Bank of America (BAC) has undertaken a number of steps to increase earnings available to common stockholders over the last years through the clean-up and optimisation of their liability structure. This brief note seeks to summarise the steps taken this year as well as to provide a view on potential further actions by management in this regard, alongside an assessment of the potential positive P&L impact that may be generated by these steps.
In this article, we are only considering preferred stock and trust preferred securities. An evaluation of past and future liability management actions with respect to the bank's long-term debt will be provided in another article.
This article does not deal with the question of whether a share repurchase over the past year at or below tangible book value may have been more accretive than the actions described herein. This, too, is left to a future article.
Bank of America received approval from the Federal Reserve to purchase approximately $5.5bn of preferred stock. This consisted primarily of preferred stock series H and 8. For both of these, the savings in preferred dividends accruing to common shareholders in 2013 can be calculated with comparative ease as exactly two dividend payments will no longer take place in 2013:
- Redemption of the Series H on May 1st 2013 will reduce total preferred dividends by 117.34m in 2013 and 234.69m in 2014 and beyond.
- Redemption of the Series 8 on May 28th 2013 will reduce total preferred dividends by 109.93m in 2013 and by 230.55m in 2014 and beyond.
The following table provides a view on redemptions (concluded or announced) and the projected P&L benefit to common shareholders over the next three years. Note that the preferred funding will have to be replaced. We have assumed that the bank will be able to do so largely through cheap deposits at about 30bps (as per recent 10k). This appears to be a reasonable assumption, considering that Bank of America has been able to grow its deposit book by over 70bn in 2012. The following table summarises the information:
In summary, the likely benefit to common shareholders is expected to be approximately $227m this year and $454m per annum from 2014 onwards.
Management has indicated that it will continue to optimise the bank's funding structure and, as such, is likely to call preferred stock where it is able to do so, i.e. where it receives approval from the Federal Reserve, presumably only in yearly intervals as part of the CCAR. Considering the remaining outstanding preferred issues, we note:
- Unfortunately, Series I, K and M, accounting for approximately 3.22bn are not callable until 2017 and 2018.
- Series L is a convertible issue permitting holders to convert preferred shares to 20 common shares. The bank may also force the conversion under certain conditions. At a current price of approximately $1,100 the conversion price would be $55.00 and as such these securities are assumed to remain outstanding in this analysis.
- Series T is the preferred stock issued to Warren Buffett in late 2011. The bank may repurchase these at a 5% premium at any time. We deal with this separately further below.
- We exclude Series B, which is non-callable and, in any event, very small.
- With Series 6 and 7 being called on June 28th 2013, only Series D through G, Series J and Series 1 - 5 appear relevant to this analysis, apart from Series T.
With an aggregate value of 4.24bn, management may choose to call the aforementioned Series in 2014, assuming a similar CCAR request and approval as has been obtained in 2013. It is reasonable to assume that management would seek to call these securities as soon as possible, in line with the timelines established in 2013. We assume, once again, that cheap deposit funding can and will be used to offset these amounts and, furthermore, that the issues will be called after two of the four annual payments have already been made. The following table outlines the calculations:
The total annual benefit accruing to common would thus be expected to be $108m and $217m in 2013 and 2014 respectively. The total potential benefit in 2015 from the actions already taken and from the potential repurchases in 2014 would then be about $671m (454 + 217), which translates to approximately 6c per share (with 10.8bn shares outstanding).
The Buffett Issue
The interest rate on Series T preferred stock issued to Berkshire Hathaway is 6% and, as such, above that of many of the remaining issues callable by BAC as shown in the preceding table and it is above the weighted cost of these issues of 5.42%. It is thus likely that management would prioritise calling this issue ahead of the other Series discussed above. In this event, it will incur a cost of $250m to do so, which should be compared with the potential net annual benefit of $285m accruing to holders of common shares from saved preferred dividends (once again, assuming a cost of 30bps to replace the preferred funding).
Should management prioritise this in 2014 and receive approval and, further, elect to call no other preferred Series, the net benefit to shareholders during that calendar year may be reduced to $489m (454 + 285 - 250) or about 4c per share, with a commensurate increase from 2015 onwards. Should management seek and gain approval for further repurchases in 2014 to bring the total in line with this year's repurchases, further incremental benefits may accrue (e.g. Series 3 for $20.8m in 2014 and $41.6m in 2015).
In summary, it is clear that management is prioritising P&L oriented measures intended to benefit common shareholders. Repurchasing high-cost funding and replacing it with lower cost deposits or medium term debt is the right thing to do. Arguably, however, a share repurchase at or below tangible book value may have been even more value-accretive.
Trust Preferred Securities
The bank had approximately 10.2bn of these securities outstanding as at February 28th 2013 and it has undertaken a number of steps to repurchase and cancel or otherwise redeem these securities and their underlying notes. We briefly calculate the potential P&L benefit from future actions of this kind below:
- All bar one (Bank of America Capital Trust XV) of these securities are now callable, with a total balance of $10.19bn.
- The interest rates applicable to these securities vary widely from as low as just under 1% (based on current 3 month LIBOR) to as high as 11.75% in the case of Progress Capital Trust II.
- The approximate weighted interest rate applicable to the outstanding balance is 6.14%.
- Assuming these liabilities are replaced at a cost of twice the rate currently paid on deposits would yield a benefit of 5.54% or approximately $565m annually.
- Taking a more detailed view and assuming that only those Issues with rates markedly above the current average cost of medium and long term debt would be redeemed, yields a principal balance of $8.6bn, which would translate into a benefit of approximately $476m (under the aforementioned assumptions).
Considering the fact that the average cost of these $8.6bn of securities is high in comparison to the bank's cost of other debt and, further, considering that repurchases and redemptions of these securities do not need to be submitted to CCAR approval, we consider it likely that management will continue its efforts to reduce the balance of this type of funding rapidly (approximately $4.8 and $9.8bn have been exchanged and cancelled in 2011 and 2012).
Summary and implications
Should management continue to proceed with re-organising the bank's liability structure in this manner, substantial benefits will accrue to common shareholders over the course of the next three years, ceteris paribus. The redemption of preferred stock this year and next, at the same pace, may add as much as $562m in 2014 and $671m in 2015 and beyond to the bottom line, with a potential wildcard of an additional annual saving of $285m through the redemption of the "Buffett" Series T preferred stock.
The continued repurchase and cancellation of trust preferred securities and the underlying notes may provide a benefit of $476m by the end of 2014, should the process continue at the same pace as in 2012.
Thus the total potential benefit for FY 2015 may be approximately $1.1bn or 10c a share. The savings may eventually be worth 8 - 10% of the current stock price, assuming a multiple of 10x.
In our view, these actions form only a small, albeit important, part of management's attempt to bring BAC back to reasonable levels of profitability. Clearly, cost savings from reduced Legacy Asset Servicing and Litigation expenses as well as savings projected from "New BAC" Phase I and II are a bigger part of the puzzle and may be the subject of a future article.
Yet, the implication for investors here is clear - management is focused on creating shareholder value through increased earnings (and likely EPS) where it is able to optimise BAC's funding structure and associated costs. Should it continue on this path and similarly demonstrate success in the cost reductions it has announced, BAC may easily deliver earnings of more than $1 per share by mid 2014 and $2 per share for FY 2015. Since this would correspond to an attractive return on TBV and, similarly, equity, a multiple of 10x - 15x does appear reasonable, implying an upside of 20 - 50% from current prices. We believe that BAC is a long-term attractive buy at today's level.
Page references: Recent 10k and 10Q for 2012 and Q1 2013 respectively, which can be found here: 10K (page 130 for costs of funds, page 224 for TRUPS, page 238 for Preferred Issuance).