This article argues that a stock buyback is more likely than an increase in the regular dividend because of management aversion to regulatory rejection of its capital plan, BAC's low stock price, and CEO Brian Moynihan's emphasis on the importance to discussions with regulators of consistent earnings.
The High-Stakes for Management in Capital Planning
Last Monday, BAC along with other large banks submitted capital plans to the Federal Reserve. This is part of an annual "stress-testing" by regulators to explore whether banks have sufficient capital to survive a severe economic downturn.
The intention is to protect taxpayers against a repeat of the bank "bailout" bill of October 2008 which earmarked ~$700 billion for the Troubled Assets Recovery Program or "TARP." The tests cover extreme conditions including a rate of 13% unemployment, a 20% decline in house prices, and a 50% decline in equity values.
BAC passed the stress test last year, catalyzing a 4% rise in the stock price on March 14th to a close of $8.84. On the other hand, Citigroup (C) failed the test and saw its stock price fall that same day by nearly 4%. A key difference between the two plans was that C asked to increase its dividend whereas BAC did not.
The failure of C to pass the stress test may have contributed to the ouster of CEO Vikram Pandit in October 2012, and we believe management at BAC will be highly averse to any possible regulatory rejection of the capital plan. Indeed, management credibility was adversely affected by the rejection of BAC's request for a dividend increase in 2011.
A Change in the Regulatory Rules for 2013
Possibly in response to the events at C, the Federal Reserve changed the rules for the capital planning process in 2013: after the Fed has assessed an initial capital plan, banks will have the opportunity to make a single downward adjustment for the distribution of capital to shareholders. (There was no provision for such adjustment last year so that C could not seek to avoid rejection of its capital plan by withdrawing the dividend request of its initial submission).
The opportunity for adjusting the capital plan meaningfully lowers the stakes but, nonetheless, C is playing it safe: management will reportedly ask for a minimal stock buyback but no increase from the current token-dividend of 1 cent per share per quarter. BAC has not commented on its capital plan but we believe management is signaling it too is unlikely to request a dividend-raise.
Earnings Consistency An Issue For Regulators
Specifically, CEO Brian Moynihan has emphasized the importance to the discussions with regulators of earnings consistency: "the element that is sort of unique to us is the predictability of the earnings stream. We are working to get through that."
As noted in our earlier article, the bank has followed through on this and, just this week, made important progress in settling mortgage-related litigation and downsizing the mortgage-servicing business. While these actions will reduce the balance sheet, and hence earnings, the risk is they do not eliminate it. There are still meaningful litigation issues (including, for example, around alleged rigging of the LIBOR rate and the civil fraud action brought by the Government around the mortgage practices of now BAC-owned Countrywide) and hence the chance of continued earnings variability.
We believe regulators are more likely to be concerned about this earnings variability in the context of an increase in the regular dividend than a one-time capital distribution such as a stock buyback or special dividend. The reason is that a downside surprise to earnings could raise questions about the sustainability of a higher dividend and, by extension, the prudence of any regulatory approval.
Good Case For A One-Time Capital Distribution
That said, BAC can make a good case for a one-time capital distribution. As shown below, it is better capitalized than JPMorgan (JPM) which received regulatory approval last November to buy back $3 billion of shares in Q1 2013 (and pays a non-token dividend of $1.20 per share per year versus 0.04 for BAC).
More specifically, BAC could make a one-time distribution to shareholders of ~$1 billion and still have a capital ratio, calculated on a Tier 1 basis in accordance with Basel 3 rules, in line with that of JPM.
Likely Preference For Stock Buyback Over Special Dividend
The CEO of JPM, Mr. Jamie Dimon, commented last April on stock buyback as follows: "Our tangible book value per share is a good, very conservative measure of shareholder value ... if you like our businesses, buying stock at tangible book value is a very good deal. So you can assume that we are a buyer in size around tangible book value."
We believe management at BAC will share this sentiment for its own bank and so favor a stock buyback over a special dividend - at least while the stock price is at or below tangible book value of ~$13.
Stock Buyback A Positive For Continuing Shareholders
Furthermore, we also believe intrinsic value for BAC is meaningfully higher than reflected in the current stock price and so we see stock buyback as improving the economics of continuing shareholders. As support for this view under the conditions faced by BAC, we find no better approach than to quote from a letter of March 2000 from Mr. Warren Buffett to his own shareholders:
"There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth"
Given the chance of on-going earnings variability, and the credibility risk to management of having a capital plan rejected by regulators, we do not expect BAC to request an increase in the regular dividend.
However, the bank is better-capitalized than JPM which already has regulatory approval for a stock buyback so that it makes sense for BAC to request a modest one-time capital distribution of its own.
With the stock trading at or below tangible book value of ~$13, the economics of a stock buyback are good and, we believe, will be preferred by management over the alternative (for a one-time distribution) of a special dividend.