Bank Of America: Why The 'Dead Money' Thesis Is Short Sighted

| About: Bank of (BAC)

My esteemed SA colleague Regarded Solutions recently published a piece entitled, "Bank Of America: Dead Money At Best" wherein he posited that Bank of America's (NYSE:BAC) legal issues and lack of a dividend are reasons that the stock will not go higher from current levels. I have a great deal of respect for RS and I have been a fan of his work for some time. However, SA allows us the free exchange of ideas and I couldn't help but pen a rebuttal to what I feel is likely a misguided argument. In short, I respectfully disagree.

The first issue RS takes with BAC is the company's dividend, or lack thereof. I agree the current dividend is meaningless; nobody holds a stock that pays four cents per year per share as that would be ludicrous. However, the idea that this is a reason not to hold the stock I think is the result of a misunderstanding or unrealistic expectations. The only way BAC isn't a stock to hold because of the dividend is if you need current income right now. If that is the case, BAC is not the stock for you because dividends could be years off still. However, no stock is for every single investor, so I don't think this is a reason to automatically write off shares as not being worth a look for your portfolio. BAC's earnings troubles since the financial crisis have been well publicized and that is undoubtedly the reason why the dividend hasn't recovered. However, BAC is back on track and making tons of money again so management is making a point of returning capital to shareholders.

Instead of returning the capital via dividends at this time, however, management has decided to retire expensive sources of funding such as term debt and preferred stock as well as repurchasing common shares following the massive dilution incidental to the financial crisis. Make no mistake; this is a return of capital to shareholders but instead of showing up in a yield number, the results are showing up in improved operating results and profits as funding costs come down and the number of shares over which profits are allocated also decreases. Management is using this strategy, which I wholeheartedly agree with, because of another point RS makes in his article; shares are cheap.

BAC's book value is north of $20, yet shares are just over $14; why is that? First, that $20 book value is the nominal book value and not the more useful tangible book value, to which shares currently trade at a modest premium as of the last quarter. Banks often trade lower than their nominal book value because it includes intangible assets that can't be sold or otherwise monetized the way tangible assets can be. However, that still means that shares are cheap and to the author's point, someone should be "biting" at these levels; that someone is BAC management. Shares are being repurchased at a pace of more than a billion dollars per quarter currently, so management knows shares are cheap and is taking advantage of the low price in order to retire shares it would likely have to pay much more for only a couple of years down the road.

This also has the cumulative effect of allowing the bank to pay a much larger dividend on a per share basis when the dividend does resume because there will simply be less shares outstanding than there otherwise would be. This is an important consideration that I think gets lost on some investors; just because BAC isn't paying a dividend currently doesn't mean it isn't investing in its shareholders' interests. In fact, I think a large dividend right now would be irresponsible of BAC in light of the high cost funding sources it still has on its books, see here for a discussion of that, and the fact that common shares are still so cheap. I would be very disappointed if BAC decided to forego the buybacks and debt retirements in favor of a common stock dividend because it would simply be the wrong move right now. The author says BAC should pay the same dividend as Wells Fargo (NYSE:WFC) but Wells came out of the crisis stronger than ever, not severely weakened and losing money like BAC. I don't think comparing the two is appropriate since they are very different banks. A more apt comparison to BAC is perhaps Citigroup (NYSE:C), who was also on the brink as a result of the crisis.

Finally, the company's legal woes have been splashed all over the internet for years now as legacy issues from Countrywide, Merrill Lynch and the bank itself have made headlines for their eye-popping settlements and fines. RS is 100% correct in pointing out that BAC's legal woes are far from over and that ignoring them is probably not the best move. However, I'd argue that the worst of the settlements are in fact behind BAC and that while there are certainly more to come, BAC is in the position of being able to afford these settlements even in the event that they top an additional $20 billion from here. BAC has been accumulating money in its legal contingencies fund in order to pay these settlements so I'm not worried. I'm not excited about all of that money being litigated away, but I'm not worried about the long-term health of BAC just because of its legal issues.

The bottom line is that while I certainly respect Regarded Solutions' position on BAC, I respectfully disagree with his conclusions. I acknowledge BAC isn't for every portfolio but no stock is for everyone. I think discounting BAC shares simply because they don't pay a dividend is shortsighted and misses the fact that BAC's money is so much better spent in retiring expensive funding sources and repurchasing cheap common shares. BAC is investing in its shareholders for the long term and the payoff is likely to be large. However, if you need current income or can't wait for the payoff to materialize, perhaps Wells or JPMorgan (NYSE:JPM) are better options for you.

Disclosure: I am long BAC. 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.

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