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The Science of Hitting
The Science of Hitting
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Update on BAC Warrants - 15 Months In and I'm Still Salivating

December 06, 2012 | About:

This is an exercise I’ll complete many times over the coming years, just because I think the potential value creation from this investment is clearly underappreciated (it certainly gets me excited to think about how this might play out over time); first, some background on the investment, from an August 2011 article in the New York Times:

“On Thursday, Berkshire Hathaway (BRK.B), run by Mr. Buffett, announced plans to invest $5 billion in Bank of America (BAC), a vote of confidence for the beleaguered financial firm… Under the terms of the deal, Berkshire will buy $5 billion of preferred stock that pay a 6 percent annual dividend, and receive warrants for 700 million shares that it can exercise over the next 10 years. Bank of America has the option to buy back the preferred shares at any time for a 5 percent premium.”

Here’s the description from the 10-Q filed a few months later:

“On September 1, 2011, we acquired 50,000 shares of 6% Cumulative Perpetual Preferred Stock of BAC (“BAC Preferred”) and warrants to purchase 700,000,000 shares of common stock of BAC (“BAC Warrants”) for a combined cost of $5 billion. Under its terms, the BAC Preferred is redeemable at any time by BAC at a price of $105,000 per share ($5.25 billion in aggregate). The BAC Warrants expire in 2021 and are exercisable for an additional aggregate cost of $5 billion ($7.142857/share).”

To put this into perspective, book value per share at Bank of America is north of $20 per share, with the company currently trading at around 0.5x book (nearly 6% gain on Wednesday left the stock price at $10.46 per share). Here are a few scenarios for what might happen to Bank of America and its common stock to give us an idea of what these warrants may be worth one day (using $20 in book value per share – BVPS – as our starting point, and rounding to the nearest dollar value in the terminal period):

Variables 0.5x Book 0.8x Book 1.1x Book
BVPS, Unchanged $10 $16 $22
BVPS, +3% per Annum $13 $21 $29
BVPS, + 5% per Annum $16 $25 $34
BVPS, +7% per Annum $19 $30 $41

With this as our guide, here is the profitability (in dollar terms) and annualized return on the $5 billion over the decade starting 2011 solely from the warrants (excluding the 6% coupon or the redemption premium, which obviously understates the overall return to Berkshire):

Stock Price in 2021 Profit from Warrants IRR
$10 $2B 3.4%
$15 $5.5B 7.7%
$20 $9B 10.8%
$25 $12.5B 13.4%
$30 $16B 15.4%
$35 $19.5B 17.2%
$40 $23B 18.8%

Obviously any of these scenarios are far from certain; with that said, the payoff in the case where Bank of America has a solid decade looks to be flat-out stellar. All I can say is that I’m excited to see how this investment will ultimately turn out for the owners of Berkshire Hathaway.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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