Bank of America Is the 'Top Sector Pick'

NEW YORK (TheStreet) -- Bank of America (BAC) is primed to outperform other large-cap U.S. banks because of continued cost cuts, loads of excess capital, increasing share buybacks and an improving market share, according to Atlantic Equities analyst Richard Staite.

Staite rates Bank of America "overweight," with a price target of $18, implying 19% upside for the shares over the next 12 months.  The company's shares have risen 30% this year through Wednesday's close at $15.14, which compares to a 29% rise for the KBW Bank Index (I:BKX) and exceeds the performance of "big four" bank peers, assuming dividends are not reinvested.

In a note to clients on Thursday, Staite wrote that Bank of America "has started to rebuild market share, costs are set to
drop by a further $9bn, the 2014 share buy back might exceed JPM's and it is a good play on the a recovering US economy, higher house prices, stronger employment and higher interest rates."

That's quite a list of factors playing in Bank of America's favor, which might explain why the shares trade at a higher forward price-to-earnings multiple than peers.  Here's a quick look at valuations, performance and dividend yields for the "big four" U.S. banks:

  • Bank of America's shares closed at $15.14 Wednesday.  The shares trade for 1.1 times tangible book value, according to Thomson Reuters Bank Insight, and for 11.3 times the consensus 2014 earnings estimate of $1.34 a share, among analysts polled by Thomson Reuters.  The consensus 2015 EPS estimate is $1.60.  The company's return on average common equity for the first three quarters of 2013 was 7.44%.  Over the past three full years, the company's ROTCE improved to 2.96% in 2012 from a negative 1.75% in 2010.  Bank of America's quarterly dividend is still just a penny a share.
  • Shares of JPMorgan Chase (JPM) closed at $56.10 Wednesday, returning 31% this year.  The shares trade for 1.4 times tangible book value and 9.3 times the consensus 2014 EPS estimate of $6.02.  The consensus 2015 EPS estimate is $6.38.  JPMorgan's ROTCE for the first three quarters of 2013 was 11.59%, despite the third-quarter net loss resulting from $9.15 billion in provisions for litigation reserves, in advance of the over $17 billion in mortgage settlements with government authorities and investors during the fourth quarter.  Over the previous three full years, the company's ROTCE ranged from 14.72% to 15.26%.  Based on a 38-cent quarterly payout, the shares have a dividend yield of 2.71%.  Considering the relatively low valuation for the shares, the company's long-term profitability and the likelihood that the bulk of its mortgage risk is behind it, one could make a strong case that JPMorgan is a screaming buy right now. 
  • Wells Fargo (WFC) closed at $43.62 Wednesday.  The shares have returned 31% this year and trade for 1.9 times tangible book value and 10.9 times the consensus 2014 EPS estimate of $4.01.  The consensus 2015 EPS estimate is $4.24.  The company continues to be the earnings leader among the big four, with an ROTCE for the first three quarters of 2013 of 17.86%, following a steady improvement to 16.70% in 2012 from 14.77% in 2010.
  • Citigroup closed at $50.77 Wednesday, for a year-to-date return of 28%.  The shares trade for 0.9 times tangible book value and for 9.3 times the consensus 2014 EPS estimate of $5.43.  The consensus 2015 EPS estimate is $5.98%.  Citi continues to pay a quarterly dividend of a penny a share.  The company's ROTCE for the first three quarters of 2013 was 8.95%.  Over the previous three years, Citi's ROTCE ranged from 4.80% to 8.04%.

Staite's market share comment centered around Bank of America's 19% year-over-year growth in commercial loans during the third quarter, a 36% increase in trading revenue and over 1 million in new credit card accounts from a year earlier.

Staite expects Bank of America to see another $9.2 billion in annual cost savings from the company's "Project New BAC" efficiency plan and from a continued decline in costs to service distressed mortgage loans, through the end of 2015.  "Costs (ex litigation) are currently running at about $62bn per year. Taking out the $9bn would bring that down to $53bn which would equate to a 59% cost efficiency ratio on the current $90bn of revenues."

A bank's efficiency ratio is, essentially, the number of pennies of overhead expenses for each dollar of revenue.  Bank of America reported an efficiency ratio of 76.22% for the first three quarters of 2013.  The company's long-term goal is to improve the efficiency ratio to a range of 55% to 59%, which "seems like a credible target," according to Staite.

A major worry for investors is the expectaction of a major settlement of an investigation into the company's residential mortgage-backed securities sales by President Obama's Residential Mortgage-Backed Securities Working Group, similar to the one JPMorgan just agreed to. 

"JPM paid $7bn in compensation and a $2bn fine. Assuming BAC takes a similar hit it would reduce the Basel III ratio by about 50bp. The effect would be to reduce surplus capital from about $20bn at end 2014 to about $11bn on our calculations."

Bank of America's estimated Basel III Tier 1 common equity ratio was 9.94% as of Sept. 30, exceeding the company's fully phased in requirement of 8.5%, years ahead of the January 2019 deadline.  Staite expects the Basel III Tier 1 common ratio "to improve rapidly over the next few years as it utilises the $14bn of deferred tax assets not currently included in capital."

Following the next round of Federal Reserve stress tests in March, Staite believes Bank of America could receive approval to repurchase $7 billion in common shares through the first quarter of 2015.  That would be a significant increase from the $5 billion in buybacks the company announced following the last round of stress tests.

Investors may be tired of hearing the term "normalized earnings," which has been bandied about for many years in the wake of the financial crisis, but it is still a very important concept.  Banks are still mired in a hostile interest rate environment, and although the market is expecting the Federal Reserve soon to curb its purchases of long-term bonds that has helped hold down long-term interest rates, what the banks really need is for the short-term federal funds rate to rise.  The fed funds target rate has been held in a range of zero to 0.25% since late 2008, and Federal Reserve Chairman Ben Bernanke has indicated many times that the rate is likely to remain in that range even after the U.S. unemployment rate falls below 6.5%.  The October unemployment rate was 7.3%, increasing from 7.2% in September.

"We forecast that delivering on the $9bn of cost savings plus share buybacks will drive up EPS from $0.89 in 2013 to $1.57 in 2014 and $1.81 in 2015 before reaching a more normalised rate of $2.02 in 2016," Staite wrote.

So Bank of America could show the best earnings growth performance among the big four in 2014, according to the consensus estimates, and through 2016, according to Saite.

Bank of America's shares were up 1% in morning trading, to $15.28.

BAC ChartBAC data by YCharts

Interested in more on Bank of America? See TheStreet Ratings' report card for this stock.

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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