It was two months ago today that I first read about Warren Buffett’s $5 billion purchase of 50,000 preferred Bank of America (NYSE:BAC) shares valued at $100,000 per share. My mouth dropped open like the bomb bay doors of the Enola Gay! My mind was racing. What is he thinking?
Here’s what I learned. Warren Buffett initiated the deal and was the first to approach BAC’s CEO, Brian Moynihan, with the concept. The deal was hammered out in less than 24 hours. I want to try to understand why this deal was good for Buffett and Berkshire Hathaway, Inc. (NYSE:BRK.A). Why was it good for Moynihan and BAC?
From Buffett’s perspective, it is "preferred stock," meaning that Berkshire Hathaway has certain rights & privileges not enjoyed by holders of BAC common stock. Berkshire Hathaway receives a 6% annual dividend on its preferred holdings. Berkshire is granted warrants, valid for ten years, allowing Berkshire to acquire as many as 700 million shares of BAC common at $7.14 per share. Berkshire receives a 5% one-time premium on any preferred stock repurchased by Bank of America. Common stock is subordinate to Berkshire’s preferred stock, meaning Berkshire gets first dibs in the event BAC fails. This adds the final layer of cushion for Buffett and Berkshire.
Bank of America gets a $5 billion dollar capital infusion that one could argue it really did not need. In fact, CEO Brian Moynihan said on the day the deal went public, “I remain confident that we have the capital and liquidity we need to run our business.” This is borne out by the fact that BAC has reduced its long term debt 36% and increased net tangible assets by 60% since the end of 2008. The 6% dividend, when compared to the BAC’s 5 year average dividend yield of 4% begins to look fairly reasonable.
The 5% repurchase penalty, at first blush, seems severe, but in the context of dividend payments, it is just a 1% premium over BAC’s 5 year average dividend yield. After all, there is no mandate for BAC to repurchase the preferred stock, ever! Moynihan is insulated from meddling, as the stock has no vote. The warrants for 700 million shares at a strike price of $7.14 have no significant financial impact for BAC, although value for holders of common stock could be significantly diluted down the road. In short, BAC didn’t give away much, financially speaking. So what did Bank of America get? In my opinion, Bank of America received a priceless endorsement from the premier investor of our century, Warren Buffett. It wasn’t just a verbose vote of confidence from Warren Buffet. Ostensibly, Warren Buffett put his money on the line. Public perception is going to be affected by a $5 billion dollar endorsement.
Consider the fact that Bank of America is embroiled in numerous law suits related to its Countrywide acquisition. It is reported that several of these have been settled -- to the tune of $8.8 billion. Then we have financial giant American Insurance Group, Inc. (NYSE:AIG) filing suit for $10 billion. This can only exert a downward pressure on the stock. When you can counter-balance that with an investment offer from Warren Buffett, the smart guy does the deal. My hat’s off to Moynihan. Short term, it was the right move for his company and for his investors.
What's less clear is the long term outcome of this. This isn’t Buffett’s first rodeo. He’s done this before, with General Electric Company (NYSE:GE) and Goldman Sachs (NYSE:GS). The $3 billion invested in GE netted Berkshire Hathaway $1.2 billion and the GS investment of $5 billion netted another $2.5 billion for Berkshire Hathaway. Both GE and GS have repurchased the preferred stock but the warrants are still valid. In short, Berkshire Hathaway isn’t through with them yet.
In late September, Moody’s downgraded BAC’s long-term debt rating from A2b to Baa1. Wells Fargo suffered a downgrade as well, from A2 to A1. Citigroup, Incorporated (NYSE:C) came through unscathed. This begs the question on the value of Berkshire Hathaway’s investment. Berkshire Hathaway is also heavily invested in Wells Fargo & Company (NYSE:WFC). Buffett has no holdings in Citigroup. Go figure!
We shouldn’t forget that at the close of the second quarter, Berkshire Hathaway held nearly $10 billion in WFC, and almost $2 billion in U.S. Bancorp (NYSE:USB) in addition to the $5 billion most recently invested in BAC.
So what is our take-away from all this? Who can know for certain? One thing is certain: Warren Buffett is a shrewd puppy, and if you sit down at the bargaining table with this big dog, be sure to count your fingers and toes before you rise to go. Berkshire Hathaway will be the only real winner on the BAC deal in the long run. BAC won’t suffer any mortal wounds, nor will the shareholders, but in my opinion neither will be all they could have been absent the Buffett gambit. Buffett is a merciful warrior, sparing the life of those he vanquishes in battle, largely I believe, to ensure that he receives that last full measure of profit from his victory (the warrants).
Many have intimated that Buffett is a white knight, charging in to the benefit of beleaguered companies. I don’t see it that way. It is opportunism, pure and simple. I respect that, really I do. It is just the shrewd practice of business. We should, however, guard against those who would have us believe that Warren wears a halo. I’m sure he doesn’t. A crown maybe -- all hail the king!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.