What B of A Gets by Passing on Lehman & Gobbling Up Merrill

We can certainly second-guess Bank of America (BAC) deciding to buy Merrill Lynch (MER) today rather than tomorrow or next week, when the price could have been meaningfully cheaper. There is speculation that the government pressed Merrill do to a deal now, so as to avoid another weekend bailout session later. Not only that, but by acting now BAC ensures it gets Merrill, rather than having to pass up on a chance that may not come along ever again.

While the price it paid (and whether it proves justifiable based on long-term profitability at the Merrill unit) will be one of the key factors in the deal's ultimate success, my job as a portfolio manager and a BAC shareholder is less about speculating on whether the company could have paid less tomorrow and more about what it is getting for the deal it actually announced, a stock swap of 0.86 shares, valued at $29 per MER share based on Friday's closing prices.

While the bad assets are abundant at Merrill's investment banking arm, it is important to remember that the crown jewel of this deal is the Global Wealth Management division, not the investment bank. MER owns 50% of Blackrock (BLK) and has a network of nearly 17,000 financial advisors.

The BLK stake is publicly traded, so we know that is worth $14 billion. The Merrill Private Client Group does about $3 billion per year in pre-tax net income, so a conservative multiple on that division of 10x gets valued at another $30 billion. In sum, that comes to a $44 billion valuation for about 45% of MER's revenue base, which excludes its entire investment banking operation.

Bank of America shares are trading around $29 each this morning, which values the Merrill deal at ~$43 billion. As a result, BAC shareholders are getting MER's investment bank for free. There is a price to pay for that luxury, however, because further writedowns of Merrill's bad assets will now be incurred by BAC. Long term though, it is hard to argue that BAC can't make this deal successful over a multi-year time frame. Just how bad future writedowns are will play a big role in determining such success.

Even Oppenheimer's Meredith Whitney, the extremely bearish analyst on the banks, today pegged Merrill Lynch fair value at between $27 and $35 per share. At today's prices, BAC is paying less than what Wall Street's most bearish analyst thinks the company is worth. That can't be a bad thing...

All in all, this deal is much like the Countrywide one. BAC is accepting near-term problems for the possibility of tremendous long term upside. I would much prefer that strategy to the one a company like Wachovia (WB) implemented when it bought a mortgage company (Golden West) and an investment firm (AG Edwards) at the top of the market. At least BAC did so when the firms were in distress, and might have gotten a bargain as a result. Time will tell.

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

Comments

[CrossProfit:]

Fair and balanced article.

2008 Sep 15 02:19 PM

[Muzie:]

The value of the deal appears to have dropped by 4B$ today...

2008 Sep 15 08:32 PM

[cashflowtrader:]

BAC can always reneg after some more DD. Just look at the MER SP!

2008 Sep 15 09:16 PM

[bryanz:]

So I'm a little confused on this... has BAC actually agreed to pay $50B for MER? Or have they agreed to pay 0.86 in BAC shares per 1 share of MER as of some closing date? Is the $29 a guaranteed number? I can't see how it is since MER is still hanging out in the teens...

Anyone care to shed some light? Thanks!

2008 Sep 16 02:52 AM

[No Moss:]

Bryanz, it's the .86 (actually .8595) shares of BAC as the date of the actual sale, which I gather will be sometime in the first quarter of next year.

The events of last weekend revealed that we're running out of options for shotgun marriages. Federal officials believed that both Lehman and Merrill were going bad, and the only suitor they could find for an unassisted buyout was Ken Lewis for Merrill. Actually, the Fed probably offerred something to BAC, perhaps down the road.

Who do you think will be interested in Goldman Sachs and Morgan Stanley? And who can afford them?

2008 Sep 16 08:42 AM

[nyka:]

A well-conceived analysis, plain and simple...and the words roll out like whipping cream.

2008 Sep 17 12:18 AM