Why Bank of America is a Solid Buy Despite Another Quarter of High Litigation Expenses

Source: Company

Investors are closely following second quarter bank earnings which have proven to be quite boring so far. Wednesday, however, was sort of a bigger event when all eyes turned to the highly expected earnings release of Bank of America (NYSE: BAC  ) .

Citigroup (NYSE: C  ) and Wells Fargo (NYSE: WFC  ) , Bank of America's closest commercial bank peers, already reported earnings which also have been largely unspectacular and already set the tone for this earnings season.

Probably the biggest take-away so far has been Citigroup's $7 billion settlement with the Department of Justice over low-quality mortgages being sold to investors. The settlement caused a $3.7 billion hit to Citi's second quarter earnings.

Naturally, with settlement negotiations between Bank of America and the DOJ ongoing and with a history of unsettling litigation expenses, investors first and foremost looked at the bank's second quarter litigation costs.

And a little nasty surprise awaited them indeed: After $6 billion of pre-tax litigation expenses in the first quarter, Bank of America reported another $4 billion litigation hit, signaling that the normalization of litigation expenses still has not occurred and will likely take another couple of quarters.

But not everything was bad
Similar to Citigroup, Bank of America squeezed out a profit despite litigation expenses weighing down earnings. In the second quarter of 2014, Bank of America earned $0.19 per share which compares against $0.32 per share in the year ago quarter and against analyst estimates of $0.29 per share.

Bank of America's litigation expenses accounted for $0.22 per share after-tax bringing its adjusted EPS to $0.41 per share and suddenly it looks as if Bank of America delivered a handsome earnings beat.

The bank was also involved in litigation over residential mortgage-backed securities with American International Group. Bank of America now reported that it resolved its legal dispute with the insurance company for $650 million. Another problem solved.

Operating performance
In terms of operating performance, the second quarter was a relatively uneventful quarter for Bank of America. Consumer & Business Banking continues to be Bank of America's main earnings driver producing $1.8 billion in net income which was an increase of $397 million over last year's second quarter.

Bank of America's Consumer Real Estate Services (CRES) business produced a net loss of $2.8 billion, mostly due to litigation expenses which accrue in this particular business division.

CRES has the most earnings rebound potential for Bank of America -- and I venture to guess that this unit will look fundamentally different three years from now if the bank continues to work vigorously through its mortgage mess.

The Investment Management business continues to do well, which is sort of a given considering that stock market indices are quoting at all-time highs. Bank of America's assets under management stood at $879 billion and rose $135 billion or 18% year-over-year.

Global Markets and Global Banking continue to do well and both units contributed earnings of at least $1.1 billion in the second quarter. Both segments are highly dependent on the overall state of the economy and can reasonably be expected to have a positive earnings impact going forward.

Asset quality trends
I have pointed the issue of asset quality out repeatedly when it came to banks and Bank of America in particular. Bank of America was among the worst hit financial institutions exactly because of its large role in the mortgage market and the fairly ill-advised acquisitions of Merrill Lynch and Countrywide, which swept a whole load of legal issues right into Bank of America's living room.

As such, loan losses and provision expenses have hurt Bank of America's earnings for a while.

However, credit quality trends have been clearly improving and it is definitely a good thing to see Bank of America's net charge-off ratio fall again below the 0.50% mark in the most recent quarter.

Source: Bank of America Second Quarter Earnings Presentation, July 16, 2014

Valuation
If investors hate one thing, it is uncertainty.

And Bank of America's litigation history certainly is the key reason why the bank trades at one of the lowest book value multiples in the sector.

And I think that this is quite undeserved. Bank of America made some respectable progress in increasing its tangible book value per share, which rose 3% sequentially and 7% year-over-year to $14.24 per share even though the bank did swallow fairly large one-off legal expenses once again.

Wells Fargo manages to command substantial premiums to both book value and tangible book value. Citigroup and Bank of America, however, are trailing massively, but also have meaningful rebound potential once litigation costs normalize.

The Foolish Bottom Line
Bank of America probably delivered one of the most ambiguous quarterly results this earnings season. Continued high litigation expenses are a big turn-off leading to a substantial discount to book value, but those charges will ultimately mean-revert and allow the bank to devote resources to growth rather than to its legal department.

Despite ongoing litigation expenses, Bank of America could tweak out a profit, which gives investors a taste how substantial earnings could increase if its legal issues are resolved.

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