At the end of July, I published an article on Seeking Alpha entitled "The Long Case for Bank of America." In it I said, "If you can look beyond the serious problems facing the banking industry, this may be a terrific time to buy one of the world's strongest banks at a steep discount to its true value and with a terrific dividend. That said, a purchase bears significant risk, as no one truly knows how the mortgage/credit crisis will play out, nor when." I made the case that Bank of America (NYSE:BAC) would not cut its dividend, which was my main reason for owning it. And in fact, BAC did not cut its dividend the following quarter.
A lot has changed since then. Let's look at the significant points from the July article and compare them to conditions today.
July: Large, mature growth company, prudently managed, paying a sizable dividend.
Today: Humongous, acquisitive growth company, with an unclear strategy, trying to digest extra-large acquisitions made in rapid order, and with a dividend in peril.
What business is it in?
July: Domestic and international retail and commercial bank, which I noted would "normally…be a stable business…[although] the banking and finance sector is beset with problems stemming from the still-ongoing sub-prime mortgage fiasco and general credit crisis."
Today: The new BAC is a domestic and international retail, commercial, investment-banking giant, plus a major brokerage and asset manager, trying to get off the ground in a clearly distressed environment.
Company Story and Quality:
July: BAC was one of the largest banks in the world, and the nation's largest consumer bank. Its coast-to-coast geographic reach gave it significant advantages of scale. It had stated its aspiration to become "the country's top retailer of financial services, with the size and scale to drive distribution and marketing efficiencies." Internationally, BAC served clients in 175 countries. Its massive deposit base (one of the largest in the world at almost $800 B) gave it a stable and low-cost source of funding.
In normal times, its retail orientation would provide steadier business results than many other banks. Of course, along with the whole financial sector, its results had become unsteady due to the mortgage and credit crises. BAC had on July 1 acquired troubled mortgage originator Countrywide Financial, making it the largest mortgage lender in the country. I opined that short-term, that may not be a great thing to be, but long-term, with the imposition of sensible lending standards, the acquisition should become a positive for the bank. The bank had just posted unexpectedly good results in Q2 2008, with record net revenues and credit-related write-downs halved from the previous quarter. Most notably, BAC did not cut its Q3 dividend.
Today: For those who are impressed by sheer size and variety, the new BAC may present a compelling story. All of the advantages listed above still exist.
That said, personally I find the story of the new BAC to be impossible to write. Look at all that has changed. BAC now owns not only Countrywide, but also soon will own Merrill Lynch (MER) (the acquisition is expected to close in Q1 2009). It has transformed itself from "just a bank" (albeit a very large one) into a sort of universal bank/mortgage processor/asset manager/retail brokerage/investment bank. BAC has totally altered its mix of revenue sources. At the same time, Congress has passed a sweeping Housing Act and more recently a $700 Billion financial bailout package. New and different legislation and regulations are sure to follow.
How will all this affect the new BAC? Questions abound:
Does BAC have the ability to integrate its disparate businesses? It has purchased Countrywide, but it would be a stretch to say that it has integrated it. These things take longer than a couple of months. Soon Merrill Lynch will join the club, which may by that time be culturally dysfunctional. A positive case can be made that BAC now has even more economies of scale, copious cross-selling opportunities, and the ability realize hundreds of millions or even trillions in "synergy savings." Well, those things are always said about mergers. But, depending on which study you read, more than half of them do not work out. You can call all these businesses "banking," but in truth the component businesses are very different. BAC has become sort of a banking conglomerate. So a negative case can be made that BAC will never become a coherent business, and that billions of dollars will be wasted trying. It will lose the competitive advantage that it had when it was "just a bank."
What does CEO Ken Lewis think about investment banking, anyway? He's displayed a love-hate relationship with it, with a resultant flip-flopping in strategy. Does that suggest that he may not understand investment banking, or that he loves it when it's going good and hates it when it's going bad, or hates it when it's home-grown but loves it when it's acquired? Last year, when the credit crisis first started to affect the bank's stock, Lewis announced that he'd already had all the fun he needed from BAC's small, organically grown investment banking operation, and he severely reduced it. Now just about a year later he's gone and bought Merrill Lynch, one of the largest investment banks. Just what is the strategy?
Most would agree that the highly leveraged trading mentality at Merrill Lynch must change back to one with a more traditional client-centered emphasis. Have you ever tried to change a corporate culture? What makes anyone sure that it will happen successfully now that BAC owns Merrill?
How can BAC's book value, earnings, ROE, indeed any of its financials be projected? Its consumer-banking revenues will go from 70% of the mix to less than 50%. What write-downs are in its future, how much new (dilutive) new stock will be issued to raise capital? How long will the housing and credit crises last, anyway? How long will it take to realize the synergy savings (early reports string them out to 2012), and will they amount to what is now being touted?
How can BAC's valuation be determined, even if one believes that long-term BAC will turn out to be one of the few true winners in the great bank debacle and transformation of 2008?
BAC had been a very attractive dividend stock, having paid dividends since 1903 and increased them for 30 consecutive years through 2007. That was my main interest in it. Will that continue, given what it has done to itself? Any financial analysis of the new BAC is just guess layered upon guess layered upon hypothesis. For example, just last weekend, BAC agreed to a costly plan under which about 400,000 mortgages it acquired in the Countrywide merger will be restructured. How will that affect shareholders? What about the acquisition of Merrill Lynch? How can anyone know what its effect will be? One thing is certain: BAC needs to raise capital. Where will it come from? The overwhelming probability is that some of will come from a cut in the dividend.
I use the Easy-Rate™ system for scoring company quality. I award from 0 to 10 points for a stock's "Story," looking for factors like competitive advantages, proven track record of good management, strong brands, clear strategy, and understandability of a company's business model (i.e., how does it make money?). Any company with a Story score of 4 or below is discarded; you don't have to look further into its financials, valuation, and the like. On that basis alone, BAC must be discarded. It has no Story score, because the Story cannot be written. There are simply too many unknowns.
In July, I rated Bank of America as "Good" on company quality, noting that any evaluation of BAC had high risk attached and ultimately depended on your views of the problems facing the whole financial sector. Today, following the acquisition of Merrill Lynch, I consider BAC to have an un-ratable Story, and therefore to be un-ratable as to company quality.
Investment Thesis and Conclusion:
July: Without going into all the details, I had rated BAC as a "Buy," especially considering its "sky-high" 8.7% dividend.
Today, I must view it as a speculative stock, surrounded by uncertainties. It has become the philosophical opposite of a safe, long-term dividend stock.
I hold BAC shares, and what I will probably do is put a trailing sell-stop under them to avoid outside losses, but try to catch any updrafts that may benefit the stock. If the stock is truly a long-term winner, as some are predicting (and frankly I hope they are right), it may stay ahead of the sell-stops, and this will turn into a holding strategy. But that would not be my prediction. Given the extraordinary volatility in the financial markets, I expect BAC will hit its sell-stop at some point, and it will be history as far as my portfolio is concerned.
I hate to lose a stock paying such a high dividend, but the dividend must be considered to be at risk if not outright doomed. It's too bad. BAC seemed to be a great long-term investment. Maybe it still will be for those who can stomach extreme unknowns, price volatility, and the probable dividend cut. But for those looking for a comfortable level of safety and a predictable, growing dividend, it is hard to make the case any more for BAC.
Disclosure: Long BAC.