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  Banks considered as potential sources of high-card points

BENJ GALLANDER and BEN STADELMANN

Tuesday, November 1, 2011

It seemed like just another day at the office on August 24 when we sent an email announcement to subscribers that Bank of America had been purchased for the President's Portfolio at $6.76. Adding this behemoth continued Benj's buying spree of American financial institutions, including the previously acquired Bank of Commerce Holdings, Fidelity Southern and VIST Financial. Though a sprawling conglomerate, General Electric has a huge financial component and was also previously procured.

As usual, the pros and cons of buying BAC were enunciated. Under the worst-case scenario, which seemed unlikely but not out of the question, the possibility of BAC filing to reorganize under Chapter 11 was outlined. After three years of ugly red ink, with annual losses of $2.5 billion or greater, the company running itself into the ground was not out of the question.

Worse still was Q2 of this year, where the loss rang the bell at $8.8 billion. Yowser. Rumours abounded that the bank would need to make a major capital raise because of the losses, but CEO Brian Moynihan denied that possibility. If it does happen, there will be dilution — not a happy outcome for shareholders.

Another risk outlined by pundits and government officials was the subdivision of the bank into parts. Again, this was not attractive, but a possible outcome that had to be recognized and reconciled when making the buy.

Moynihan has been attempting to resolve many problems plaguing the bank. A key one is an $8.5 billion settlement to put the subprime mortgage fiasco behind the firm. Unfortunately, while the CEO moved swiftly to deal with this issue, AIG has sued the bank for $10 billion relating to this situation.

Of course, associated with this and other lawsuits are legal costs, which are absolutely outrageous in the United States, the world's most litigious nation. Brian probably wishes at some points that BAC had not taken over Countrywide and Merrill Lynch, the two divisions tied to most of the lawsuits.

Costs have also been associated with employees being let go by Bank of America. This does not come cheaply, but the top brass has decided that this is a must. Seemingly every quarter now there is an expense associated with people shuttled to unemployment.

But yes, there are positives, or this enterprise would not have been purchased. Putting aside the subprime debacle, the corporation is profitable. Five of the six divisions are making money. That bodes well. Plus, the company sells for less than book value, even after goodwill is eliminated. And the balance sheet is stacked with liquidity that will make it far easier to get through the current difficulties.

Sheer size also makes it difficult to let BAC fail. By many metrics, this is the largest financial institution in the world. If it died, it would make the Lehman Brothers bankruptcy look like a walk in the park. And Moynihan is enough of a bulldog to perhaps work BAC through the travails.

Why was our purchase of BAC not just another day at the office? Well, the morning after our purchase a gent named Warren Buffett announced that he had also bought into the organization. Mr. Buffett invested $5 billion with a 6 percent coupon and has 700 million warrants to buy shares at $7.14 over the next ten years.

And while we like to note that our purchase price of $6.76 is lower than that, undoubtedly, he got the better deal. Evidently, it helps to be Warren.

After Buffett's transaction was announced, our in-box spiked with letters from subscribers, more than at any time in the past. Some people wanted to know if we have a personal relationship with the Berkshire Hathaway CEO. While Benj kidded about Warren being over to play bridge with Bill Gates and himself, unfortunately, only the latter two people know each other, and Benj's limited skill had to wait on the sidelines.

One thing is certain though: Mr. Buffett investing lowers the risk associated with owning this enterprise. In fact, immediately after his purchase was announced, the stock price spiked, although bad news sent it tumbling once again. However, the recent quarterly profit of better than $6 billion perked up the valuation once more along with the European rescue fund.

Worth noting too is that the combo of long- and short-term BAC debt has been reduced by $43 billion. Some of this is being achieved via asset sales. The company sold its Canadian credit card business and is in the process of selling half its stake in the China Construction Bank for better than $8 billion.

If BAC does survive, and we think it will, Moynihan's goal is to increase the dividend from a penny per quarter. He would also like to buy back shares. While the process back to blue-chip status will undoubtedly be long and is anything but guaranteed, we think there is a reasonable probability that he will reach his goals.

Our Initial Sell Target is $38.74, a price below where the stock traded for years. If this level is indeed seen again, maybe Benj and Warren will indeed sit down for that game of bridge. They could then enjoy yakking about their grand slam with BAC.


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