BofA's Lewis Is Still Making Deals, But Now Aiming for Distressed Assets

Lots to get to this morning, so I'll be writing on several topics throughout the week, but first let me address a reader question re: Bank of America (BAC).

Shepherd writes:

Chad,

If the wires are correct, it looks like Lewis paid a premium to purchase Merrill Lynch (MER). I'm curious why you hold BAC, given that he seems to have an almost emotional need to acquire things, which gets in the way of negotiating the best price for his shareholders. My guess (admittedly from afar) is that he could have done better...

Shepherd, your characterization of BofA CEO Ken Lewis and his love of acquiring things is spot on. Earlier this decade BAC has acquired companies like FleetBoston, MBNA, and U.S. Trust, and paid full prices for all of them. As a result, BAC rarely traded above 10x earnings since most of its growth was coming from acquisitions, not organic growth.

During that time, Peridot clients did not hold BAC shares. It was only after the subprime crisis started to bite the big banks that I invested in BAC. There were a couple of reasons I chose BAC. First, relative to its size, BAC had less subprime exposure than its large cap bank peers. It did take writedowns, but given that it is the largest bank in the nation, firms like Citigroup (C), UBS (UBS), and Merrill Lynch had far more exposure. On that front, BAC's losses were manageable, and they were forced to dilute shareholders far less than others via capital raises.

The second reason was that BAC is the largest bank by deposits in the country. As we have seen with the investment banks like Bear Stearns and Lehman Brothers (LEH), without deposits to fund your business, capital can dry up overnight and a freefall can result.

On the acquisition front, people have criticized the Countrywide deal, but Lewis actually bought them on the cheap. Time will tell if he gets a decent return on the investment (I suspect he will over the long term, despite short term losses), but buying distressed assets on behalf of shareholders is far better than what he used to do (pay a huge premium for assets that were already fully priced).

The Merrill Lynch deal is a similar situation. We can argue if the price he paid was fair, but at least he is buying on the cheap. That will increase the odds of a very successful deal. I'll have more on the Merrill deal in another post to examine exactly what BAC is getting for its money.

Full Disclosure: Long shares of BAC at the time of writing.

Comments

[weiwentg:]

BoA doesn't have a lot of avenues for organic growth, so it's not surprising to me either that Ken would seek to acquire companies in this environment.

As a fellow shareholder, the question for me is, can BoA integrate Merrill while still digesting Countrywide? Can they stay well capitalized? And did they pay too much?

Merrill did purge a lot of dodgy assets last time, but they still have some mortgage and CDO exposure. BoA's capital position was a hair above well capitalized as of last quarter. Given their CFC acquisition, they really needed to rebuild their position. And now they've gone and bought a bunch of dodgy assets. Personally, I wouldn't object if they reduced or even suspended the dividend temporarily so that they won't have to raise capital while their stock is depressed.

Meanwhile, their stock is down over 10% today. I understand the MER deal is in stock. Let's hope that BoA's stock price will remain high enough that Merrill's shareholders will vote yes on the deal.

2008 Sep 15 11:28 AM

[No Moss:]

Well, I grudgingly like the deal for Merrill. Ken Lewis wants three things from Merrill, i.e., increased deposits (MER's deposit-gathering arms are classified as a thrift and an ILC), relationships with wealthy individuals (MER has that in spades), and a chance to use BAC's access to cheap cash to get the easy money that will be available when investment banks start handling M&As and similar transactions again.

Traditional banking doesn't allow BAC much room for growth, since BAC will be well over the 10% deposit threshold with the MER purchase. BAC will get deposit growth by offering loans and services that are tied to a BAC bank account.

On the other side of credit excesses and unemployment growth is a future of better credit quality, a normal yield curve, and a pent-up demand for homes, cars, and stuff in general.

2008 Sep 15 10:28 PM