income due to lower expenses.

Now, we can’t talk about banks without talking about interest rates.

After nearly a decade of near-zero rates, the whole financial sector is eagerly waiting for the prosperity from the normalization of interest rates. At its December 14th meeting, the Federal Open Market Committee (FOMC) raised the fed funds rate by 25 basis points to a range of 50-75 basis points. This is the first hike in over a year and the second in over ten years.

Fed Chair Janet Yellen expressed her expectations of three additional hikes in 2017. This was in response to the massive public spending figures proposed by President-Elect Trump.   Bank CEOs were ecstatic to hear this. Though rates have been low for so long, they haven’t forgotten the days of 5%-6% in the mid 2000’s and are itching to get back to that.

I’m looking at Bank of America because it is set to benefit from higher rates more so than other banks. BofA has focused on issuing floating-rate commercial loans versus standard mortgages, which are typically fixed-rate. This is a very important business strategy of theirs and has resulted in the third highest net interest margins in the industry.

Mind you that a whopping 45% of their revenues come from interest income.

Bank of America’s revenue is so sensitive to interest rate changes that a 100 basis point increase would add $5.3 billion in net interest income annually.  Its competitors, JP Morgan, Wells Fargo, and Citigroup would only enjoy an added $3.1, $2.4, and $2 billion increase under the same circumstances.

Chump change! You may say.  With the prospects of three more hikes within the next 12 months, you’d have to be mad to ignore Bank of America’s interest rate sensitivity.

BofA has also simplified their offered services, which has drastically lowered expenses. The number of checking accounts offered has been reduced from 22 types to 3. Credit card options have been reduced from 18 to 6. Savings account options have been lowered from 44 to 11. This simplification has also bled over into their home, business, and auto loans.

They’ve also decreased their legal entities by 50% since 2010. This systematic reduction in non-core assets such as equity interests in other financial institutions, non-core credit card portfolios, international wealth management, and ancillary mortgage businesses have significantly reduced risks associated with owning BofA stock.

All of these moves are driving a culture focused on sustainable operating leverage. In response to the success of these moves, BofA was able to pass the regulatory stress tests imposed by the government. This means they have leapt over the final hurdle preventing them from raising dividends and buying back shares.

Dividends are set to rise 50% over the next 12 months with a $5 billion share repurchase program. This would push their dividend yield to nearly 3%. Not too shabby and much more of what we expect from a company that is over 200 years old.  With this in mind, I used a two-stage dividend growth model and found that Bank of America is undervalued by 18%. Similarly, my implied P/E model showed an undervaluation of 23%.  With this massive upside potential, the increased interest income from higher rates, and a substantially higher dividend payout, Bank of America is portfolio must-have in 2017.

Bank of America Merrill Lynch has now gone from a punching bag to a heavy-weight contender.

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