"It is important for you to realize that Bank of America is, in effect, our fifth largest equity investment and one we value highly…We can buy 700 million shares of Bank of America at any time prior to September 2021…We are likely to purchase the shares just before expiration of our option."
Well, it looks like Bank of America (NYSE:BAC) has been forced to call an audible. For shareholders (including myself) that viewed the $4 billion buyback and $0.20 annual dividend last month as a signal that the first measurable steps on the marathon road to recovery were underway, we recently learned with disappointment that accounting errors led the bank to overstate their capital by $4-$5 billion, which inspired the Fed to demand that Bank of America resubmit its capital plan.
There are a couple of options that Bank of America could pursue with its revised proposal to the Fed. First, they could keep the quarterly dividend at a penny and keep the $4 billion buyback. This move would likely be appealing to value investors and those interested in maximization of value, as buybacks are most beneficial when the price is heavily discounted from intrinsic value (the catch is that prices tend to be low during periods when it is politically unfashionable to do buybacks).
Although Bank of America's complexity makes it tough to pin down an exact intrinsic value, we can take a ballpark estimate by looking at the company's book value that is currently shy of $21 per share. At the current price of $15 per share, Bank of America's buyback would be the act of buying dollar bills for roughly seventy cents. If Bank of America chooses to keep the buyback plan, they could retire 250-275 million shares (depending on stock price fluctuations) which would reduce the outstanding share count by about 2.5%.
Alternatively, Bank of America could temporarily halt its buyback plans and go ahead with the quarterly dividend hike to $0.05 per share. The appeal of this strategy is that it would finally put Bank of America back on the path to dividend growth and give long-suffering shareholders some cold, hard cash. After years of bumbling through home loan settlements and Tier 1 Capital concerns, the penny per share quarterly dividend from 2009 until 2014 became the gravamen of shareholder restlessness. Buybacks are generally more pliable when it comes to long-term investing (that is, vacillations in buyback commitments do not earn the same scorn as inconsistent policies) whereas going back on a dividend declaration is somewhat akin to trying to take a bone out of the dog's mouth. Keeping the dividend commitment allows Bank of America to start creating something that resembles shareholder harmony, and plus, share owners can take advantage of the undervaluation by reinvesting their dividend into additional shares of Bank of America at the discounted price.
Those are the current quantitative concerns and remedies facing Bank of America. The other reason why the latest news development accentuated Bank of America's reputation as the bumbling, stumbling bank is that it makes you wonder about the company's internal controls when $4 billion in Merrill Lynch structured notes can be gone without anyone noticing. Oops.
The concerns about Bank of America are real and fair: the litigation that could last a decade, the revised earnings plan, the questions about internal controls. Given that those things exist, the question becomes: Why is Warren Buffett going to add 700 million shares of Bank of America to Berkshire's (NYSE:BRK.A) (NYSE:BRK.B) portfolio in September 2021, given the bank's litany of headaches and encumbrances? Because of the intersection of long-term earnings power with the prevailing valuation.
Although it may not seem like it, Bank of America had $11.4 billion in net profits over the course of 2013. Before we take into account litigation expenses from the Countrywide acquisition and the other follies of 2008-2009, Bank of America is making $1 billion in profits per month. If I could make an educated guess as to what Buffett finds appealing about this company, it would be this: the truly patient share owners will find themselves sitting on a bank with enormous earnings power once the litigation abates.
The current dividend payout, and the current earnings per share figures reported by the bank, are not truly reflective of the company's earnings power, and Buffett's substantial investment recognizes this. The latest news about the $4 billion in Merrill Lynch structured notes that stated the presence of $4 billion in capital that does not exist will not materially impact the company's Tier 1 Capital Ratios nor will it affect the company's long-term earnings power.
The headline risk is not consistent with the company's long-term profit potential. Bank of America is better capitalized today than it was before the financial crisis, and although it may not seem like it, 2013 was the 5th most profitable year in the banking giant's history (the reason it doesn't feel like it is because there are twice as many shares outstanding now as in 2008). The current earnings power of the company is somewhere around $1.50 per share, and that figure is set to rise as problematic assets work their way off the balance sheet. If you are equipped to think and act in 5-10 year increments, this could be yet another example where you could do well for yourself by following Buffett's lead, even though the current price is higher than what Buffett paid in 2011.
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.