BAC Earnings

[bmichaud]

Given $.96 EPS, I'd say "Earning Power Value" is $8 assuming a 12% cost of equity (8.3x PE). If BAC can reinvest at a rate higher than 12%, then perhaps it warrants a PE of 10x, for a FV of $9.60.

 

I hate the exploding share count. Earning power is supposedly there, but it's been severely diluted.

 

And my weekly struggle with BAC continues....

[PlanMaestro]

I used cash flow from operations (pre- WC adjustments) to estimate PTPP. I get numbers so much higher than those being discussed, and much more in line with BAC's historic profitability, that I will keep them to myself to avoid looking ridiculous.

 

Value investors are truly conservative.

[vinod1]

I have looked at this thing time and time again, and still continue to struggle....

 

For 2011, PTPP income was $17 billion, and if you add back the $12 billion of cost savings Parsad and Eric refer to, "normalized" PTPP is around $29 billion. Are you guys modeling higher PTPP due to future revenue increases, or does BAC becoming "lean and mean" involve a lower revenue base?

 

Loan loss provision seems about at normalized levels, $13.4 billion, so pre-tax income is $15.6 billion, and net income $10.1 billion assuming a 35% tax rate.

 

Shares out as of FYE were 10.5 billion, so normalized EPS is $.96.

 

Curious what type of normalized EPS figure board members are looking at....

 

In your $17B PTPP you are assuming the following costs that have been realized in 2011 would recur indefinitely into the future:

 

–$15.6B representations and warranties provision

–$6.3B mortgage-related litigation expense and assessments and waivers costs

–$7.3B of other noninterest expense in Legacy Asset Servicing

 

There would always be some costs for each of the above items and you have to come up with your own estimate of what the reasonable numbers are. Your estimate may be higher or lower than above but at the very least I would expect anyone trying to come up with an IV estimate to make adjustments to the above numbers.

 

On top of this you have planned operating cost cuts which one might reasonably incorporate into their IV estimates.

 

We can ignore many things like (a) growth (b) synergies via cross sell which not many have done successfully © better loan quality and consequent lower loan losses on loans made during periods of stress. All these are likely but it is hard to put a number, so we can ignore them.

 

Vinod

[alertmeipp]

How about interest rate?

[vinod1]

How about interest rate?

 

My list is definitely not comprehensive. Just wanted to point out what I thought were not very obvious ones like the mortgage related charges for example. You would also need to back out the asset sales from revenue. 

 

Vinod

[ERICOPOLY]

and if you add back the $12 billion of cost savings Parsad and Eric refer to, "normalized" PTPP is around $29 billion.

 

2011 isn't normal, so I just wouldn't be tempted to use it for anything.  This interest rate environment isn't normal.  The falling home prices aren't normal.  Jingle mail isn't normal.  The unemployment rate isn't normal.  Their portfolio isn't even normal!  They are still taking losses on Countrywide crap for example, which isn't normal because they didn't even underwrite that crap in the first place and never would have nor will they in the "normal" scenario.

 

Start with the $12b in cost savings from reducing headcount, add back in $15b from R&W reserve build and you have $27b.  Then add back in the 2011 elevated legal expenses, adjust for the elevated loan losses.  What about all those mortgage LOSSES!  They are in that business to MAKE money, not lose it.  So add back in some normal amount of profit in addition to the 2011 losses they took on mortgages.

 

I'll bet you're well and truly blasting through $35b (pre-tax) although I'm too lazy to add it all up.

 

Sooner or later they are going to lower those corporate tax rates in the US to be more competitive with headline rates found in other countries -- guess who is going to benefit?  Being nearly the top tax rate in the world is also not "normal". 

[Uccmal]

We discussed alot of this nearly 9 months ago here:

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/bruce-berkowitz-on-bac/

 

Berkowitz's thesis is playing out, possibly even faster than he anticipated.  He figures 2.50 per share, roa of 1-2 %, 10-15%roe.  At 10 x earnings this gets us 25 per share minimum.

 

We are beyond the fire fighting stage with this bird and into the recovery stage.  It's amazing to watch - value investing in action.

[twacowfca]

We discussed alot of this nearly 9 months ago here:

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/bruce-berkowitz-on-bac/

 

Berkowitz's thesis is playing out, possibly even faster than he anticipated.  He figures 2.50 per share, roa of 1-2 %, 10-15%roe.  At 10 x earnings this gets us 25 per share minimum.

 

We are beyond the fire fighting stage with this bird and into the recovery stage.  It's amazing to watch - value investing in action.

 

Yes!  Whack - A - Mole!  But it won't be any fun when it's all over. 8). Boring

[alertmeipp]

guys, there are still political, econ and execution risk ... don't get too excited!

[frog03]

I think most of us (and some pros like Berkowitz) should happily have put BAC in the too hard pile...

 

Sure it trades at a discount to BV, sure things could get better on the earnings front and the mutliple could go up.

 

This being said, what about their exposure to derivatives?  what about the true quality of their earnings?  what about the systematic risk in the financial sector?

 

 

 

[bmichaud]

My apologies for my original post - pure laziness, as I had not yet looked at the latest financials in depth....

 

PTPP income excluding goodwill impairment and merger costs is $17 billion. Add back 90% of R&W provision, PTPP is $31.04B. Equity Investment Income, Gain on Sale of Debt Securities and Other Income total $17.6B. These are lumpy YOY, and given the large amount of asset sales this year, I'd say it's safe to deduct 25% of $17.6B from PTPP. So pro-forma PTPP is $26.64 billion.

 

Loan loss provision of $13.4B seems reasonable at ~1.4% of FYE gross loans & leases. So EBT is $13,240, and Net Income is $8,606 assuming a 35% tax rate. Assuming 11.2B shares out (assuming 10.5B currently out plus WEB 700MM shares), current normalized EPS is $.77. Assuming a 12% cost of equity, EPV Is 8.3 x $.77 = $6.39.

 

Assuming Phase 1 & 2 expense reductions of $7.5 billion (Phase 2 50% of Phase 1) and litigation/LAS expenses of $12.24B (90% of $13.6B in 2011) are achieved in full by 2014, FYE 2013 capitalized after-tax cost reductions are $106.5 billion (35% tax rate, 8.3x PE). Discounted back two years at 12%, present value of future cost reductions is $84.9B or $7.58 per share.

 

WEB $5B conversion, $.45 per share ($5B / 11.2B)

 

Total current EPV = $14.22

 

If a 10% cost of equity is used instead, current EPV is $17.62.

 

 

As Donald Yacktman says, banks can create assets with a stroke of a pen. The balance sheet still kills me....

 

How did everyone here involved in the Fairfax restructuring get comfortable with its balance sheet at the time? Was it more of a trust in Prem given how familiar you all are with him?

 

Or is it just a matter of sucking it up and banking (no pun intended) on the earning power of BAC to allow it to earn its way out of this mess and assuming there are no major skeletons on the balance sheet?

[finetrader]

Bmichaud, you should take into consideration that bac won't pay taxes before a long time. That is the thesis for BB. PTPP = PP.

 

[bmichaud]

Great point. BB says tax savings are about $80B....

 

2012 EBT: $13,240, Tax Savings = .35 x EBT = $4,634, PV @ 12% = $4,138

2013 EBT: $13,240, Tax Savings = .35 x EBT = $4,634, PV @ 12% = $3,694

2014 EBT: $32,980, Tax Savings = .35 x EBT = $11,543, PV @ 12% = $8,216

 

2012-2014 accumulated EBT = $59,460, so $20,540 remaining for 2015 ($80,000 minus 59,460). So 35% x $20,540 = $7,189, PV @ 12% = $4,569.

 

Cumulative PV of tax savings = $20,617, or $1.84 per share.

 

New EPV @ 12% cost of equity = $16.06

[Uccmal]

How did everyone here involved in the Fairfax restructuring get comfortable with its balance sheet at the time? Was it more of a trust in Prem given how familiar you all are with him?

 

Or is it just a matter of sucking it up and banking (no pun intended) on the earning power of BAC to allow it to earn its way out of this mess and assuming there are no major skeletons on the balance sheet?

 

Simple answer, we were not comfortable.  And we placed our bets accordingly.  My initial bets on ffh leaps were quite small.  It was only after the stock began to rally that it quickly became 80% of my portfolio and I stuggled with it the whole time, as did many I know.  I lost more sleep when my Leap positions had become 10 baggers than when I bought them.

 

I cannot say that I am ever comfortable with a new value investment.  It often takes a couple of years, like Seaspan. 

 

The problem is that once an investment gets comfortable it no longer is a value investment.  The only way to mitigate this is to not back up the truck on any one thing and try to have a margin of safety.

 

There is MOS with BAC at this price.  Maybe not so at $18/ share. 

[bmichaud]

How did everyone here involved in the Fairfax restructuring get comfortable with its balance sheet at the time? Was it more of a trust in Prem given how familiar you all are with him?

 

Or is it just a matter of sucking it up and banking (no pun intended) on the earning power of BAC to allow it to earn its way out of this mess and assuming there are no major skeletons on the balance sheet?

 

Simple answer, we were not comfortable.  And we placed our bets accordingly.  My initial bets on ffh leaps were quite small.  It was only after the stock began to rally that it quickly became 80% of my portfolio and I stuggled with it the whole time, as did many I know.  I lost more sleep when my Leap positions had become 10 baggers than when I bought them.

 

I cannot say that I am ever comfortable with a new value investment.  It often takes a couple of years, like Seaspan. 

 

The problem is that once an investment gets comfortable it no longer is a value investment.  The only way to mitigate this is to not back up the truck on any one thing and try to have a margin of safety.

 

There is MOS with BAC at this price.  Maybe not so at $18/ share.

 

Well said! It'd be interesting to take a poll of the average position size BAC is for board members. Perhaps that's my biggest hang up with BAC, since I usually take very large positions. I believe I've seen 30% for some people, but could be wrong on that. I just re-read BB's interview on BAC - phenomenally compelling and that was with BAC over $10 per share. Gosh, I'm so frickin close to pulling the trigger.

[twacowfca]

How did everyone here involved in the Fairfax restructuring get comfortable with its balance sheet at the time? Was it more of a trust in Prem given how familiar you all are with him?

 

Or is it just a matter of sucking it up and banking (no pun intended) on the earning power of BAC to allow it to earn its way out of this mess and assuming there are no major skeletons on the balance sheet?

 

Simple answer, we were not comfortable.  And we placed our bets accordingly.  My initial bets on ffh leaps were quite small.  It was only after the stock began to rally that it quickly became 80% of my portfolio and I stuggled with it the whole time, as did many I know.  I lost more sleep when my Leap positions had become 10 baggers than when I bought them.

 

I cannot say that I am ever comfortable with a new value investment.  It often takes a couple of years, like Seaspan. 

 

The problem is that once an investment gets comfortable it no longer is a value investment.  The only way to mitigate this is to not back up the truck on any one thing and try to have a margin of safety.

 

There is MOS with BAC at this price.  Maybe not so at $18/ share.

 

 

Almost the same take on FFH in all respects.  What surprised me the most about FFH was how long it took to earn the company out of the hole.

 

What gave me the most encouragement was Prem himself giving me two hours of his time early one AM as we pitched in to help his staff set up for a meeting with analysts and investors at the depth of their problems, the loyalty of his staff.  (no rats trying to escape a sinking ship there)  :) and the depth of support from long term fans like Cundill , Hawkins, and everyone at Markel.  :)

 

BAC is a little different.  They are one of the few big money center banks.  That is a big moat in itself in normal circumstances. They are in a heck of a lot better shape now than they were in March 09 when we first took a very large position for the expected bounce and then exited a few months later for a large gain.  Expected because the US Treasury and the Fed had determined that the big banks and the financial system would not fail.

 

Last year, Uncle Warren demonstrated that he thought they were a good value with a margin of safety when he invested and got warrants at a strike price 50% more than the stock price was when we bought their Tarp warrants several weeks later. That's a great predictor of success.

 

We've have made the biggest of all returns on stocks in a relatively short period when Warren, or major long term value investors or the US government have put their support behind a company that has tanked, but still has competitive advantages.

 

There was all the positive EOY technical dynamics, described in my earlier posts.

 

Finally, there was all the well justified negative sentiment among bank analysts and hedge funds that led to their stock price tanking.  When a company is very likely to be a survivor, extreme disgust is a powerful predictor of extreme mispricing.  :)

[ERICOPOLY]

I think I saw the $10 strike 2013 calls trade down to 20 cents or 22 cents in December.

 

That's roughly 50x leverage of notional value at the strike price, with tangible book value likely at $14 or so by expiration.

 

Not that dissimilar to the FFH situation in 2006!

[Parsad]

As Donald Yacktman says, banks can create assets with a stroke of a pen. The balance sheet still kills me....

 

How did everyone here involved in the Fairfax restructuring get comfortable with its balance sheet at the time? Was it more of a trust in Prem given how familiar you all are with him?

 

Or is it just a matter of sucking it up and banking (no pun intended) on the earning power of BAC to allow it to earn its way out of this mess and assuming there are no major skeletons on the balance sheet?

 

They were two very different investments for us.  I was already a Fairfax shareholder when they had their problems, so I was completely familiar with the company's history, Prem, insurance, etc.  In BAC's case, this was a completely new analysis.  We were interested in financial institutions because they had been seriously battered, but I was not comfortable with BAC back in 2008.  I was familiar with Wells at that time, and we bought a bunch of shares around $9. 

 

That allowed me to continue to explore financials during a period when many were restructuring through TARP, and generally when you have such periods of deleveraging, huge opportunities tend to sprout.  BAC didn't garner my interest until 2011, when Brian Moynihan's changes started to become more obvious.  He was not only talking the talking, but walking the walk and tearing this sucker apart.  The system had become significantly more stable, loan portfolios of better quality, capital was cheap and housing had already gone through a significant correction.  Much of the risks that made BAC a risky investment in 2008/2009 had now been significantly reduced, yet the stock was far cheaper than back then relative to earning power.

 

The problem with buying with a margin of safety is that most people, even seasoned value investors, are fearful of making investments exactly when they should...margin of safety is high, but the market sentiment towards the investment treats it as extremely risky.  Was BAC more risky in 2008/2009 when it was higher priced, or in August of 2011 when it was of lower price and much of the risk had been reduced?  The answer is obvious, but unfortunately investors have a very difficult time wrapping their heads around an obvious concept because they are fearful. 

 

Another couple of examples: 

 

- Everyone thinks Fairfax is a fantastic investment today.  But it really is only a good investment.  While the underlying risks to the business are low, the market has valued it at a price that takes into account the lack of that risk.  Six years ago, the underlying risks looked significantly higher, but the stock was actually trading at a signficant discount even after accounting for that risk.

 

- We bought Steak'n Shake at a split-adjusted price of $80 when it was distressed, and no one wanted to touch it.  We sold it some time ago once things had turned around and Sardar had started to implement his Biglari Holdings strategy.  Our average sale price was about $380.  Where is the stock price today?  $380!  And investors think it is a great investment now, while they bypassed distressed investments in financials over the last year.     

 

- We've recently acquired about 4% of a business that today is trading at about a tenth of its price from 5 years ago.  The business has nothing but cash and we paid less than the cash per share price after all liabilities are paid, yet no one wants to buy this company right now even though it trades at 2/3rds of book.  If I told you guys what company it was, you would tell me that there is business and execution risk, even though the business is now break-even and is growing.  Five years ago, this was not a good business, even though it traded at a price nearly ten times higher.  Today, it is completely liquid, growing and profitable, yet the market values it at ten times lower!

 

So the simple answer is that by the time the average investor (and this is true for professionals, value investors, contrarians, you name it) becomes comfortable with a distressed business, the market would have already started to value it at a signficantly higher price and much of that risk would have dissipated.  You are seeing it happen right now with BAC.  By the time most investors decide to participate, it will already be at tangible book and it's Tier 1 capital will be over 10%!  Well over double where it was four years ago, yet the price would be just a fraction of the 2007 price.  This is the general behavior of the investor.  Cheers!   

[bmichaud]

Tremendously helpful Parsad - love hearing how great managers think through tough situations.

 

So with Steak & Shake, Fairfax, WFC back in 2008, and your most recent undisclosed acquisition, I'm assuming you had determined in one way shape or form that your investment had a very low probability of permanent impairment, as should all value investors with all investments. IDK anything about Fairfax, but I'm assuming when it was distressed, you were able to readily determine that in a worst case scenario, such as a liquidation, that your investment would be made whole, no? Same with Steak & Shake - worst case scenario, perhaps the real estate, cash, and receivables would cover your investment while any upside from operational improvements would be pure upside.

 

This is where I struggle with BAC. The upside case is very obvious - IMO, the downside protection in a worst case scenario is NOT. We can argue all day long whether or not a worst case scenario will actually materialize, but assuming there is a greater than 0% chance of one, where is the downside protection? Asset valuations are stretched to the max, are they not? In a liquidation scenario, how is BAC's "Other Asset" category going to hold up? How are the "trading account" assets going to hold up? How are NPAs going to hold up? At 10x leverage, there is only a small margin for error.

 

This is where I am struggling - I can't determine the downside protection. It's not a matter of having the guts to buy something distressed, it's a matter of being able to determine what the downside is. That's where Yacktman's quote comes into play - how do you trust asset valuations that can be created with the stroke of a pen? I hate to "LVLT" this thread, but one could make the argument with LVLT that in a worst case liquidation scenario, the highly valuable "fat pipes" could be auctioned off for at least as much as the current TEV. I can't reliably make that determination with BAC - you can't tear apart its balance sheet and come up with a worst-case liquidation scenario that comes out favorably for equity holders. That's what I'm trying to get a feel for on this thread is how folks here are looking at the worst case scenario - what is the downside protection people are looking at? Simply saying "the Fed will just print" or "WEB bought a preferred stake" aren't valid margins of safety, IMO. There is in fact a scenario out there that another global credit crisis will impair the asset side of BAC's balance sheet and it will be forced to raise expensive equity - so the earning stream stays the same over the long-term, but the share count doubles, rendering the investment very if not permanently impaired. This line of thinking isn't Zero Hedge-derived either - it's being careful to avoid investing in the next WaMu, Fannie, Freddit, Bear, AIG, Merrill Lynch, etc... etc...

 

Just curious how others look at the downside given the opacity of the balance sheet.

[Uccmal]

bmichaud, I honestly think that circa 2005 the downside for FFH was zero.  A repeat of 911 would have toasted them.  As it was they had to raise equity at below book, two years in a row and sell off substantial parts of their healthiest business.  Lsongleaf held 25% of Ffh, BUT it never made up 25% of the longleaf portfolio.  The MOS for me was in the Leaps As Eric mentions.  10-15% of my portfolio would have gone to zero in a worst case. 

 

The downside for Bac is definitely not zero.  The retail banking arm in itself must be worth at least $7 in a fire sale. 

[ERICOPOLY]

I liked the FFH at bottom trade in June 2006 because you had the 2005 annual report already in hand where it said very clearly that they believed runoff would break even in 2006.  Runoff was the only thing wrong with the company that would scare people -- we had the numbers by then to show us that the company actually made a profit in 2005 were it not for the runoff division -- and 2005 was the Katrina/Rita/Wilma year.

 

People were dropping the stock in 2006 because of hurricane fears and that's something where I KNEW that Mr. Market didn't know anything about that I didn't.  It wasn't like I was worried that everybody else knew the future regarding the hurricane season.  Very expensive multiple landfalling hurricanes are exceedingly rare, yet people thought they were likely due to recency bias perhaps?

[rranjan]

At 10x leverage, there is only a small margin for error. This is where I am struggling - I can't determine the downside protection. This line of thinking isn't Zero Hedge-derived either - it's being careful to avoid investing in the next WaMu, Fannie, Freddit, Bear, AIG, Merrill Lynch, etc... etc...

 

Just curious how others look at the downside given the opacity of the balance sheet.

 

Did all of the above names had issue due to only high leverage or liquidity was concern as well? How high the leverage was with Bear? Is BAC situation comparable to above names?

 

Yes, there is risk here but making an argument about having 10x leverage will eliminate most finacials. If an instituation is leveraged 10 times and using their 100% of asset to make some bet then it's a different case. BAC has reduced their risk greatly in last few years. Liquidity is all time high and they are improving their capital structure each quarter. Question you would have to ask - under which circumtances they will be in trouble and chance of happening that? yes, there can be circumtances where they can get wiped out and you lose everything so position sizing should be based on how much comfortable you feel.

[ERICOPOLY]

yes, there can be circumtances where they can get wiped out and you lose everything so position sizing should be based on how much comfortable you feel.

 

Personally I think this is a low risk investment with very high probability of doubling in next 6 to 18 months.  So my position is likewise humongous.

 

I still drive my car most days even though I've heard reports that people get horribly mangled in these things.  I take mortal risks every day.

 

[hyten1]

home many of you would initiate/add to an existing position in BAC today as oppose to 1 month ago when it was $2 cheaper

 

i know you should judge it from the fundamentals, but it is very difficult knowing it was just $5 1 month ago

 

 

[Parsad]

So with Steak & Shake, Fairfax, WFC back in 2008, and your most recent undisclosed acquisition, I'm assuming you had determined in one way shape or form that your investment had a very low probability of permanent impairment, as should all value investors with all investments. IDK anything about Fairfax, but I'm assuming when it was distressed, you were able to readily determine that in a worst case scenario, such as a liquidation, that your investment would be made whole, no? Same with Steak & Shake - worst case scenario, perhaps the real estate, cash, and receivables would cover your investment while any upside from operational improvements would be pure upside.

 

Correct with Fairfax.  We thought in the worst case scenario, there was enough margin of safety that we would walk away with most, if not all, of our capital.  With Steak'n Shake, they were burning through cash and Sardar had a limited amount of time to raise cash...we bought through call options and then exercised them over the next few months as they had raised cash from a tax refund and things improved on the operations side.  With Wells, the bet was that the credit quality of their loans were better than other banks, and we bought at a little over half of book in 2008.

 

This is where I struggle with BAC. The upside case is very obvious - IMO, the downside protection in a worst case scenario is NOT. We can argue all day long whether or not a worst case scenario will actually materialize, but assuming there is a greater than 0% chance of one, where is the downside protection? Asset valuations are stretched to the max, are they not? In a liquidation scenario, how is BAC's "Other Asset" category going to hold up? How are the "trading account" assets going to hold up? How are NPAs going to hold up? At 10x leverage, there is only a small margin for error.

 

Naturally there is some risk.  For BAC to go under now at this point, you would need to see another Depression...probably 20% unemployment.  If that were to happen, then you better sell your Berkshire shares too, because they would be trading at a third of current prices.  Because of the leverage, and the fact that BAC is still working on improving facets of their business and loan portfolio, we don't have a massive position.  This is a 5% equity position and another 2.5% in warrants. 

 

This is where I am struggling - I can't determine the downside protection. It's not a matter of having the guts to buy something distressed, it's a matter of being able to determine what the downside is. That's where Yacktman's quote comes into play - how do you trust asset valuations that can be created with the stroke of a pen? I hate to "LVLT" this thread, but one could make the argument with LVLT that in a worst case liquidation scenario, the highly valuable "fat pipes" could be auctioned off for at least as much as the current TEV. I can't reliably make that determination with BAC - you can't tear apart its balance sheet and come up with a worst-case liquidation scenario that comes out favorably for equity holders. That's what I'm trying to get a feel for on this thread is how folks here are looking at the worst case scenario - what is the downside protection people are looking at? Simply saying "the Fed will just print" or "WEB bought a preferred stake" aren't valid margins of safety, IMO. There is in fact a scenario out there that another global credit crisis will impair the asset side of BAC's balance sheet and it will be forced to raise expensive equity - so the earning stream stays the same over the long-term, but the share count doubles, rendering the investment very if not permanently impaired. This line of thinking isn't Zero Hedge-derived either - it's being careful to avoid investing in the next WaMu, Fannie, Freddit, Bear, AIG, Merrill Lynch, etc... etc...

 

That is the game!  ;D  That part of investing is the art.  The science portion is the valuation, calculating margin of safety, tearing apart financials, notes and the MD&A.  But managing and estimating the risk relative to the science is all art.  The intangibles of the business and estimating management also fall into this category.  Cheers!