Bank of America (NYSE:BAC) recently announced some changes in its agreement with Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) about the $5-billion worth of its preferred shares. It is a significant event for both the companies, in my opinion, which has not received much coverage. I believe more focus should be given to the deal and investors should understand what it means for both the companies. I will try to briefly explain the deal and what to make of it, in this article. Also, what it means for the Bank of America shareholders.
Understanding the Amendment
First of all, let's take a look at the initial agreement - Berkshire Hathaway bought 50,000 shares of preferred perpetual cumulative stock in 2011- the yield on the shares was 6%, and the total amount given to BAC for the deal was $5 billion. The most important element in the deal was the warrant to convert the preferred stocks to 700 million of the common shares. The conversion rate, according to these numbers, comes to $7.14 per share. A technical point to notice here is that BAC allocated $2.9 billion to the preferred stock and $2.1 billion to the warrant given to Berkshire Hathaway - this allocation cannot be categorized as Tier I capital, which has now resulted in the amendment in the agreement. Bank of America has proposed the amendment in order to meet the Tier I capital requirements for the Federal Reserve Stress Test.
Three changes have been made to the agreement: First, the shares are no longer cumulative - the easiest explanation is that the bank will not have to pay any preferred dividend if the business runs into losses. Cumulative preferred stocks mean that the preferred dividend is deferred to the period when the company again starts to make a profit, meaning the company will have to make payments to preferred stock holders for the period it was in losses and was not able to pay preferred dividend. Now, this is a big indication where the people at Berkshire Hathaway think the bank is going. My regular readers know that I am bullish about the banking sector and believe the fundamentals are favorable for the banks to grow over the next few years. Looks like people at Berkshire Hathaway share my optimism and do not fear any slowdown over the next few years. As a result, they have decided to agree to this amendment.
The second change is that the dividend rate is fixed at 6%, meaning that the bank will have to make an annual payment of $300 million to Berkshire Hathaway until the expiration of the warrant. And finally, the third change is that Bank of America will be able to redeem the shares only after the fifth anniversary of the amendment, meaning that the earliest BAC can redeem these shares will be in 2019, if the amendment is approved.
What does this tell us about the Future Prospects of Bank of America?
As I mentioned above, that BAC made these changes in order to enhance its Tier I capital ratio, which is an important metric for the stress test. However, Berkshire Hathaway's willingness to agree to these changes tells a different story. Here's what I think.
First of all, the change in the preferred dividend structure shows that Berkshire Hathaway does not expect the business to get into trouble, and they are confident that the bank will be able to meet its dividend obligation of $300 million every year.
Secondly, as Berkshire Hathaway holds the preferred shares, they have not categorized it as their equity investment and it does not show in their portfolio. However, recently, Warren Buffett had this to say about Bank of America.
"Berkshire has one major equity position that is not included in the table: We can buy 700 million shares of Bank of America at any time prior to September 2021 for $5 billion. At yearend these shares were worth $10.9 billion. We are likely to purchase the shares just before expiration of our option. In the meantime, it is important for you to realize that Bank of America is, in effect, our fifth largest equity investment and one we value highly"
The most important part is about the timing of the exercise of the conversion option. It shows that Berkshire Hathaway believes that the stock will be trading considerably higher than the current value and it will be better to just collect $300 million in annual dividends till then. If Berkshire Hathaway exercises its option in 2021; the company will collect $2.4 billion in dividends and the capital gain will be substantial as well. The option is already deep in the money. If Buffett thought there was not a chance of BAC going up, he might have exercised the option and secured his profits. Furthermore, he has clearly stated that he values BAC highly and it will be an important part of Berkshire Hathaway's portfolio.
The above mentioned two factors should alone warrant a buy recommendation for the stock, but let me give you another reason.
Stress Test Will Likely Result in Increased Dividend
The Federal Reserve has announced that it will release the results of the stress test on March 20. As I have mentioned, that the bank has done all this to meet the requirements of the stress test; I believe Bank of America will pass the stress test and it will be allowed to pay more in dividends. The table below shows the capital ratios of the bank. The table has been taken from the 10-K filing of the bank.
There is a clear improvement in the common capital ratio, and other ratios also remain strong. Furthermore, the capital and risk-weighted assets are also strong. The only risks for the bank come from its litigation issues, which I have discussed in detail in my previous articles.
Bank of America is a buy, in my opinion. I believe the stock can make substantial upside movement over the next few months. Furthermore, the long-term prospects of the banking sector are bright, which should allow the bank to continue its impressive performance. This might be the best time to buy Bank of America, as the market is still putting too much pressure on the stock due to the litigation issues, in my opinion.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.