BAC Stock And Warrant Returns Relative To Book Value - Part II

| About: Bank of (BAC)
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This is Part II of a series of articles discussing the returns on common stock and TARP warrants for a few financial institutions relative to the institution's book value. Part I, on AIG, is located here.

Bank of America (BAC) received aid from the government during the financial crisis. As a result, the government was given two different long-term warrants in the company, which they have since sold off. Both sets of warrants are now publicly traded and accessible to all investors. Series A warrants expire Jan. 16, 2019. Series B warrants expire Oct. 28, 2018. This article investigates these instruments to see whether either warrant is a better way to gain long-term exposure to the company than simply buying the common stock.

Throughout 2012, Bank of America made slow but steady progress in returning the company to profitability. It has increased its capital position to conform to Basel 3 regulations. It has worked to reduce expenses and reduce exposure to legacy assets as well. The bank very recently announced it was settling a lawsuit with Fannie Mae for $11.6 billion. The share price more than reflected this steady increase in solid fundamentals, rallying over 100%. I believe this rally was mostly due to the fact that the bank was undervalued to start the year as opposed to being overvalued to end the year.

The bank has such a large footprint in the U.S. and abroad that it has become a proxy for global growth. This generalization is justified because the bank is involved in nearly all aspects of lending and banking throughout the world. This generalization can also be used on many of the other large banks as well.

With the recent rally in the stock as well as its performance over the past year, it is good to put the current price of the stock into prospective relative to historical valuations. BAC still trades significantly below book value. Before the financial crisis, large money center banks traded at roughly 1.6x book value. Both BAC warrants have around six years until expiration, so these instruments have a long enough life that they should see the bank return to more normal valuations.

As a result of the continued lawsuits, BAC has a damaged reputation and somewhat of a stigma associated with it. I don't expect valuations to return to the previous levels, but a move up to at least book value is reasonable and a move above book value isn't out of the question in a six-year horizon.

In the table below, I list the relevant information about the warrants, the current stock price, the current stated book value (from the latest quarterly report), and two scenarios for warrant and stock returns based on price relative to future book value. I assume book value grows at 3.5% per year from current levels. This is a low growth rate to keep the analysis conservative.

BAC Warrant A (BAC.WS.A) BAC Warrant B (BAC.WS.B) BAC Common Stock (returns calculated until Series A exp.)
Warrant Strike Price $13.30 $30.79 --
Warrant Price $5.73 $0.76 --
Warrant Exp. Date 1/16/2019 10/28/2018 --
Time until expiration (years) 6.03 5.81 --
Current Stock Price $11.98 $11.98 $11.98
Current Book Value per Share $20.40 $20.40 $20.40
Price if stock trades at 1x BV which grows at 3.5% per year till expiration $11.80 $0.00 $25.10
Historical P/B Ratio 1.6 1.6 1.6
Price if stock trades at historical P/B & growth in BV of 3.5% per year $26.86 $9.07 $40.16
Return if stock at BV 106% -100% 110%
Return if stock at historic P/B, 1.6x 369% 1093% 235%

All TARP warrants have dividend protection, but the BAC Series A warrants have some of the most generous dividend protection thresholds. As the annual total dividend rises above $0.04, the strike price of the warrant is adjusted down by the amount above that level. The Series B warrant threshold is $0.32 per share, so it is probably not reasonable to assume the strike on the Series B warrants are adjusted at all. The table above neglected any strike price adjustments.

BAC currently pays an annual dividend of $0.04, so any dividend increase from here begins to reduce the strike price of the Series A warrant. The bank is widely expected to get approval to increase its dividend in March 2013. Any positive announcements resulting from the Federal Reserve Board review could serve as a positive catalyst, though these announcements can also serve as negative catalysts, as was the case with Citi last year.

To keep the calculation simple and conservative, I recalculated the expected returns for both warrants and the stock assuming the annual dividend averages $0.25 from now until the expiration of the warrants. That equates to roughly 6 cents per quarterly dividend for the next six years. The table below details the returns given an average annual dividend of $0.25 until expiration. Note that this is less than half the dividend the bank paid out between 2006 and 2008.

Returns with average $0.25 dividend until warrant expiration
BAC Warrant A (BAC.WS.A) BAC Warrant B (BAC.WS.B) BAC Common Stock (returns calculated until Series A exp.)
Total Dividend Paid $1.50 $1.44 $1.50
New Warrant Strike Price $12.04 $30.79 --
Price if stock trades at 1x BV which grows at 3.5% per year till expiration $13.06 $0.00 $25.10
Historical P/B Ratio 1.6 1.6 1.6
Price if stock trades at historical P/B & growth in BV of 3.5% per year $28.12 $9.07 $40.16
Return if stock at BV (including dividends for common stock) 128% -100% 122%
Return if stock at historic P/B, 1.6x (including dividends for common stock) 391% 1093% 248%

Bank of America does have continuing problems with bad mortgages stemming from its purchase of Countrywide. The settlement mentioned above, for $11.6 billion, does remove some uncertainty surrounding the bank, but these sums of money being paid out start to add up pretty quickly to hurt profitability. The bank is working to put these problems behind it, though they will still weigh on the bank for the next few years. Over the next six years, the bank should be able to address and move past the warranty issues in the lifetime of the warrants. If you expect valuations to stay at or near current levels, both sets of warrants should be avoided. Unless the stock price increases above the warrant strike price, the warrants will have an intrinsic value of $0. Until that time, entire value of the warrants is time value which is subject to decay.

For those who are positive on the bank but don't expect the shares to top $30 by expiration, it would make sense to go long the stock or the Series A warrants and short the Series B warrants. The big problem with this idea is the margin requirements for the Series B warrants since they trade below $5.00 per share (100% margin).

Using the assumptions outlined above, including a dividend payment and a return to book value by the warrant expiration dates, the Series A warrants will return around 128%, or roughly 13% annualized return for six years. Over this same time period, the stock also returns 122% including dividends, or a 11% annualized return. The Series B warrants don't have any intrinsic value at expiration unless the bank either trades above book value or the bank grows book value at a faster rate than I calculate. As a result, the Series B warrants are only for investors who are very positive on the banking sector over the next six years and believe the stock can trade over $30 per share by expiration.

From this analysis, more risk-averse investors in Bank of America can use common stock to gain exposure to the company. Those with more risk tolerance could use the Series A warrants to gain exposure and those with high risk tolerance and who are very bullish could use the Series B warrants. The choice between these instruments depends on your expectation for future valuations, risk tolerance, and comfort with volatility.

After the big run that BAC has had, I believe it is undervalued from a long-term prospective but probably overextended shorter term. As a result, it makes sense to buy a partial position now and wait for the market to fall to purchase the rest of the position. Since the warrants have a strike price above the stock price, they are very volatile and should drop significantly as pessimism returns to the market. This drop in stock and warrant prices should provide a great entry point for investors who can handle volatility to achieve long-term gains.

Disclosure: I am long BAC. I am long BAC Series A warrants. 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.