Why Bank Of America's Future Is Brighter Than It Was On Wednesday

Mar.28.14 | About: Bank of (BAC)

Summary

BAC's capital return plan allows the repurchase of all outstanding, publicly traded warrants.

BAC should tender for all Series A warrants immediately, offering leverage on its repurchasing dollars.

Doing so would allow BAC to retire ~65 million more shares than if it simply repurchases common stock.

Bank of America's (NYSE:BAC) much-anticipated capital return plans were released Thursday, along with the rest of the CCAR firms, and the reaction from market participants was a resounding yawn. The proposal, which had to be resubmitted to the Fed due to it apparently being too aggressive the first time around, allows BAC to pay a 5 cent dividend (up from 1) and repurchase $4 billion worth of common shares… and that's it. I predicted earlier this week that we'd see a total of $12 billion in capital returns from BAC in this announcement, and I was, as they say, wrong. I have no problem being wrong or admitting I was wrong, because predictions are just that, and subject to being proven incorrect in the end. However, we have something to go off of now, so we'll see what it means for the future of BAC.

I was hoping for a larger capital return plan, for very obvious reasons. BAC is much stronger and healthier than it was even last year at this time, when it returned a quite robust $10.5-billion split between common and preferred repurchases. BAC is on track to earn roughly $14 billion this year, so given that the company also has some excess capital on the balance sheet, I figured $12 billion was a reasonable number. However, the Fed felt differently, and here we are. Now, that doesn't mean all is lost in terms of returning capital, so let's take a look at what BAC is doing and how it can benefit shareholders.

First, the cash dividend on the common was widely expected. BAC bumped it to 5 cents in order to bend to shareholder pressure to pay a higher dividend. The stock now yields just over 1%, which is far from an income stock, but the more important thing is that it symbolizes the crisis era is over for BAC. After being permitted to raise its dividend for 2014, I think we'll see BAC raise it every single year for the foreseeable future. This is good for those who already own their shares, as their yield on cost will increase dramatically in the coming years. It is going to be a long time before BAC is an income stock again, but at this point, I'm okay with that. The bank is still growing earnings at a ridiculous rate, so I'd rather see excess capital deployed into the business, instead of cash dividends.

Speaking of that, the $4 billion in buybacks is nice, but I was hoping for more. Last year saw more in common share buybacks, with the addition of preferred repurchases. However, the Fed's tests are more stringent this year, resulting in lower capital return approvals. While I will admit I was disappointed with "only" $4 billion, there was a piece of the press release I found more interesting than the rest. The press release states that BAC can spend that $4 billion on common share repurchases, as expected, or warrants. This is huge, as it means that BAC could potentially remove enormous dilution that is possible given the warrants that are outstanding on its common stock as a result of the financial crisis. As of the end of December, BAC had 121.8 million of Series B warrants and 150.4 million of the Series A outstanding. This means that BAC has flexibility to either retire ~235 million common shares outright, if it simply purchases common stock at today's prices, or every single warrant that is publicly traded (excluding Berkshire's warrants, those are off-limits for now). At today's prices, BAC's Series A and B warrants have a combined market value of ~$1.33 billion, meaning that BAC could either purchase them on the open market, or tender them for some price over their current market value.

Let's say BAC decides to tender for all outstanding warrants and offers a 25% premium, which I believe would get most, if not all, investors to give up their warrants. If we assume that, BAC would need to pay $1.67 billion for its outstanding warrants. This would eat up almost half of the newly-minted repurchase program, but think of the positive effects. BAC would be retiring ~272 million warrants that aren't common shares yet, but at least in the case of the Series A's, will certainly be at some point. BAC would be reducing future dilution in a big way by tendering for all outstanding warrants, because it could reduce future float by an average cost of only $6.125 per share, instead of purchasing common shares on the open market today for ~$17.

Some would argue that BAC's Series B warrants are too far out of the money to warrant repurchasing, and I can see that point. While I fully expect BAC will trade north of $31 by 2019, that is a long way from today's price. So assuming BAC were to tender for the Series A warrants only and use the balance of the repurchase commitment to buy common stock on the open market, BAC would offer $10.15 per warrant (at my 25% premium estimate), and with 150.4 million outstanding, that would cost $1.53 billion, leaving $2.47 billion for common share repurchases. I love this scenario, and I hope this is what BAC comes up with. It offers the best bang for its repurchasing buck, retiring a total of 296 million shares, or almost 3% of the float today. Since the Series A warrants are so far in the money at this point, I believe they should be considered common share equivalents, and retiring them now means BAC can leverage its repurchasing dollars in a big way.

Whatever BAC decides to do, it has a great record in recent times, repurchasing shares at cheap prices, leaving investors with larger gains than they otherwise would have. I would love to see BAC tender for the Series A warrants, as even if it has to pay a large premium, it will end up being a prescient move. I don't realistically think BAC will tender for the Series B warrants, since they are so far out of the money, but the Series A's offer BAC an opportunity to remove ~150 million shares of future dilution for a very low price. If it waits until those shares are converted into common stock, it will have to pay much, much more to retire them. The best use of BAC's somewhat limited repurchase budget is to tender for the Series A's and use the balance on repurchasing common stock. In this way, it can reduce the common stock float by nearly 300 million shares, instead of the 235 million it can retire by simply purchasing on the open market. Either way you slice it, however, it's good for BAC shareholders, as a reduced float is always an unequivocal positive.

Disclosure: I am long BAC. 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.