Loving The Leverage: Bank Of America

Aug.31.14 | About: Bank of (BAC)

Summary

First off we'll go over the terms of both the Class A and Class B warrants, including strike price, expiration date, and adjustment terms.

Next we'll try to find a reasonable forward valuation for Bank of America common stock through 2018..

Lastly, we'll compare the returns of the common stock to the returns of both the Class A and Class B warrants.

BAC Warrant Terms

Bank of America Corporation (NYSE:BAC) has two outstanding issues of warrants, Class A and Class B. Combined, both issues represent approximately 2.6% of the company's current shares outstanding. Below is a table comparing the terms of the two issues.

BAC WS A BAC WS B
Exp. Date Jan. 16, 2019 Oct. 28, 2018

Years Until Exp.

4.378 4.161
Strike Price $13.30 $30.79
Div. Adj. Threshold $0.01 $0.32
Warrant Premium 27.16% 96.83%
Shares/Warrant 1.000 1.000
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Like other TARP warrants, both issues of Bank of America warrants offer strike adjustment features to account for dividends paid out to common stock on a quarterly basis in excess of the dividend adjustment threshold noted above. In any quarter where the dividend payout exceeds the respective threshold, the strike price will be adjusted downward in accordance with the following formula:

Additionally, in the case where the quarterly dividend exceeds the dividend threshold, the number of shares purchasable per warrant increases:

So far, since Bank of America has yet to exceed the dividend threshold, the Class A and Class B strike prices remain unchanged and the number of shares purchasable per warrant remains 1; but this will surely change considering that Bank of America was recently approved to increase its quarterly dividend to $0.05 per share. Initially this will have no effect on the Class B warrant adjustment because it is well below the B dividend threshold, but it will trigger an adjustment for the Class A warrants.

BAC Common Stock

In order to place a value on these warrants, we have to get an idea of what Bank of America common stock will be worth by the time of expiration. Today, the stock trades for around $16 per share, .75x book value, and roughly 11x forward earnings. There's no question that the stock seems cheap on a multiple valuation basis, perhaps because the market is still a little wary of the company's ability to deal with regulatory hurdles. But, with the recent announcement of a massive settlement with Uncle Sam, it's beginning to seem as though Bank of America may finally be returning to normalcy.

In order to come up with a future price target and common stock returns, I want to account for a few things: 1) The company's equity growth rate. 2) The market's valuation of the company's equity. 3) Quarterly dividend payouts. Since, unfortunately, I can't see into the future, I think it would be best to use rather cautious hypotheticals.

1) To arrive at the company's projected book value per share, I'll be borrowing Josh Arnold's forecast, which I find to be extremely appropriate for this conservative approach. For the purposes of warrant strike price and shares per warrant adjustments (which take into consideration the share price at the time of the payout), I'll be using a quarterly compound growth rate of the book value per share. In Arnold's forecast, book value is projected to grow at a quarterly rate of 1.2% through 2018.

2) The market currently assigns a 0.75x P/B multiple, which might very well have been reasonable a few years ago, but now that the company has largely cleared the litigious cloud that overshadowed its profitability, I think we'll begin to see the discount erode over the next few years. I'm not saying that we'll see pre-recession multiples of ~1.8x anytime soon, but I think we can assume that, barring any financial disaster, a ~1.2x P/B multiple will be more than feasible by the end of 2018. For this model, we'll assume that the P/B multiple will increase 0.025 points each quarter through 2018.

3) In terms of dividend payouts, I think it's prudent to err on the side of conservatism, especially considering the profound impact dividends can have on strike price and shares per warrant adjustments. For dividends, we'll be assuming that the company maintains its $0.05 quarterly payout through 2016, which then increases to $0.10 per quarter thereafter. Realistically, I think payouts could be much higher than that but, again, I don't want to overstate the warrant adjustments.

Assuming all of the above, the stock would appreciate a total of 87.8% through the end of 2018, including dividends, to $30.96. Below you'll find the stock returns relative to book value.

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Those returns are nothing to scoff at, but with the leverage that the warrants offer, you could potentially multiply your gains.

Warrant Returns Relative To Common

First we'll start off with strike price and shares purchasable per warrant adjustments. Under the above scenario, Class A warrant strike prices would be adjusted down $0.63 to $12.67 and shares purchasable would increase from 1 to 1.05, but Class B strike prices and shares purchasable wouldn't be adjusted at all since the dividend threshold was never broken. (Please keep in mind that these adjustments consider share price at the time of the payout, which will surely differ from the linear appreaciation of the above model.)

Now for the all important intrinsic value of the warrant. Since, according to the above model, common shares will be trading at $30.96 by the end of 2018 (we'll assume that this remains constant from the expiration of the B warrants to the expiration of the A warrants), we can easily calculate the intrinsic value by simply subtracting the stock price from the respective strike price of each warrant, and then adding the value of the fractional share purchasable. The Class A warrants would be worth $19.84 (30.96 - 12.67 + (.05 * 30.96)). The Class B warrants, on the other hand, would only be worth $0.17 (30.96 - 30.79 + (0 * 30.96)). Below is a comparison of the value of the common stock to the intrinsic value of the warrants under these circumstances.

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Now I know this paints a pretty grim picture of the Class B warrants, but this is only under the given scenario. If we tweak some of the assumptions to be a little more optimistic, the B warrants vastly outperform the A. For instance, if the market should be willing to award Bank of America a 1.6x book multiple by 2018, rather than the 1.175 that we originally used, the common stock would be worth $42.16 per share, a ~153% increase. Under that situation, Class A warrants would appreciate over 300% and Class B warrants over 1190%. Wow. Talk about leverage. Of course there's inherently more risk associated with the B warrants considering that they are pretty far out of the money, but under the right conditions you can start to see the potential gains to be had - but remember the key term here is right conditions.

Final Thoughts

These warrants are certainly not for the risk intolerant. There are so many moving parts that will affect their value over the coming years. The underlying stock price is obviously the most important, and while many believe that Bank of America common stock is a no brainer bargain, that logic doesn't necessarily extend to the warrants. They have a finite life, and timing is crucial to their value. Whereas you can buy and forget about Bank of America stock until you retire to the sunny beaches of Florida, if you tried to do that with these warrants - guess what - you can forget about Florida. I hear the beaches in Wisconsin are nice in the summer.

Disclosure: The author is long BAC.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.