That Warren Buffett Confidence Boost Doesn't Come Cheap
Warren Buffett's $5 billion investment in Bank of America - the Ghost of Christmas Past here is his $5 billion investment in Goldman Sachs in 2008 - has definitely stopped the slide in Bank of America's shares. In fact, the stock is up 10% today with a Buffett premium..
The difference between last night's closing price and today's opening price in Bank of America's shares amounted to a $20.26 billion boost in the bank's value.
But it doesn't come cheap.
As he did with Goldman Sachs, Buffet is imposing onerous terms on Bank of America.
First, here are the terms of the deal, as Keefe Bruyette & Woods analyst Jefferson Harralson has them:
Buffett will invest $5.0 billion in cumulative preferred yielding 6%, which is below the market rate for BAC for perpetual cumulative paper by roughly 250-300 basis points. Alongside this investment, BAC will give Buffett warrants to purchase 700 million shares at ~$7.14/shr, so another $5 billion option. The warrant strike was set at a ~2% premium to yesterday's close. If exercised, Buffett would own 7% of BAC.
That probably looks like Martian, so here's what it means: Buffett will invest $5 billion in preferred shares that will pay him a 6% dividend, a pretty good deal compared to Bank of America's usual preferred shares. Bank of America will also allow Buffett to buy - if he wants to - another 700 million shares at around $7.14 a share, which comes to another $5 billion investment if he decides to go ahead with it. If Buffett goes ahead with the second $5 billion investment, he will own as much as 7% of all of Bank of America.
But it's a pretty pricey deal for Bank of America and its shareholders.
How price? Harralson notes, "it appears to us Buffett got $6.5 billion to $7.0 billion of value for $5.0 billion."
The deal will also affect Bank of America's earnings per share, according to Keefe Bruyette & Woods analyst Jefferson Harralson. Harralson previously estimated that Bank of America could earn about $20 billion a year, spread out over 10 billion shares outstanding.
Now, because of the Buffett deal, that profitability per share will fall. Bank of America has more shares outstanding - 10.7 billion - and is likely to earn slightly less money, around $19.7 billion, because it may to pay a dividend to Buffett.
Sandler O'Neill analyst Jeff Harte considers the investment a turning point in Bank of America's fortunes - and those of other beleaguered banks, like Citi, that have taken it on the chin from the markets for weeks. Here's what Harte said today:
blockquote>Warren Buffett sounds the near-term 'all clear' for large cap financials.
Berkshire throwing its support behind BAC is clearly a positive for BAC shares. However, we expect the move to also diminish fears that financials in general are on the verge of another 2008-like crisis. While environmental headwinds persist, the investment should be positive for both BAC and its peers."
Harte said that in his analysis of Buffett's investment, he thinks it's a matter of emphasis about what really matters: the cost to Bank of America, and the dilution of its shares, is nothing compared to the benefit of buying some belief. He says that yes, Bank of America still has a lot of litigation trouble - all those mortgages! - and yes, nothing has really changed for the bank.
But getting the market to stop slamming the bank's shares? Priceless.
Don't focus on the fundamental dilution, focus on the market psychological improvement. While mortgage related exposure concerns remain and warrant conversion would be dilutive to TBV, we believe the recent decline in BAC's share price was driven by investor fear more than fundamentals. BAC's market cap at the close yesterday implied what we believe to be an unrealistically large pretax loss of close to $100B. ...While we believe management did not need the capital, it clearly needed to turn the tide of negative perception.
In other words, this investment will make Bank of America looks safer - but only at a cost, and only temporarily, as Harralson says:
We are disappointed that BAC raised capital at these levels, even though we understand the structure of the deal was designed to limit a new common share issuance in the near term. As shown in the PDF of this note, $5 billion does not move the needle a lot on capital, so the market's capital views should be largely unchanged, in our view. That said, we do appreciate the significance of the confidence boost from a Berkshire investment. Importantly, the $5 billion investment will most likely not change the view of the bears that believe BAC needs significantly more capital.
So while Bank of America may have bought some confidence from the market, it didn't buy the genuine good health it needed. It remains to be seen how long the market will be willing to overlook that.