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| Stock Symbol BAC |
| Stock Price $7.65 |
| Shares Outstanding 10.13 Billion |
| Book Value $20.29 per share |
| Tangible Book Value $12.65 |
| Discount to Tangible Book 40% |
| Market Capitalization $77.53 Billion |
| P/E TTM |
| P/E Forward |
| Net Income |
| Carryforward Losses $27 Billion |
| Rep & Warranties Reserves $18 Billion |
| Future Write-Offs? |
| Pre-Provision Pre-Tax Earnings $40-45 Billion |
| Intrinsic Value $16.00 (Present Value) |
On August 14, I submitted my first stock report on Bank of America (BAC). It had closed that day at $7.19 a share. The stock has significant volatility regularly experiencing 10% down — and up — moves on a daily basis. I have read two analysts propounding that BAC may have to raise capital but a number of other analysts arguing that it is absurd for Bank of America to raise capital.
Why the dichotomy? The past few days the cost to issue new debt has increased, further, the credit default spreads have widened. Eventually BAC will need to tap the debt markets so the bearish analysts are partially correct; however, the analysts arguing BAC does not need to raise capital are correct as well. BAC has enough cash on its balance sheet to pay off all its short term debt plus some long-term debt. BAC won’t need to tap any credit for several months. Moreover, BAC still has China Construction Bank on its balance sheet that it can sell after August 29. BAC has recently said its stake will not go less than half its current stake (which is worth roughly $17 Billion) but if it needed to access capital China Construction Bank is an option.
Latent Earnings Power
Excluding the Consumer Real Estate Services (CRES) division, BAC earned $5.7 billion last quarter. Its pre-provision pre-tax earnings are $40-$45 billion. It has six business segments and five are earning a good profit except one, the purchase associated with Countrywide back in 2008.
As I stated in the last report, I don’t know when BAC will put the legacy issues behind it or the exact amount. Once the legacy issues have been resolved and/or a reliable liability is quantified, and the economy has returned to a normalized state, the earnings power of BAC will manifest itself and it is formidable. BAC can earn $40 billion before tax and provisions and roughly $25 billion after tax. If those earnings are capitalized with a multiple of 10, BAC is worth $250 billion or roughly $25 a share, closer to $24 after the announcement of Buffett’s purchase which I will examine later.
Risks
No one knows the exact amount (or even a rough range) of the amount BAC will ultimately have to pay. The worst case scenario I have read from an analyst is $62 billion in addition to what BAC has already reserved for. That equates to $6.20 a share or about three years of earnings.
There are a number of ways the resolution can manifest itself 1) BAC doesn’t get an agreement with the NY State Attorney General or the other states and has to fight everything in court on an ad-hoc basis. This can literally take decades. However, due to the time value of money, the present value would be lower the longer it takes for BAC to pay, moreover, the longer they have to pay the lower the percentage it would make up of its balance sheet; 2) the NY State Attorney General and all 50 states come to an agreement to settle for $25 billion. BAC would be responsible for a majority of this amount but well within what they have reserved for and easily replaced by the earnings power of the company and 3) there is one large agreement but BAC is still liable for several states. The process drags on but the vast majority of the liabilities are settled although the exact amount is still not quantified investors would be assuaged to some extent knowing the majority of the liabilities have been resolved
Of course this is a very simplified analysis and several different scenarios can manifest but I tried to lay out the more probable scenarios.
Valuation
Earlier I submitted my view that BAC’s intrinsic value is $25 a share once the liabilities are resolved and assuming the economy is in a “normalized” state. What do I mean by normalized? I would argue a normalized state is a range of 2.5-4% GDP growth and unemployment below 7% and a fed funds rate of 1.25% or greater. BAC should earn 1% return on assets and 10% on tangible book.
Any intelligent analysis would be remiss without a time value of money. This is especially important for BAC. My conjecture is the time frame for 1) the liabilities to be resolved/quantified and 2) a normalized economy to return is 1-4 years. My estimate could be too optimistic but I deem this the probable scenario. My analysis uses a 10% discount rate or cost of capital. If BAC is worth $24 a share in 4 years, using a 10% discount rate to adjust for the risk and the time capital can be deployed to another alternative, the present value is about $16 a share. If the reader disagrees with the discount rate and/or the time frame, they can be adjusted, but the earnings power of BAC, I would argue is very reasonable.
Warren Buffett
Today, August 25th, BAC announced that Warren Buffett’s Berkshire Hathaway made a $5 billion investment using preferred stock. Buffett enjoys a 6% coupon and a 5% termination premium if BAC deems it appropriate to pay Mr. Buffett back. Furthermore, Buffett extracted warrants with a strike price of $7.14 a share that have 10 years before expiry, in the amount of 700 million shares or roughly 6% of the company.
I adjust for this dilution with the assumption that BAC pays Mr. Buffett back when the stock is at $20 a share (to be conservative I use an expensive price for BAC) and I offset the dilution assuming the $5 billion that Mr. Buffett pays BAC for the investment is directed towards repurchasing the shares (the treasury stock method) which comes to a dilution of roughly 450 million shares since BAC would be able to buy 250 million shares at the assumed price of $20 in the market. This raises the outstanding shares from 10.13 billion to 10.58 billion. If one assumes a $30 share price when Mr. Buffett exercises, the share dilution would be about 534 million shares which comes to 10.66 billion shares. Assuming $250 billion market cap (from earlier) the intrinsic value is about $23.50 a share future value assuming 4 years or $16 present value.
Mr.Buffett’s investment doesn’t change much over the intermediate and long term. It provided ballast today for the stock price but the stock price will follow the economic value of the company over the long-term and not a $5 billion investment even though it is from the world’s greatest investor.
Conclusion
As a value investor I was distressed from the rise in the stock price today as I wouldn’t want to pay $7.65 a share when I could have paid a little over $6 a couple of days earlier. Mr. Market can be fickle. Mr. Market’s perception of BAC seems to swing from melancholy to euphoria almost daily. I expect the Buffett premium to attenuate as poor economic data in Europe and/or the United States come to the fore in the future as well as doubtless negative developments regarding BAC’s mortgage problems.
However, whether it is 1 year or several years, BAC will emerge from this stronger as will the United States. The United States has had 15 recessions since its birth and it has recovered from every one. It would be a mistake to bet against it recovering from this one, once it does, that will provide ballast for BAC and get us one day closer to resolving its liabilities. Each day that passes another loan is being underwritten with good terms and another poorly underwritten loan is coming off the books.
Ben Franklin said, "He that has patience can have what he will." A patient investor in BAC can have an attractive return.
Please visit my blog for more articles/posts:
[searchingforvalueinvestments.blogspot.com]
*Disclaimer: This is not a recommendation in any shape, matter or form.
* I own a small amount of warrants.
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"_Earlier I submitted my view that BAC’s intrinsic value is $25 a share once the liabilities are resolved and assuming the economy is in a “normalized” state"
" the present value is about $16 a share."
"I wouldn’t want to pay $7.65 a share when I could have paid a little over $6 a couple of days earlier."
"* I own a small amount of warrants."
Why such a lack of confidence in your own analysis? or is it lack of confidence in BAC?