Given my rocky history with the company, you may be surprised to learn that one of our investment funds’ biggest winners last year was-are you ready?-Bank of America. Yes, that Bank of America: the company whose non-stop dealmaking in the 1980s and 1990s helped me make a name for myself as an analyst, simply by pointing out that then-CEO/raving egomaniac Hugh McColl was diluting his shareholders half to death with all the new shares he was having to issue to pay for his empire. Looking back, it was one of the most enjoyable long-running feuds from my sell-side days. We used to pack ‘em in at the group lunches, let me tell you.
Anyway, I did not believe then and do not believe now than BofA has been managed as much more than a mediocre banking franchise. But since the credit crunch, the company has been through the wringer, and the stock shows it. The company has of course added huge mortgage-credit and litigation-related risk as a result of its acquisition of Countrywide in 2008. What’s more, regulators seem to have chosen BofA to be their favorite whipping boy. Media coverage has been, ahem, less than adoring. Nothing has gone right. While the rest of the big banks have at least stabilized since early 2010, BofA has lagged badly.
So our investment thesis on BofA is simple: all the company needs to do is get back to its former levels of mediocrity, and shareholders will be amply rewarded. What’s more, we believe material fundamental improvement at BofA has already begun. As I say, simple. (Note: We own the stock via the “A” warrants. More on that later on.)
Here, in particular, is our case for owning BofA:
1. The company is shrinking to become a more focused, profitable franchise. Looking back, the numbers make one want to weep. At year-end 2003, BofA had $719 billion total assets and a market cap of $279 billion–at which point, CEO/lunatic Ken Lewis (McColl’s successor) embarked on a whirlwind six-deal M&A spree (Fleet, MBNA, US Trust, LaSalle, Countrywide, and Merrill Lynch) that in aggregate added $1.6 trillion in assets, boosting the company’s total assets (pro forma) to $2.3 trillion. (At the peak, BofA groaned briefly with $2.8 trillion in assets.) We of course now know that Lewis skimped on due diligence and overpaid for each deal, so that the value received was astonishingly poor. By the end of 2011, BofA’s assets had slipped to $2.1 trillion-and its market cap had fallen to $54 billion, an 80% drop from 2003 when Lewis’s M&A blitz began. Stewardship!
Mercifully, Lewis was gone by the end of 2010, to be replaced by Bryan Moynihan. Moynihan’s first year was rocky, marked by iffy personnel decisions and disappointing regulatory rulings (notably the Fed’s denial of a dividend increase). The company continued to underestimate mortgage credit costs. But by the end of 2011, Moynihan had begun to turn things around and set on a path to slim down the unholy mess Lewis has assembled. Since then, the company has reduced its assets by over $600 billion via more than 30 deals and other dispositions. Today, Bank of America is a more focused, $2.2 trillion organization that I believe will ultimately be more profitable and grow faster than the company Moynihan inherited.
2. The company’s capital ratios have been tremendously strengthened; capital will soon start being returned to shareholders. Chart 1 shows the impact the downsizing at BofA, along with some capital raises, has had on its Basel I Tier I common ratio.
Also, under the soon-to-be-adopted Basel III standards, BofA’s Tier 1common ratio is estimated at 9.25%, comfortably above the 8.5% minimum the company will be required to maintain. (see Chart 2)
The capital story at Bank of America has changed completely over the past five years. Rather than have to issue new common and preferred stock, as it did from 2008 through 2011, the company is now in a position to use any capital it generates through earnings to pay out to shareholders through common stock dividends, retirement of preferred stock, or common share repurchases.
We believe the company will seek permission for all three options in its annual CCAR (stress-test) submission currently being reviewed by the Fed. The results are due in March. Whatever happens this year will be just the beginning. We expect common stock dividends and share repurchases could ultimately rise to 90% of the company’s annual earnings in 2015 and beyond.
3. Drastic expense cuts will help boost profitability. Even in the best of times, BofA was never a paragon of operating efficiency. But the company’s expense base is especially bloated now, as BofA spends billions annually working through the bad mortgages housed at its Legacy Assets and Servicing (LAS) operation. But both in the company’s “core” business and at LAS, spending is set to fall sharply.
With respect to the core company, first of all, management is executing a reengineering program called New BAC that’s being implemented in two phases. The first phase, to be completed by the end of this year, is designed to reduce annual expenses by $5 billion, off a base of $58 billion. The second phase, scheduled to be completed by mid-2015, should take out another $3 billion. (See Chart 3.)
But it will be the savings at LAS that figure to be eye-popping. LAS-related expenses, which are inordinately elevated due to litigation expenses as well as the high cost associated with servicing delinquent mortgages, peaked at $20 billion, annualized, in the fourth quarter last year. But the company made tremendous progress in reaching settlements in 2012; that should reduce litigation expenses sharply in 2013 and beyond. In addition, investors may be under-appreciating how much progress the company made at reducing delinquent mortgages in 2012.
But that improvement is real. As Chart 4 shows, the company entered 2012 with 1.2 million delinquent mortgages, with a goal to reduce that pool by 300,000 during the year.
By the end of the third quarter, BofA was running ahead of plan, having reduced the delinquent loan total to 936,000 (a reduction of 88,000 per quarter on average). However, thanks to external and internal factors, the company was able to reduce its delinquent mortgages by fully 163,000 in the fourth quarter alone, resulting in a year-end total of 773,000. And when you factor in the company’s recently announced sale of mortgage servicing rights (some of which were delinquent) the pro forma total of DQs drops to 541,000, or less than half the beginning of year total.
A drop of that magnitude will of course be accompanied by serious associated expense reductions as staff can be cut and locations closed. The cuts will lag by approximately one quarter but will likely be dramatic. Chart 5 shows that the number of employees in LAS has already started to decline. We expect major reductions in LAS staffing and expenses to occur in 2013 and 2014.
4. Bank of America’s net interest margin will benefit from a funding mix shift. As a result of its years of acquisitions, along with a conscious decision to rely more heavily on long-term funding than its peers, BofA has an adverse funding mix right now relative to other large banks. The company can thus cut its funding costs as it moves away from reliance on long-term debt vs cheaper deposits.
Chart 6 shows the reduction in the company’s long-term debt since the second half of 2010.
Despite this progress, BofA’s long-term debt plus wholesale funding still accounts for around 45% of its funding, compared to 24%, on average, at other large banks. The savings that occurs as BofA cuts its reliance on debt funding will be significant: BofA’s long-term debt costs over 300 basis points and its wholesale funding around 120 basis points, versus its retail deposits’ cost just 15-20 basis points.
We expect a continued funding mix shift over the next few years, with deposits increasing and debt and wholesale funding declining. The company has $28 billion of long-term debt maturing this year and $39 billion maturing in 2014.
5. The strong earnings recovery outlook is not reflected in its stock price. Bank of America’s common stock more than doubled last year, driven by improvement in the company’s capital ratios, easing of global economic concerns, and falling anxiety over the ultimate cost of the company’s residential mortgage woes. However the stock is still trading at just 85% of tangible book value of $13.34 (Chart 7) and just 5.7 times our estimate of “normalized” earnings of $2.00.
We believe that as investors see that the company’s actions are pushing reported earnings up to “normal,” and also see bright prospects for capital actions, the stock will reach the low $20s over the next 18-24 months.
Investing in an “A” warrant
We have chosen to make an equity investment in Bank of America through ownership of the “A” warrants. These were originally issued to the U.S. Treasury as part of its TARP investment and have since been resold into the market.
The warrants, which expire on January 16, 2019, entitle the owner to buy Bank of America common stock at $13.30. The warrants today trade around $5.25. However, the structure of the warrants is unusual (to the warrant-holder’s benefit) in that the exercise price is adjusted downward each time Bank of America pays a quarterly dividend over 1 cent. In addition, the number of warrants adjusts upward each time a quarter dividend is paid over 1 cent. So every time BofA boosts its dividend-which we expect to happen regularly over the coming five years–the exercise price on the warrants will fall and the number of warrants the holder owns will go up.
The formulas to calculate the lowered exercise price and increased number of shares per warrant are somewhat complicated, and require assumptions of the company’s earnings, payout ratio, its stock price between now and January, 2019. However, we conservatively model that the exercise price will fall below $11 per share (from $13.30 now), and the number of shares per warrant will raise over 1.2 from 1.0. We do not believe investors are accounting for these quirky but investor-friendly adjustments in their current valuation of the warrants.
Path to Mediocrity
Kew Lewis almost destroyed Bank of America with his ego-driven growth-through-acquisition strategy. He is long gone and his successor is trimming down the company, fixing its balance sheet, and improving the level of profitability back to a mediocre level. We believe equity investors will make an excellent return if Bank of America just returns to mediocrity. The warrants add a little spice to an already attractive equity investment.
What do you think? Let me know!