Predictions For Bank Of America's Capital Return Plan

| About: Bank of (BAC)
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Bank Of America's capital plan will drive the stock lower or higher this week.

I'm predicting $12 billion in total capital returns split between common share repurchases, common share dividend payments and preferred/debt redemptions.

Paying a higher common dividend is an important signal to the market and should not be overlooked.

With the Federal Reserve's annual stress test now out of the way, and all but one firm having passed every scenario that was thrown at them, investors can now turn their attention to what is arguably the most interesting piece of the whole stress test program; the capital plans. Part of the stress testing regimen every year is now a requirement that each CCAR firm submit its plans to return capital to the Fed for approval for the coming year. As Bank of America (NYSE:BAC) was widely expected to pass all stress testing scenarios due to its significant fundamental improvements, most investors are more interested in how the company will return capital in the coming year. In this article, I'll make some predictions for what I think we'll see from BAC this week when the capital plans are released.

To begin, we'll take a look at the ways BAC could return capital and then assess the relative likelihood and any amounts that may come into play. The most obvious way to return capital is to simply pay a higher cash dividend. BAC's dividend is still languishing at one penny per share per quarter and is likely the biggest gripe from investors. The second way is to repurchase common shares. BAC has been doing this and indeed, was the thrust of the bank's capital return plan last year at this time. BAC has done well retiring billions of dollars of shares at prices much lower than where shares trade today. Finally, BAC could return capital by continuing to retire high cost sources of funding such as preferred shares. BAC also made this part of its capital return plan last year and retired a significant portion of its preferred funding, saving the bank enormous sums of money on dividend payments each year.

Using last year's capital return plan of a total of $10.5 billion as a baseline, split between $5 billion of common shares and $5.5 billion in preferred shares repurchased, we can estimate how much BAC will ask to return to shareholders this year given its much improved fundamentals and prospects. BAC's balance sheet has greatly improved since last year due in no small part to those preferred redemptions. Also juicing the bank's ability to return capital in 2014 is simply greatly improved earnings prospects. BAC is expected to earn more than $17 billion this year, allowing the bank to not only continue to improve its balance sheet but return even more capital to shareholders.

I think we'll see BAC ask for around $12 billion in total shareholder returns this year but I also believe it will be distributed differently from last year's plan. I think BAC will continue to buy back common shares but not as aggressively as it has been. With shares trading much closer to book value and over tangible book, which was true last year, the attractiveness of retiring common shares has likely diminished. I still think we'll see another $5 billion in common share repurchases in the plan for 2014 based on the bank's earnings prospects and the fact that shares are still cheap, just not as cheap as they were last year. While I recognize that $5 billion would match last year's total, I think that if shares were still in the $13 area that number would be much higher, perhaps in the $7 to $8 billion range instead of $5 billion.

With $7 billion left on my estimate for BAC's capital return this year, I think we'll see just over $2 billion in common dividends. At the current share count a 20 cent annual dividend would cost BAC around $2.1 billion over the course of a year. At that dividend, the stock would still only yield just over 1% but it would signal to investors that the era of a virtually non-existent dividend was over, which is very important indeed. I think that BAC will come out in a big way with its common dividend in order to send that signal to the market. It can afford much more but I think for now, a 20 cent dividend is enough to satisfy market participants and still allow the bank to return capital elsewhere.

Finally, I think we'll see the remaining ~$5 billion go back into preferred and perhaps some debt redemptions. BAC still has hundreds of billions of dollars of preferred stock and debt on its balance sheet and while that amount isn't unreasonable for a bank its size, it is still costing BAC large sums of money to service each year. In particular, I think preferreds will be the focus again this year as those typically carry coupons in the 6% to 7% range for BAC whereas debt is much cheaper. I think what we'll see is BAC retiring a large amount of preferred shares and perhaps some debt again this year in order to reduce its interest expense and increase earnings. The bank isn't using this leverage to fund its operations the way it used to before the crisis so there is no reason to hold these sources of funding anyway. If I had to guess, I'd say $4 billion in preferred share redemptions and perhaps $1 billion in higher cost long-term debt funding. However, I wouldn't be surprised if debt didn't come into play at all and the bank focused on retiring preferreds entirely.

While I think BAC will return capital in three ways, common share repurchases ($5 billion), preferred and debt redemptions ($5 billion) and common share dividends ($2 billion), I'd like to see the bank forego the common dividend for now. That $2 billion would prove much more effective for the long term if it went towards retiring common shares or more preferred redemptions as it would increase earnings forever. However, BAC is under pressure from market participants to pay a higher common dividend and I don't think there is any doubt it will happen. The only thing still up for grabs is the amount and I think five cents per quarter is what we'll see. BAC can easily afford $2 billion per year in common dividends and coming from only one cent per quarter, that should satisfy market participants for the time being. I hope the bank will continue to retire large amounts of common shares and preferred/debt issues because those sources of capital returns increase the value of common shares forever.

The bottom line is that I think BAC is well-positioned to return $12 billion in capital this year and I think it will ask for a $2 billion common dividend and $10 billion in share/debt repurchases. This is the most diplomatic way BAC can return capital as it will satisfy investors that want a common dividend but also position itself well for the future with a lower share count and less burdensome capital structure. In addition, if BAC disappoints with its capital return plan and shares sell off, you should see it as a buying opportunity. Any knee-jerk reaction to, say, a lower common dividend than expected should be bought as shares will still be very attractive even if the common dividend comes in lower than expected. It will certainly be an interesting week in too-big-too-fail banking as we all eagerly await the results of the capital return plans.

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.