High-yield/macroeconomics (fka YIELD)

[DewDiligence]

B of A's Biggest Bet Ever

[Some things have changed since this article was written three weeks ago; however, inasmuch as the Merrill acquisition is an all-stock deal, the size of the acquisition in relation to BAC’s market cap is unchanged from when the deal was announced.]

http://online.barrons.com/article/SB122187666961059619.html

›September 22, 2008
By JACQUELINE DOHERTY

Last week, when almost all financial companies were playing defense, Bank of America CEO Ken Lewis went on the offense. After years of coveting the Thundering Herd, Bank of America purchased Merrill Lynch and its 16,690 retail brokers for $50 billion in stock. While some bemoan what they consider a hefty price tag, given the questionable value of some of Merrill's assets, the deal is a sign of Lewis' confidence in Bank of America's long-term prospects, not to mention those of the U.S. economy and the nation's roiled financial markets.

If the deal is approved by both companies' shareholders, a combined B of A and Merrill Lynch would be a behemoth, with leadership positions in commercial, consumer and investment banking and retail brokerage. Its sources of revenue will be much more evenly distributed than the current Bank of America's (ticker: BAC), which depends disproportionately on consumer and commercial banking. The new company should be able to generate 6% to 9% annual revenue growth, and 10% growth in earnings per share, on "the other side" of the current financial crisis, Lewis told Barron's last week. If his assumptions about loan performance and the economy are correct, the deal should add to Bank of America's earnings by 2010.

"Merrill Lynch fills the two holes we had," Lewis said, referring to global investment banking and a broader wealth-management business. Merrill (MER) joins a stable of Lewis-acquired companies, including Countrywide Financial, MBNA and FleetBoston Financial, that form today's Bank of America, a colossus in its own right with $1.6 trillion of tangible assets and a market capitalization of $171 billion, even after its shares, now 37.48 apiece, have been punished.

"We don't need anything else," Lewis insisted.

B of A's boss struck the Merrill deal believing the U.S. is in a shallow recession and that the credit crisis wracking the financial markets for more than a year is approaching a bottom. A true bottom won't emerge, he says, until the nation's housing market starts to stabilize, something he expects to happen in the first half of 2009.

"Interest rates have decreased, and our mortgage-refinancing volumes have increased," Lewis notes. "Hopefully, that will be part of the cure."

Lewis forecasts continued high levels of loan charge-offs for B of A and the need to keep building loan-loss reserves. The Charlotte, N.C.-headquartered bank has set aside $17 billion in the past four quarters for credit losses and to boost reserves. Even if residential real-estate losses, and losses on securities tied to residential mortgages, decrease, losses in the bank's credit-card and commercial-loan portfolios are likely to grow if the broader economy softens. While this will keep overall earnings depressed, Lewis doesn't expect Bank of America to slip into the red.

In its latest quarter, for example, B of A's revenue exceeded $20 billion, owing in part to the difference, or spread, between the low rates the bank pays on deposits and the higher rates it can charge for loans. The company provided for $5.8 billion of loan losses, an expense three times that incurred in the same quarter of 2007. But it still managed to generate $3.4 billion of net income, or 72 cents a share. Analysts expect Bank of America to earn $11 billion, or $2.39 a share, this year. Lewis credits "diversity, and a risk-management system that didn't catch it all, but put us in a better position than many."

Buying Merrill Lynch, with its billions in troubled assets, could threaten that position -- or burnish B of A's status and bottom line. Analysts question the value of about $86 billion of Merrill's assets, including almost $9 billion of collateralized debt obligations, or CDOs; $22.9 billion of commercial-real-estate exposure, and $17 billion of non-prime residential mortgages, according to Bernstein Research. Merrill's assets would be subsumed into B of A's $871 billion loan portfolio and $460 billion portfolio of securities.

If Merrill's loans are priced to market and the market accurately reflects future losses, they won't cause losses for Bank of America. If they aren't priced low enough, however, B of A might have to increase its write-offs, which would hurt the bank's earnings, shrink its assets and eat into its capital base. The U.S. Treasury's move Friday to establish a rescue plan that would buy distressed assets from financial institutions could help to stabilize debt prices -- potentially a plus.

In the best-case scenario for B of A and its holders, Merrill's assets will have been marked too conservatively, and its loans will perform better than expected. As such, Bank of America would pocket the gains, and its assets and equity would increase. That's hard to imagine amid the revelations of recent weeks, but not impossible.

The Merrill deal is likely to close in the first quarter. So far, large investors haven't "given us any push-back on the strategic benefit of the deal," says Lewis. But they have questioned the amount of due diligence the bank conducted in a deal that came together over a weekend, as well as the price B of A agreed to pay in the all-stock deal -- $32 per Merrill share, based on Bank of America's current price.

A sum-of-the-parts valuation of Merrill performed by Bernstein analyst Brad Hintz might still some skeptics, as it suggests B of A bought Merrill's loans at a discount to their value. That could help it compensate for further losses. Hintz values Merrill's equity stake in asset manager BlackRock (BLK) at roughly $13 billion, its retail brokerage business at $26.7 billion and its capital-markets operation at $16.2 billion, or 0.75 times tangible book value, for a total price tag of $35 per share.

As for B of A itself, the company had $163 billion of shareholder equity at the end of the second quarter, but only $75 billion in tangible equity. As a result, its ratio of tangible equity to tangible assets -- some 4.6% -- is a bit below the industry norm of 5% to 7%. Citigroup 's (C) ratio is 4.05% and JPMorgan Chase 's (JPM) is 4.84%, according to RBC Capital Markets.

Lewis -- and regulators -- prefer to look at the bank's Tier 1 capital ratio, or its equity divided by risk-adjusted assets. B of A's Tier 1 ratio stood at 8.25% in the second quarter, and will decline to 7.4% after the July close of the bank's Countrywide Financial purchase and the forthcoming purchase of Merrill. The feds consider a bank with a 6% Tier 1 ratio well capitalized, and Lewis aims to return the ratio back above 8%.

Lewis doesn't plan to sell equity to achieve that goal, but he may sell stakes the bank holds in China Construction Bank and other entities, and cut the dividend. Bank of America pays about $11 billion of dividends annually, and isn't likely to earn more this year than its annual payout of $2.56 a share. The dividend's abnormally high 7.1% yield implies that the market expects a reduction.

From a strategic perspective, the deal has much to recommend it. The Merrill Lynch private-client business will go far to balance Bank of America's revenue mix. In the first half of 2008, the combined company would have generated 48% of revenue from the consumer and small-business commercial-banking group; 32% from the global corporate and investment bank, and 20% from asset management. Prior to the deal, the split was 70%, 24% and 6%.

Wealth management has historically been a business with steadier, more consistent revenue, a higher growth rate (due to an aging population) and wider margins. It also has garnered price/earnings multiples that can be double those of commercial banks.

The deal also creates cross-selling opportunities for B of A -- something often promised in mergers but rarely delivered. Among the bank's clientele are eight million "mass affluent" customers, with assets of $100,000 to $3 million, says Lewis. Merrill brokers won't have to make cold calls to drum up business, with so many hot leads.

Conversely, if Bank of America uses Merrill brokers to sell more services to B of A clients, it's less likely those clients will get poached by the competition. "If you have more relationships with the customers, they're more likely to stay with you and be more profitable," says RBC analyst Joe Morford.

Lewis plans to retain the Merrill name, keep the retail-brokerage operation intact and provide retention bonuses for financial advisers. Merrill also brings to Bank of America a top-notch investment-banking operation that can provide financial services to the bank's commercial clients.

Lewis has targeted $7 billion of cost savings from the merger, equal to 10% of the combined companies' cost base, or 25% to 30% of Merrill's cost base, RBC calculates.

Ken Lewis has rolled the dice on a risky deal at an uncertain time. If it succeeds, and adds long-term value to Bank of America's franchise, he'll be viewed as the consummate value investor -- and one of the key architects of a new and stronger Wall Street.‹