Apple Inc (AAPL), updated

Apple Inc. (AAPL) weekly chart ;
We now have a clear head and shoulder pattern (as mentioned several weeks ago)
We now need a clear "bearish" trigger (key news event)
See my target... am I dreaming ? I hope so ...

Source | Alpha Global Investors | http://gicharts.blogspot.com/2012/12/apple-inc-aapl-head-and-shoulder.html

Euro Dollar bullish pattern ?

Here we go again with the Euro Dollar, another attempt to break that key resistance.
We now need a key event, maybe from Germany's Merkel ? 

Source | Alpha Global Investors | http://gicharts.blogspot.com/2012/12/euro-dollar-bullish-pattern.html

Get ready to short Amazon.com Inc. (AMZN)

Amazon.com Inc. (AMZN), get ready to short !
1) Focus on "reversal level"
2) Pattern shows high probable sideway pattern followed by a fall below those two triggers.
3) Common sense says people will spend less for the holidays ...
Gut feeling ? Price below short trigger 2 by mid Jan

Source | Alpha Global Investors | http://gicharts.blogspot.com/2012/12/get-ready-to-short-amazoncom-inc-amzn.html

Fiscal Cliff Doesn't Matter

So the markets now are driven by the fiscal cliff.  What will happen?  If they don't do something, the markets will plunge.  If they come to some sort of agreement, the Dow would be up 1,000 points. 

Nobody wants to be long on a failure to come up with a solution, and nobody wants to miss the boat on a 1,000 point Dow rally.   OK, 1,000 points is not much.  Maybe I should say 2,000 points.

In any case, this reminds me of a recent Howard Marks interview where he talked about the European situation.  He says there are three things he can say for certain about the situation:

1. He doesn't know what will happen in Europe
2. Nobody knows what is going to happen in Europe
3. If you ask an expert what they think will happen and take their advice, it would be a mistake.

So to apply this to the current situation:

1. I have no idea what will happen in Washington with the fiscal cliff
2. Nobody knows what will happen in Washington with the fiscal cliff
3. If you ask an expert what they think will happen and take their advice, you are making a mistake.

Of course, ths fiscal cliff matters in many ways.  But what I am talking about is within the context of investing for the long term.

If you believe that the U.S. and the world is drowning in debt and the Fed is out of silver bullets and the economy is peaking out and won't recover for years to come, then you shouldn't be invested in the stock market fiscal cliff or not.

If you believe that the U.S. and the world will eventually recover and be fine (maybe not as 'hot' as back in 2007, but some growth and stability), then you should be invested in businesses you like at reasonable prices fiscal cliff or not.

Here are some things you might want to think about:

• Selling stocks now because you are worried about the fiscal cliff is a mistake.  This is not a rational decision; it is driven by emotion (fear).  And emotions should never drive investment decisions.
• Buying stocks now because you think the fiscal cliff will be resolved is a mistake.  This is not investing; that's speculating.  Nobody knows what will happen with the fiscal cliff.  Betting on single event outcomes is speculating, not investing.  (One should invest in businesses or situations because they are priced right etc...)  Betting on single outcomes if the odds are reasonably calculable and the stock is priced or mispriced accordingly, that's different.
• Shorting stocks or hedging against the fiscal cliff is also a mistake as it is not too different from selling your stocks out of fear (although hedging may be tax efficient as you don't have to realize capital gains like you do when you sell out longs).  This may seem 'prudent' and responsible, but it's still speculating.  Nobody ever knows when the markets go up or down.  Hedging or buying puts in anticipation of a sell-off, to me, seems more like speculating than rational investment behavior.  

...which leads me to the something that I thought about that is related to Buffett's frequent comments about not selling a good business you own just because of what is in the headlines.

Why People Make Money in Real Estate
OK, so this title seems odd given that we are trying to recover from the biggest real estate bubble/collapse in history.  Real estate has a history of big booms and busts, and there have been big real estate bankruptcies (Reichmann, Trump etc...) not to mention the disaster that is Japan and the most recent U.S. real estate bust.

But on the other hand, why is it that so often the biggest gain that many people have ever made in their lives have been in real estate?   (I know tons have been lost in real estate too)

Just thinking about family, relatives and friends (very small sample size, but...), it seems that the biggest winner has been their house or some other property, and not a stock.  I don't live in Omaha so I don't know anyone in person that has owned Berkshire Hathaway since the 1970s.

I have always noticed this and thought about it but never really expressed it out loud. 

There are a lot of reasons for this, of course.  Your primary residence is a big asset; if there is inflation, of course it's going to be your biggest winner.  Tax-incentivized leverage also helps.  Nobody is going to take out a 20% down loan and spend a good portion of their disposable income paying interest/principle on a stock investment.

But for me, what I often thought about was the illiquidity of the house.  This is why individuals were able to do so well in real estate over time while they get clobbered in stocks. 

Check this out. Compared to stocks, in real estate:

• You can't get a quote on your house every day.  You can't look up the price of your house on Yahoo Finance.  OK, you can Zillow it, but it's not the same as seeing a firm bid and offer that is hittable instantly.
• The evening news doesn't start by telling you that your house price was marked down by 2% that day due to some event that happened in Europe, or because of what some politician in Washington said.
• You can't push some buttons on your iPhone and liquidate your house in less than five seconds.
• Pundits are not on TV, the internet or in magazines telling you every minute of the day to sell your house and buy the one across the street because it will go up more, or tell you to sell your house because it will go down because of some fiscal cliff, canyon, valley or whatever...
• People don't talk about how much their house went up at cocktail parties (well, this did happen during the housing bubble) and tell you to buy a house next to theirs (unless you are so wealthy that you buy and sell homes like people buy and sell stocks).
• Financial Advisors don't tell you to sell some of your house and put more in bonds as the economic outlook isn't as good as it was a few months ago.
• People don't pound the table and tell you to sell your house because it has been raining in your neighborhood for the last five out of seven days.
• People don't tell you to sell your house because it is worth 10% less than it was last week and it may go down more.  Or because your house value, as of yesterday, is now below the 200-day moving average.
• You don't have some crazy guy on CNBC every day waving his arms around spitting into the camera telling you to sell your house and buy the one across the street one day and then doing the exact opposite the very next day.  But I already said this in bullet point three, but I thought it's important enough to say it again.
• Most people can only afford to own one or two houses at a time, so each purchase is done very, very carefully (like the Buffett 20-hole punchcard*; only most people have a 2-hole punchcard).  They spend days, weeks, months and even years looking and researching their house before they buy as it is a huge commitment (unlike people buying 100 shares "for fun" just in case someone's 'tip' proves correct.  Many people can afford to do this very often; so often as to build up a really crappy portfolio of stocks they know nothing about).

Anyway, we can go on and on with this list.  Surely, there are some negatives too.

But my point is that many people have done really well in real estate over a long period of time, but it's not so common to hear the same about stocks.  And that's because of the curse of liquidity.  I think liquidity is actually a good thing, of course.  But it can have it's drawbacks.  When it's right there at your fingertips, it's hard not to want to do something. And everyone around you including the professionals are constantly telling you to do something!

I was stunned when a "professional" investor on CNBC was telling people with a straight face that you can't ignore this stuff (fiscal cliff); this stuff is very important and it will move markets.   Well, if you are a professional fund manager being evaluated on a daily, weekly and monthly basis, I guess he is right; you can't ignore this stuff.  But if he thinks people can trade in and out based on what is going on in Washington, I think he's nuts.

Anyway, with the fiscal cliff approaching, everybody talks about what to do with the stock portfolios, but nobody ever talks about what to do with their houses (OK, I admit some people must be thinking about it and I'm sure personal finance magazines, websites and blogs probably do consider that too as they would make good 'filler' content).

But no real rational person is going to buy or sell their house on this issue.  And that's what Buffett keeps saying about stocks.  You have to look at it like a business (or a house).

What businesses are thinking about selling out because of fears of the fiscal cliff?  If you own and run a profitable restaurant at a great location, why would you sell just because of this near term issue?   If you love your house, why would you sell just because of this?

So What's Going to Happen?
Well, I said I have no idea and nobody really knows.  Anyone who claims to know has something to sell you.

Having said that, this is a blog and we are allowed to say anything we want.  So if I had to guess, my guess is that they go to the very end of the line, the market plunges, people freak out and they come to some sort of kick-the-can-down-the-road agreement.

You know at the end of the day they will come to some agreement.  The only question is when it will happen and how far the market has to go down to convince Washington that something has to happen.

It's just like what happened with TARP.  First, they said "no", the market plunged 700+ points (or whatever it was) and they all suddenly rushed in, "where do I sign?!".

This doesn't mean that's the way it's going to go this time around.  It's just my guess.

To do anything based on that scenario (buy puts, sell out with the intent of getting back in cheaper later etc...) is pure speculation so don't do it. 

Ignore all this noise.


*Buffett's 20-hole Punchcard
Value investors know what this is, but I realize this blog is read by a wide range of people.  For those who don't know what the 20-hole punchcard idea is, it's Buffett's way of telling students to choose investments carefully.  In a lifetime, people will find only very few really good ideas. And having just a few very good ideas is going to be enough to get very rich.

So instead of just buying stocks left and right promiscuously (as many novices tend to do), do solid research, look hard and look for only the best ideas.  When that is found, then invest big in the idea and try to go on to the next one.   And invest as if you only have 20 times you are allowed to invest.  Once you invest in one thing, one hole in the punchcard will be punched out. 

This will make you think very carefully about what you buy as you can't afford to make too many mistakes.

This also reminds me of Peter Lynch's comment that he is baffled that people spend more time researching and shopping for a refridgerator or car than they do a stock even when their stock investment is much larger than their fridge or car.

Going back to my house argument, if people did as much work on stocks they buy as they did shopping for a house, more people would do better.

Even if they did, though, since this is not Lake Wobegan, we can't all become better than average investors.

Source | The Brooklyn Investor | http://brooklyninvestor.blogspot.com/2012/11/fiscal-cliff-doesnt-matter.html

Bank of America Corp (BAC)

Bank of America Corp  (BAC) weekly chart ;
Red arrow = Perfect entry level, buy the break out only !

Source | Alpha Global Investors | http://gicharts.blogspot.com/2012/11/bank-of-america-corp-bac.html

Focus on gold

Once again, focus on Gold !
Key resistance level is clear, we need to clear that "trigger" first !

Source | Alpha Global Investors | http://gicharts.blogspot.com/2012/11/focus-on-gold.html

Is Japan back ?

Compare the Nikkei (top chart) with the $USD/YEN
Nikkei shows a clear higher lows pattern, with a resistance ready to break ?
JPY shows a clear broken trend, facing a test of a key support level

Source | Alpha Global Investors | http://gicharts.blogspot.com/2012/11/is-japan-back.html

Leucadia-Jeffries Merger Loose Ends

So after posting my initial look at the merger, a couple of points have been raised.  Or I should say one was raised (in the comments section in the previous post) and that lead to another point.

One is the issue of dilution.  I said that this merger would have a 4.7% or so dilutive effect at the prices on the LUK presentation.  This is correct on a pro-forma, post-merger stated book value basis. 

But someone pointed out correctly that the book value of JEF in that calculation uses LUK's acquisition price for JEF and not the book value of JEF; the post-merger book value of LUK would include the premium to book value that LUK pays for JEF (which would end up as goodwill).

Is this fair?  I will get to that in a moment.  I don't think it's a bad analysis because we still look at Berkshire Hathaway, for example, using book value per share even after the Burlington Northern acquisition (we don't adjust the BNI value down to the pre-merger book value of BNI).   Book value is only a rough guide and there are other models to look at BRK, but still, BPS is an important measure for BRK's value; important enough for Buffett to use 1.1x book as a buyback level.

But anyway, when we look at financials, we do tend to look at if it is dilutive or accretive to book, and we do often look at stated book value of the respective firms.

"Real" Dilution

OK, so let's recalculate the dilution to LUK shareholders of this deal excluding the goodwill that may arise from it.  In order to do that, I will use JEF's current book value instead of LUK's purchase price of JEF, add it to LUK's current book value and get a post-merger BPS.

Here is the page from the presentation.  If you can't see it, it's page 32 of the merger presentation available at LUK's website.

 

So instead of using the LUK share price times 0.81 x JEF shares outstanding to calculate JEF's adjusted book value, let's just use their stated book value.

According to JEF's latest 10Q, JEF's adjusted shareholders' equity is ,515 million.  So let's use that instead of the ,782.1 million adjusted JEF equity value.  To calculate this quickly, all we need to do is adjust the combined book value for all of LUK down by the difference which is 7 million (,782 mn - ,515).

The adjusted combined book value for LUK in the above table is ,325 million.  Deduct 7 million from that and you get ,058 million.  Divide that by the adjusted LUK shares outstanding after the merger of 377.7 million and you get a post deal book value per share of .98/share.

According to the above table, LUK's current BPS (less Crimson) is .91/share.  That means that excluding the goodwill from the deal, dilution to LUK shareholders is close to 7.5%.

So that looks like a lot of dilution!

Obviously, if you think JEF is worth only book value, then you would be pretty unhappy with this deal.  Not good.  

But wait a second.  All the time we have been valuing LUK, we have marked the LUK holdings to market.  When JEF was trading far above book value, we didn't adjust book downward to JEF's stated book value.  We marked the position to market.

So in that sense, we don't need to force the value of JEF to book value just because they own all of it.  Why mark to market when partially owned and then force a mark to book value (and exclude acquisition goodwill) when wholly owned?  That is not consistent. 

Of course, recently, JEF has been trading lower and LUK's deal has pushed the stock price up so one can argue that appreciation in price is artificial.    But let's take a closer look at this and see what JEF might be worth (or at least what maybe the LUK folks feel it's worth).

JEF Value

When LUK first bought into JEF in April of 2008, the deal was priced on April 18. The closing price of JEF on that day was .98/share.  As of the end of the most recent quarter at the time, JEF's book value per share was .03 and the adjusted BPS was .10 (adjusted for RSU's).  

So that was done at 1.15x BPS and 1.24x adjusted BPS.  Granted, at the time, LUK's share price was .36/share against a BPS at 2007 year-end of .03/share.  So they issued stock at 2x book to buy something at 1.2x book.  Nice trade.

But LUK has also bought stock in the open market over time.  They have said previously that JEF is a good buy at close to book value.

So JEF has been on the LUK books since 2008.

I just jotted down the BPS, adjusted BPS and stock price of JEF since 2009 to see how JEF has been valued in the market.  I figured 2008/2009 stock price would be depressed due to the financial crisis and not really that representative and anything before that of course may be even more unrealistic as financials were valued pretty high pre-crisis.

Anyway here is the data:



JEF Valuation



Common BPS is the GAAP BPS that most people see.   This is the figure people see when they think the LUK deal was done at below book value.  The adjusted BPS is adjusted for RSU's and is more accurate since it is fully diluted for RSU outstanding.


Anyway, since the first quarter of 2009 (the panic low during the crisis), JEF has traded at an average of 1.56x adjusted book value per share.  1.56x is not a bad benchmark as it is mostly a post-crisis valuation and it includes the MF Global contagion/JEF panic in late 2011.

If you exclude the early 2009 panic low and the MF Global panic and only include the quarters 2Q2009 through 2Q2011 (labeled "average*" in the above table), JEF traded at 1.96x adjusted book value per share.

So that is sort of the market evaluation of the JEF business model post-crisis excluding the effects of the Euro-meltdown/MF Global panic. 

JEF has not recovered from that, and the market is now undergoing a fiscal cliff panic.  So excluding these effects, JEF may be reasonably be valued at 1.5-2.0x BPS.

Going Back to the Dilution Issue
So the first point would be, if we didn't adjust downwards the value of JEF to it's stated book (when it traded above book) and we calculated LUK's book value using the mark-to-market value of JEF when it was partially owned, then it doesn't make sense that we do so now post merger just because this "goodwill" is artificial. 

The part that is artificial is that LUK's acquisition did push up the price of JEF; it doesn't reflect pre-merger mark-to-market of JEF itself.   But it didn't do so beyond the previous range of where JEF has traded in the recent past.

With LUK trading at around /share now, that makes the deal worth .35 per JEF share. Since the adjusted BPS of JEF is .63/share, that's a 4.6% premium, not much.   Even at the presentation value for JEF of /share (when LUK was at .80), that's a 9% premium, or a value of 1.09x book value for JEF; not an unreasonable valuation at all given it's recent trading history.

You can argue that this very deal will reduce or eliminate the liquidity concern that arose about JEF after the collapse of MF Global; there is no reason why after this deal that JEF should be worth less than book.  As an independent, there was always a concern of an MF Global-type run triggered by a European collapse or some other event.

So I would be inclined to say that the LUK presentation post-merger valuation (including goodwill) is fine for looking at dilution.  I think it's important for shareholders to understand all of this, though, and realize that there is another way too look at it (7.5% dilution).

And By the Way
Also, there is a circular aspect to this dilution calculation and what LUK is trading at now versus a post-merger BPS.

Since the deal is not fixed in terms of price (no price floor/collar or anything like that), we don't really know what the dilution is going to be.

Calculating the above LUK presentation dilution (using LUK acquisition price as JEF adjusted equity), the dilution changes as follows at various price levels of LUK:

LUK Price           post-deal BPS        dilution
                       .21                   1.1% (accretive)
                       .73                   -0.7%
                       .25                   -2.6%
.80                  .68                   -4.8%  (price on presentation)
                       .30                   -6.2%
.32                  .98                   -7.5%  (price at which deal value is equal to JEF adjusted BPS)

There would be no further dilution under .32/LUK share because if the deal price was worth less than adjusted JEF BPS, there would be a bargain purchase gain, and JEF will be booked at the original JEF book value.

There is obviously less dilution the higher the LUK price upon the closing of the deal because the JEF adjusted equity value will include "goodwill"; it will be booked at a higher value on the balance sheet in proportion to how high the LUK stock price is.

With LUK shares trading now at /share, the immediate dilution to LUK shareholders (including acquisition goodwill) would be -6.2%, more than the -4.8% calculated according to the presentation (due to the lower LUK price since then).

Post-Deal BPS and LUK Valuation
One other thing is that since the post-deal BPS is dependent on the price of LUK at the closing of the deal, the post-deal BPS on the LUK presentation is not current since the stock price has changed.

I said that the post-deal LUK BPS is .69, and if you add back Crimson Wine, then the value is .50.   Against that, it looks like LUK, which closed at around .00 today is trading at a 17.7% discount to post-deal BPS.

But this post-deal BPS is only good with LUK priced at .80.

With LUK trading at .00/share, the post-deal BPS is actually .30, and with Crimson added back in, that's .11.

So the actual discount is 16.4%, not 17.7%.  Not that big a difference.  It's still pretty cheap.

Anyway, here is a table that shows how the discount changes according to LUK's price:

LUK                          post-deal                     
price                          LUK BPS                  discount
25                              27.02                           -7.5%
24                              26.54                           -9.6%
23                              26.06                         -11.7%
21.80                         25.50                         -14.5%
21                              25.11                         -16.4%
20.3                           24.79                         -18.1% 

The above post-deal BPS includes Crimson Wine to make it comparable to the current price.
Below around .30/LUK share, JEF would be valued below book, so there would be a floor there because JEF would be recorded at their own book value with the difference recorded as a bargain purchase gain.

Of course the other way to look at the post-deal BPS is to use JEF's current book value instead of LUK's purchase price.  This would not change because of changes in the LUK stock price.

From the above calculation, this would be around .00/share.  So even with JEF booked at the old book value and not including goodwill that may arise, LUK's post-deal BPS would be .00/share.  Adding back Crimson Wine's .81/share value and you get .81/share.  With LUK trading at /share, that's a 15.4% discount.  Not bad.

LUK is Still Cheap
So even with the above adjustments and high dilution due to a lower LUK stock price, LUK stock is still pretty cheap, and even if with no acquisition goodwill, LUK is trading at a 15% discount to the post-deal BPS. 

So Why'd They Do It?
If you asked them why they did this deal despite the dilution, I bet they would say that they think that the deal is accretive to LUK on an intrinsic value basis.  They will tell you that they are not too concerned with conventional accounting, GAAP book values and things like that.

They did say that they really like JEF at close to book value, which means they think it's worth much more.  They were comfortable owning this at 1.5x-2.0x book for much of the post-crisis period.

If you think JEF is worth 1.5x book, for example, then this deal may not be dilutive at all.  The trick is figuring out what LUK is worth, of course.

Dilution Based on Instrinsic Value
Just for fun, I will fill in some of the above tables and see what the dilution would be if JEF was in fact worth 1.5x book value.  I know some of you will think I am reaching here and trying too hard to make this deal look reasonable.  But that's OK.  I am just looking at this from different angles and I'm not trying to argue one way or the other.

Using the LUK presentation table, let's just wave a magic wand and change the number in the adjusted JEF equity value to 1.5x JEF adjusted book value.  Adjusted book value of JEF was ,515 million at 3Q-end, so 1.5x that is ,273 million.

Now the post-merger LUK BPS comes to .63/share.  The current LUK BPS (excluding Crimson) is .91/share, so now the deal is suddenly 11% accretive.

And then adding back the value of Crimson, LUK BPS would be .44, so that would make LUK at /share trading at a 29% discount!

OK.  So there are problems here. I used an intrinsic value of JEF against the book value of LUK.  To be totally fair, you have to look at intrinsic value versus intrinsic value.  But for me, since I usually value LUK at book value (adjusted for some things), it is not too far off.

This is just an illustration of why this deal is not as simple as "it's 8% dilutive so it's horrible!".  Technically it's dilutive, but there is more to the story than that.  And that's what I tried to illustrate with this example.  I don't mean to say that this deal is 11% accretive, or that LUK is now trading at a 30% discount.

I just point out that it can be seen this way if one thinks JEF is reasonable worth 1.5x book value.  And that's not a stretch at all, again, if you think that this deal will reduce the risk of an MF Global-type run, or someone Egan-Jonesing them again.

Of course, if you think JEF is worth 1.5x book, then JEF has been a great value in the past year or so.  Well, maybe that's why LUK is buying them out.


Can We Really Get to 1.5x Book for JEF? 
One last thought.  I think the smaller investment banks do tend to trade at higher multiples than the large ones.  Recent history of JEF trading when not being Egan-Jones-ed tends to support higher valuation for a company like JEF.

Many of us make fun of investment bankers all the time, but I do like to read merger proxies as they do tend to have valuation comps that can be interesting (and silly at times too).  So we may get more insight into valuation for JEF.

But we may be able to get 1.5x valuation on our own.  We know that the LUK folks want to get 15% pretax return (or much better).  So let's use a pretax 15% return.   Since I already did the work, we can use book value growth plus dividends as a proxy for long term return-on-equity (it will serve as a sort of comprehensive return on equity over time)

From the other post, here is the growth in book (plus dividends) of JEF over time (annualized):

                            Growth in BPS+DVD            Pretax Comprehensive Income
1996 - 2011         +15.4%                                 +25.7%
1999 - 2011         +13.9%                                 +23.2%
2007 - 2011           +5.6%                                 +  9.3%

So since 1996, JEF grew book value including dividends at a rate of +15.4%.  On a pretax basis (using a 40% tax rate), that's +25.7%/year.

From the 1999 peak, they earned 23.2%/year pretax.

If they need 15% pretax returns, JEF can be worth 1.5x book (at 1.5x book, this 23.2% pretax return turns into 15%).

Now this too is not so simple.  Yes, the previous ten to twelve years has not been the greatest time for financials but there is no guarantee that the next ten or twenty will be as good for JEF.

This, again, is just to get my arms around a 1.5x valuation.  Is it reasonable or not?

I don't do this to convince anyone either way; I just present the facts and analysis as food for thought.

Conclusion
So I fine tuned some stuff from my other post here and there were some adjustment/changes that had to be made, but I don't think the conclusion changes much.

The deal is dilutive looking at it conventionally. But who said these guys are conventional?

For me what's important is that I do like the people involved on both sides, the deal is not ridiculous (this is not Time Warner / AOL) and in fact might be a great deal depending on how you look at it (1.5x book value scenario), and the LUK stock is currently pretty cheap either way.

The 1.5x book value scenario and analysis is just illustrative and shows that this can be a a totally reasonable deal depending on what you think JEF is worth.  1.5x is just a figure I plucked out of the air as it seemed to be at the lower end of the range of JEF's stock excluding periods of panic (and it's the average since 2009).

I know many people assume investment banking is dead and that's why JEF is trading cheap.  But I tend to disagree with that.  I don't think investment banking is dead at all; I do think it will come back.  And I think JEF was trading cheap mostly for fear of another MF Global-like run.  This is clear from the valuation pattern through 2011; it traded well until MF Global collapsed and a bad (and wrong) report about JEF came out.

Of course, if you think investment banking is dead and the low valuation is the correct valuation, then obviously we will disagree on what we think about LUK going forward, and about this deal.

You can easily make a similar but more moderate argument using 1.1x book, 1.2x book etc.

So my opinion remains the same.  Good deal, but of course it would've been better if it wasn't dilutive, but then again, from a value gained perspective, it may not be as dilutive as it at first appears.

Also, this is not a complicated deal at all.  It's pretty simple.  But there are a lot of numbers involved in the stuff I wrote, so I may have missed something (hopefully nothing big!).  If so, I apologize in advance.

In any case, we all have to do our own work so do your own work and make up your own mind!

Source | The Brooklyn Investor | http://brooklyninvestor.blogspot.com/2012/11/leucadia-jeffries-merger-loose-ends.html

Lazard: Countercyclical Finance Play?

Nelson Peltz's Trian Partners bought a 5.1% stake in Lazard recently and has supported Lazard's new strategic plan.

I haven't looked at these independent advisory firms too closely in the past as they have usually traded at very high levels.  The other independent advisory firms are Evercore Partners (EVR) and Greenhill & Co (GHL).

Also, revenues are correlated to global M&A volume and whenever I see a graph of that it just looks like the Brooklyn Bridge; big upcycles where volumes shoot up during boom times and then slide way back down and stay down until the next upcycle.  I just don't know how you would put a multiple on earnings like that, unless you can buy an advisory at trough earnings for a reasonable multiple or something like that.

But Peltz's purchase gave me an excuse to take a close look at LAZ.  I looked at it briefly when it came public in 2005 but had no real interest in it back then for the reasons I state above.

Before I go on, there are some good presentations on LAZ that is worth a look (if you are interested in LAZ, of course):

Peltz's slide presentation was posted at Market Folly:
http://www.marketfolly.com/2012/06/trian-funds-presentation-on-lazard.html

Lazard's new strategic plan, slides and investor presentations are here:
http://www.lazard.com/Investorrelations/Presentations.aspx


Here's the long term chart of LAZ since it's listing back in 2005.  When it was listed, LAZ was run by Bruce Wasserstein, a legendary investment banker (He wrote a pretty good book about M&A; check it out here). 




Anyway, why is LAZ so interesting now?    The main story is that if LAZ can get their compensation and benefits in line with peers, operating margins can be much higher and this would make LAZ a cheap stock at this point.

But others factors are:

M&A Ripe for Recovery
Trian and LAZ feel that the advisory business is at a low point and ready to move up as equity prices are reasonable (for M&A), financing is available, organic growth is limited at corporations so there is incentive for acquisitions, corporate balance sheets are healthy and CEO optimism is on the rise.  So the M&A business is ripe for recovery.  Trian points out that when M&A starts to recover, it tends to go on for a few years.  Here's a chart from their presentation (see, I told you it looks like the Brooklyn Bridge):

Here's a longer term look at M&A deal volume from an Evercore presentation:




Fee-based Business Model
LAZ's business is in advisory and asset management.  Neither of these are capital intensive; they don't use the balance sheet.  In this environment of concern for potential losses at financial firms (not knowing what's really on the balance sheets), this is a positive.    I don't have too much concern about financial balance sheets (at least at the good firms like JPM and GS), but a fee-driven model can be interesting as long as it's not too expensive.  Also LAZ would not be affected by much of the new regulations (Volcker rule, capital ratios etc.).

Independence
LAZ is an independent advisory firm as opposed to a full service bulge bracket investment bank,  and this can be an advantage these days with all the problems of conflicts of interest that seem to plague the big banks.

Countercyclical Nature
I did call this a countercyclical play and of course, that may be overstating it.  It's a play on financials and LAZ will do well on a global economic and market recovery.  That's the scenario that will make them the most money.

But, like Oaktree Capital Managment, there is a countercyclical component here.  Oaktree tends to raise funds and invest in bad times and do less in good times. They manage themselves in that way for good long term performance.   But still, in a bad market, the funds that OAK manages will probably not do too well.

In the case of LAZ, they are a fee-based business so bad times will reduce fee income and they won't do well either, but their advisory business in restructuring tends to do well providing a built-in hedge to the overall business.

Check out this slide from LAZ's presentation:




Notice how the restructuring business did really well back in 2003 and in 2009.  If you think there is still way too much debt out there and there will be a lot of restructuring needed over the next decade (in Europe, for example), it does seem like LAZ can be a big player in this area.

David Einhorn bought some Oaktree recently, and I think that is sort of a countercyclical play for him too.  Of course, I have no idea what he is thinking, but since he does tend to think that things can really blow up in some places due to excessive leverage it makes sense that he would be interested in investing in someone who would know how to pick up the pieces and make some good money.

LAZ has that aspect to it.  Notice how revenues actually went down in 2004 versus 2003 even though nonrestructuring advisory revenues went up; restructuring did so well in 2003 it caused revenues for the advisory segment to go down in 2004.

The 2009 increase in the restructuring business proved to be quite an airbag for the business.   Restructuring revenues went up from  9 million to 7 million.

Here's a slide from LAZ's investor presentation that should get Einhorn and other people looking for serious debt-related dislocations around the world in the next few years excited:

When things really unravel, LAZ may very well be a big beneficiary of that.  So you think big bankruptcies are on the way?  Have I got a stock for you!


Asset Management is Basically Equities
This is a slide from LAZ's investor presentation:



The other half of LAZ's business (net revenues) is asset management.  What surprised me here is that most of their assets are in equities.  From the above table, you see that equities is 82% of total assets under management (AUM), and a lot of that is in international and global equities.

People will have different views about this, but I tend to think it's a good thing.  Everyone else seems to be rushing into hedge funds and alternatives.  I do think that stock prices are reasonable and believe they will do better than most people think (funds seem to be rushing out of stocks into alternatives).  





 And AUM has risen nicely over the years, recovering the 2007 highs, and operating revenues are already above 2007 levels.

There isn't much detail provided about the actual funds; I would like to see more of that like asset managment firms typically show in their filings.

But one thing I did notice is that throughout the crisis, from 2007-2010, the asset management business had net inflows into their funds every year which is interesting.  Most of the AUM is institutional and the funds do seem to be sticky so far. 

There is some comfort in knowing that LAZ is increasing AUM in equities while we know that institutions are rushing out of stocks and into alternatives. It's much more comforting than an asset management firm that is growing AUM due to the current rush into alternatives (which may or may not pan out).   LAZ seems almost contrarian.


Trian's Valuation Case
Trian's case is pretty simple.  Management announced a new strategic plan in April of this year and said they will target at least 25% operating margin by 2014.   Trian simply took that figure and adjusted 2012 estimates to get a 'normalized' earnings figure and comes up with .50/share in EPS giving LAZ a less than 10x p/e multiple.




Trian also shows what LAZ could be worth in various margin and revenue growth scenarios.  LAZ could be worth anywhere from to /share depending on if operating margins are 25% or 32% and revenue grows 4% - 8% per year through 2014.

Trian uses a 14x p/e multiple, which is reasonable.   If you want to be conservative, you can put a 10x multiple on it and say LAZ can be worth - 43/share  by 2014.

LAZ Strategic Plan
LAZ's plan is pretty simple.  They want to increase return to shareholders.  They are increasing dividends and plan on doing more share repurchases so that shares outstanding go down instead of going up (repurchase more shares than it issues as compensation).

That's a good thing, and I sort of wonder if something like this would have happened under Wasserstein or some such "star". 

The key for the plan is getting expenses down in line with peers.  Here are some slides that show how LAZ plans to get to 25% operating margins.

Compensation Expense
Below is a table that shows that LAZ has compensation expense that is much higher than peers.  Getting this down is key to improving operating margins.  The table also shows that they are making some headway in this expense control.  During the years 2006-2009, compensation expense averaged 69% of revenues, but that got down to 62% in 2010/2011.  Their goal is to get that down to 55-59% which is around where the peers are.

I should note that in this table and in LAZ compensation discussion, they use what they call "awarded compensation" as opposed to GAAP compensation; they feel it more accurately reflects costs as incurred.  If someone earns a certain amount of income but it is deferred, it should be charged to when it was earned, not when it is paid out etc.   That seems reasonable and fair to me.   Payout timing can be completely arbitrary.

This table shows LAZ's compensation ratio versus the peer averages:



...and this shows Non-compensation expense, which looks good versus peers:

And the result is the operating margin:

Peers have averaged around 25% operating margins in 2006-2009 while LAZ's was only 12%.  They have since improved that to 18% in 2010-2011.   Their goal is to get that to 25% by 2014. 


No Improvement Scenario / Sanity Check
Just to do a little of our own checking, here is some historical data from the LAZ presentation:

Here is the table of earnings based on awarded compensation.  To do our own scenario (versus Trian's scenario), first let's just make sure we got this model correct.

The above table has adjustments to it that are footnoted in the LAZ presentation.  

All we want to do is to be able to manipulate the operating margin, revenues and get our own awarded EPS.

Operating revenue in 2011 was .9 billion and awarded operating income was 1 million.  To get from the operating income of 1 million to .34/share in EPS, we have to deduct interest expense, taxes and then divide by diluted shares outstanding.  We will use 2011 figures to see if we can get from 1 million to .34:

Interest expense in 2011 was million and the tax rate was around 20%, and there was 137 million shares outstanding.  So 1 million less million is 1 million, less 20% in taxes leaves 5 million or so.   With 137 million shares outstanding, that's .35/share in EPS; close enough for a free blog.  

Worse Case Scenario
OK, so this is not a worst case scenario.  You can't really do worst case scenarios for financials because if we have an extended recession / depression, you can't really model that.  Obviously, in that scenario, LAZ would not be a good bet.

So my downside scenario is just that the M&A business doesn't recover and LAZ's revenues just doesn't grow.  I do think that using the average revenues of the last three years is conservative because the financial industry is in a depressed state now, and the years 2009, 2010 and 2011 are sort of trough-like (see the long term M&A volume chart earlier in this post).   We can assume that the conservative scenario is that M&A volume does NOT pick up and revenues don't grow as Trian's slide shows.

Using 2011 figures from the above model, I will just plug in the figures using revenues that is the average of the last three years and then various operating margin levels and all other factors the same (tax rate, interest expense and shares outstanding same as 2011):

So if the M&A business just muddles along at recent lows and LAZ earns the average revenues that it has earned in past three years, the EPS would be as shown above according to various margin levels.  Since Jacobs took over and restructuring has taken place, margins has averaged 18%.  If this can be sustained, even at current low revenue levels, LAZ can earn .40/share giving the stock a p/e ratio of 18x, or an earnings yield of 5.6%.

Clearly, this is not an attractive valuation for a steady-state, no improvement situation.  If they can get their margins up to 20%-25% range, the valuation becomes much more reasonable in the 11-15x range.

For those who might have an issue with tax rates, I added pretax figures.  We know that Buffett likes to pay 10x pretax and Leucadia wants to make 15% pretax returns, so those are pricing benchmarks (not that they would be interested in investing in LAZ).

On a pretax basis, even with volumes stuck at recent lows and not picking up, if they can get their margins up to 20% or so, they can still earn 8% pretax return on the current stock price; not bad at all.

Lower Interest Expense Scenario
OK, so let's take it one step closer to Trian's scenario.   In Trian's slide, he assumes further share repurchases (slightly lower shares outstanding) and higher revenues, but notably he has a much lower interest rate expense.

This is because the long term debt of LAZ expires in 2015 and 2017 and they yield 7%;  the assumption is that they can pay down some of the debt and refinance the rest in 2014.  To come up with a million interest expense figure, they took the current debt at market value of .17 billion or so and deducted 0 million in excess capital and then applied the current trading yield levels for LAZ debt of 4.7%.

This is not at all unreasonable because it reflects debt at market and current interest rate levels for LAZ.  For normalizing earnings over time, this is a fair assumption.

Also, Trian uses a 25% tax rate, so I will bump that up to 25% too. 

Redoing the above spreadsheet, we get:

With this lower interest expense, LAZ looks a lot more interesting.  Even with no improvment in revenues, if LAZ can maintain an 18% operating margin, LAZ is trading at 16x p/e ratio.  On a pretax basis, it would be earning 8.3% on the current stock price; not bad at all given the conservative assumptions.

If margins improve, to 20-22%, then it gets reasonable pretty quickly.  These independent advisors, because they are not capital intensive (and don't have balance sheet risk) tend to trade at much higher multiples than full service investment banks and universal banks.

Here is a table of historical P/E ratios of the independent advisors; I just pulled these from Morningstar:

Historical P/E Ratios

The averages exclude negative numbers and the 500x p/e in 2008 of LAZ.  I didn't bother with EVR since as you can see, it would be pretty meaningless.

This is not to suggest that LAZ has to trade at 20x p/e or more, but it would not be out of historical norms. 

Yes, it's a different world now.  Some will argue that if you look at it that way, then banks should be worth 3-4x book value per share.  Fair enough.  But I do tend to think there is a better chance of advisory companies having a high multiple than banks going back to 3-4x book again (capital / leverage has been reduced etc...).  These independent advisories won't be restricted by tighter capital rules or the Volcker rule, and don't have the balance sheet risk that is the cause of lower multiples at other financials these days.


Conclusion
So that's just a quick look that I now admit is a neat idea.  A play in the financial sector that has no balance sheet or regulatory risk, no (or minimal) conflict of interest issues.  No big accidents waiting to happen.  

It's a business that is basically a services business that earns fees.  Yes, it may be run by a bunch of untrustworthy, greedy bankers (not my judgement) but the new, post-Wasserstein CEO seems to be much more shareholder friendly with actual proof of that (more share repurchases, increased dividends and lower compensation expense ratio).

The M&A market, even I admit, is probably not dead and there are probably a lot of deals to come in the future for the various reasons sited in these presentations, and the market is probably at a cyclical low point following the financial crisis and the current ongoing European crisis.

This stock does have an airbag built in so if things get really hairy and bankruptcies and restructurings boom again, LAZ has a dominant position that can boost revenues to offset declines elsewhere.

Of course, this is not the cheapest stock out there, say, compared to Goldman Sachs or JPM, but it is still an interesting story nonetheless.


P.S. About Financials
I do tend to talk about financials here a lot, but I would caution that it doesn't mean one should necessarily own a lot of financials.  Financial stocks are volatile and if we have another recession, financials will get hit hard.

I talk about financials here a lot, mostly because they are unloved and hated but also because I have some comfort with them that others probably may not have.  Having worked in the industry, I am probably a little more comfortable with, for example, JPM's humongous derivatives book and other things people would run away from.

This is not to say that bad things can't happen.  There are risks in these things.  If someone told me that they had 80% of their net worth in Berkshire Hathaway, I'd say, cool.   That sounds fine (even though BRK did go down 50% during the crisis too).

But if someone said they had 80% of their net worth in Goldman Sachs or JP Morgan, I would say, hmmm.... you might want to think about that.

Greenblatt, in his genius book talks about concentration, but warns against being overly weighted in any single sector.  Five to eight stocks may give you enough diversification to get through market volatility, but not if all five of them are financials!

Anyway, I have said this before but I just wanted to point that out.  I don't talk a lot about financials here because I think people should be heavily weighted in financial stocks;   I do think they are cheap, but I post about them because I feel comfortable talking about them and feel like I have something to say about them.

Source | The Brooklyn Investor | http://brooklyninvestor.blogspot.com/2012/06/lazard-countercyclical-finance-play.html

Stubbing Bank of America

OK, I have to stop with these misleading post titles.  You can't really do a stub trade on Bank of America (BAC) as a stub can only happen when the piece you want to back out is publicly traded.

Anyway, with News Corp breaking up (after repeatedly saying it's not going to happen) and many calling for the big banks to break up, I thought it's a good time to look at BAC as a potential spin-off/ potential stub / sum-of-the-parts.

You know people will keep denying things until the day before something happens (remember Goldman Sachs?  Nope, we will not become a bank.  Next day, um, well, yes... we are now a bank, lol...)

I don't agree with the many people calling for breaking up banks that are too big to fail and too complex to manage but BAC is one bank where I would tend to think that wouldn't be such a bad idea.

In any case, a spin-off may not happen; the first quarter resegmenting of business units seems to make it more unlikely it will happen than not.   But who knows. 

Doing this exercise, though, will shed some light on what this beast really is made of so even if we come up with a similar sum-of-the-parts valuation as the "1% ROA for the whole firm" valuation we will have a little deeper understanding of the components that make up that value.


Use 2011 Year-end
Starting with the first quarter of 2012, BAC rejiggered their business segments.  They used to report two segments that were pretty much the old Merrill Lynch (with some old BAC tossed in); Global Banking and Markets  (GBM) and Global Wealth and Investment Management (GWIM).

In the 1Q 2012, they broke up GBM into two parts again, Global Banking (GB) and Global Markets (GM).   This is what they used to report a while back too, but for most of the time after the Merrill acquisition, it was reported as one segment, GBM.

That's all fine, but the problem is that when they broke it up again, they stuck some of the Global Commercial Banking into Global Banking.  The GB and GM together now is bigger than GBM back in 2011.

So instead of using the most up-to-date figures, I will use the data from 2011 year end as that is reported with the old segments.  Judging by their 1Q earnings report, there hasn't been anything dramatic so it shouldn't make too much difference analysis-wise.


How is the old Merrill doing?
So first of all, since we are focusing on the old Merrill and the hypothetical spin-off scenario, we need to look at how they are doing.  I will ignore what Merrill did before the crisis as it's a different world now.

So I decided to just take a look at how they have done since the crisis.  Since there aren't a lot of data points, I just looked at the quarterly figures.  Maybe I am tricking myself into thinking I have more data points by using quarterly, but at least I get to see more of what's going on inside this way.

Here is the Return on Average Equity (ROAE) of what I call BAC-MER or the old Merrill Lynch compared to Morgan Stanley (MS) and Goldman Sachs (GS), the only two large independent investment banks.    I also included a four quarter average ROAE so we can see trends.

Return on Average Equity

I took out some one-time figures from the BAC ROAE figures.  In the second quarter of 2009, BAC-MER's GBM unit had a .8 billion gain on a joint venture with First Data, and in the fourth quarter of 2009 the GWIM segment booked a .1 billion gain on the sale of Blackrock (The BLK stake was later moved to "Other" so I don't think the sale of the rest of it went through GWIM).

So in that sense, the BAC-MER figures should be pretty clean.  I may have missed a gain here or there, but I think the two above were the big ones. 

I didn't do the same for MS or GS; they are as they were reported so may include gains and losses here and there.

But anyway, it's very interesting to look at this table.  Since 2009, BAC-MER has earned an ROAE of 11.15%, solidly in the double digits; not far from what GS was able to achieve.  We can sort of see why MS is so cheap; it has only earned 4.2% in ROAE since the first quarter of 2009.

(DVA adjustments are included in all of these figures; GS is known to 'hedge' out there DVA volatility to minimize earnings impact from credit spread changes).

On a rolling four-quarter basis, it even looks like BAC-MER is doing better than GS (never thought I'd ever type that!) since the 1Q 2009.  In the full year 2011, BAC-MER had an ROAE of 8.4% versus GS's 3.7%.

So despite the nightmare of BAC, BAC-MER is doing fine and is even doing better than GS.


Valuation of BAC-MER versus Comps
The problem with a sum-of-the-parts now is that investment banks are trading pretty cheap too.  Since MS is doing horribly, let's compare BAC-MER with GS.

Using current stock prices and balance sheet values as of the end of March 2012, here is the valuation for BAC-MER comps:
         
                Stock                                                 Tangible
                price              BPS          P/B             BPS            P/TB
MS          .51             .74    0.44x            .37      0.49x                 
GS           .00           4.48    0.68x          3.94      0.73x

MS is not doing too well, so is trading pretty cheap.  But GS is doing well, sort of like BAC-MER, but it is trading at 0.7x book.  For valuation purposes, I would argue that a business earning double digit ROE's deserve to trade at book, particularly when the business is in a depressed state.

Let's see if I can find some support for valuing BAC-MER at book value.   Here is a table showing the book value per share (BPS), tangible book value per share (TBPS), stock price, P/B ratio and P/tangible book ratio for GS in the recent past.

GS Stock Valuation: Quarterly Since 1Q2009

We see that even after the crisis, GS has averaged around 1.2x P/B ratio and around 1.0x P/B if you look only at the past eight quarters.  It has averaged around 0.8x for the past four quarters, though. 

In any case, just by looking at this table it is not a stretch to see that these banks, if they earn double digit ROE's over time, they should be valued at or over book value.  The problem in the past few quarters is that there was the European crisis last fall that has continued this year.  So these valuations may reflect 'crisis' or 'fear'-based valuations.

Of course, there is always the possibility that the world will in fact end soon in which case all is moot. 

Another way to look at this:

GS has traded at an average 0.84x P/B ratio in the past four quarters while it earned an average ROAE of 5.5% during that time.   BAC-MER, however, in the past four quarters earned an average ROAE of 7.14%, 1.3x times higher than GS.  Yes, it feels strange to say that BAC-MER has done better than GS, but there it is.

So let's say a fair valuation for BAC-MER is 1.3x what GS has traded at.  That comes to 1.1x P/B (1.3x 0.84x = 1.1x).

GS has also traded at 1.0x book for the past eight quarters while it earned an ROAE of 6.6% during that time.  BAC-MER has actually earned an average ROAE of 8.6% during that time, or 1.3x better (this is getting really weird to keep typing that).  It would not be at all surprising if BAC-MER then also traded at 1.3x book over that period.

Yes, I know that sounds like I'm really reaching here.  But I'm just trying to justify book value for BAC-MER, not trying to get the highest valuation or anything like that (I'm not an investment banker representing a seller).

So looking at it in the following ways, you can easily justify valuing BAC-MER at book value:

• A business earning double digit ROE over time should trade at book or more, and BAC-MER has earned double digit ROE since early 2009.  If one concludes that the current crisis is cyclical and not a permanent situation, then it's reasonable to assume that they will continue to earn double digit ROE over time, in which case book value is a reasonable valuation.
• GS has earned double digit ROE since 2009 and has averaged a valuation of 1.2x book. Even excluding the perhaps overly exuberant 2009 rebound valuation, it averaged 1.0x book over the past 8 quarters.  BAC-MER has done at least as well (8.6% ROAE for BAC-MER versus 6.6% for GS), so a 1.3x book value valuation would not be out of the ordinary.
• In the past four quarters, GS has averaged a valuation of 0.84x book value while earning an ROAE of 5.5%.  BAC-MER has averaged an ROAE of 7.1% so it would not be unreasonable for BAC-MER to be valued at 1.1x BPS.
• Of course, many will insist on using current valuation and not some average valuation.  GS currently trades at a P/B ratio of 0.68x book, so even using current depressed valuations, BAC-MER can reasonably be valued at 0.9x book (0.68 x 1.3x).  

Of course if you think the investment banking model is dead, then none of this really matters.   None of this is going to be interesting.  But I tend not to think that way.


What's the Stub Worth?
So if we back out the old Merrill, what does that leave and what's the valuation there?

Here are the basic figures:


                                                        GBM                         GWIM                 Total BAC-MER
Total assets (period-end):               7.8 bn                  8.8 bn             1.6 bn
Average equity:                                .2 bn                    .8 bn              $ 55.0 bn
Average economic capital:               .6 bn                      .1 bn              $ 33.7 bn

(I use average allocated equity and economic capital because that's what reported in the filings; any difference between that and period-end shouldn't change the conclusion.  Economic capital is basically tangible equity.)

At year-end 2011, there were 10.5 billion shares outstanding and the stock is trading currently at .60/share for a total market cap of .8 billion.

Backing out BAC-MER at book, that leaves a market cap of .8 billion.     On a per share basis, BAC-MER is worth, at book, .24/share, and the rest of BAC is valued at .36/share.

So what do you get for .8 billion?

Backing out the above capital and assets from the consolidated BAC will leave the balance sheet excluding BAC-MER:

                                  Consolidated              BAC-MER               BAC ex-MER
Common equity:       1.7 bn                   bn                      6.7 bn 
Tangible equity:        3.1 bn                   .7 bn                     .4 bn
Total assets:            ,129   bn                 1.6 bn                ,206.4 bn

So BPS and tangible BPS of BAC excluding the old MER would be .92/share and .47/share respectively versus the market valuation of .36/share.

That values BAC at 0.16x book value or 0.25x tangible book value.  I know most people believe that the goodwill from the Countrywide acquisition is worthless, but management is guiding ROA of the whole firm at around 1.0% (including BAC-MER). 

Since BAC-MER has a much lower ROAE, this implies that BAC excluding BAC-MER will have an ROAE higher than 1.0%.

So even assuming a 1.0% ROA for the core BAC, that implies profit potential of .06 billion/year or .15/share.  At 10x p/e, that's .50/share for the core BAC.  Combining that with BAC-MER being worth .24/share, BAC as a whole is worth .74/share versus the current price under .00/share.

(You can also say that .06 billion/year is a 12% return on tangible book and and say core BAC is worth at least that.  Tangible book value per share for the core BAC is .47/share, adding MER back to that gives .71/share in value for BAC overall).

Just to check that, the following table shows the long term ROAA, ROE and ROTCE over time for BAC.

BAC Summary of Returns

So it seems like in more normal times BAC does consistently earn ROAA over 1.0% and can be as high as 1.3-1.4%.  BAC has morphed over the years through multiple mergers, so I actually don't know how relevant some of the older figures are.  For most of these years, BAC didn't have MER (which was added to BAC in the first quarter of 2009) so it's a good indication of what the core BAC may earn.

But what we can say is that it seems like they earn sufficient ROE to merit trading at book.  You will notice that the leverage of BAC has come down over time.  Reduced leverage will certainly lower return on equity, but even at a lower 10x leverage and a 1.0% return on assets (BAC management's goal and Berkowitz' valuation assumption), that is a 10% ROE.

At this point, excluding BAC-MER, core BAC's leverage is down to 7.7x, and a 1% ROA would result in a ROE of 7.7% so that's on the low side.  The question is if BAC is holding back on leverage due to BAC-MER, or if they spun it off if they can lever back up to 10x.  

A conservative view, though, would be to see the core bank worth at least tangible book.

To get to core BAC being worth book value, one of two things would have to take place:  Leverage has to get back to 10-1 with ROA at 1.0% or ROA would have to get back up to 1.3%.  From the above ROA table, you can see that BAC hasn't earned 1.3% ROA in the 90s, but did so in the 2000s.  But that includes the bubble years so it's hard to tell what BAC can do over time on a normalized, non-bubble basis.

Comparing Core BAC and WFC
One reference point may be WFC.  BAC excluding BAC-MER would look pretty much like WFC.  Of course, WFC is way better managed, but Buffett owns both of them and thinks that BAC's underlying businesses are doing fine.

Anyway, I put the ROA of both companies side by side to see if what WFC is earning can be a hint to what BAC might earn:

The interesting thing here is that although BAC has a history of earning well over 1.0% ROA, it has been consistently lower than WFC even before BAC bought MER.  The average ROA since 1997 for BAC is 0.99% versus 1.42% for WFC (actually, if you include a negative number for 2010 for BAC, it would be lower, but I am being generous here by leaving out 2010 which isn't even fair).

Excluding the bust, we get the same result.  BAC averaged 1.2% ROA versus 1.6% for WFC in the ten years 1997-2007. 

So unless we get a full recovery (including housing) in the U.S. economy, BAC (ex-BAC-MER) may not earn much above 1.0% ROA in which case the valuation for BAC ex-BAC-MER would be worth around tangible book or slightly more, but not stated book.

Review of the Simple Model for BAC Valuation
Berkowitz's valuation for BAC is simply that BAC can earn 1.0% ROA and with 10x leverage can earn an ROE of 10% so is worth book value, which at the end of 2011 was .09/share (tangible BPS was .95/share).

BAC in their presentations also present a base case "normalized" earnings scenario of at least 1% ROA.

If we go backwards, backing out BAC-MER at book value, we can figure out what kind of ROA the core BAC will need to earn to make a 10% ROE (to justify being worth book value).

Since BAC-MER (investment bank etc.) typically earns a far lower ROA than the core bank, in order for BAC as a whole to earn 1%, the core bank needs to earn a higher than 1% ROA.

We have already seen above that in order for core BAC to be worth book value, core BAC would have to either increase leverage (assets) 30%, or earn a ROA of 1.3%.  I don't know if BAC can grow assets 30% in this environment; getting to ROA through restructuring, costs cuts etc. might be more manageable.

But that is still not an easy thing to do given the historical ROA (see above table), the fact that BAC has consistently earned an ROA 30-40 bps lower than WFC.

Conclusion
In any case, either way you look at it, BAC does seem pretty cheap.  We looked at the two main pieces and I would be comfortable with the conservative assumptions, but the /share value might only be achievable in a broader economic recovery, especially housing.

It is encouraging that WFC is doing so well with 1.25% ROA with housing still flat on it's back, so BAC with a similar model (perhaps not as well managed) should be able to earn 1.0% ROA even without a housing recovery.   In that case, a .74 or so would seem completely reasonable (valuing BAC-MER at book value for the reasons I stated above and assuming a 1.0% ROA on the core BAC, valued at 10x p/e).   This valuation would not offend me, and I would tend to think it's conservative.

If you insist on giving an investment bank a 30% discount like the current GS (even though I would argue that since MER is doing better, they might need only a 10% discount), you can just knock off .60 (since BAC-MER is worth .24/share at book) from the above .74.   That would still get you to .14/share versus the current stock price of .60/share.

Of course this is not to say that BAC as a whole can't earn an ROA of 1.0%; BAC suggests they can do that on a normalized basis with no asset growth (implying no real housing recovery?).

So BAC may very well be worth or more.

But picking apart the details, at least we know it can be worth at least .00 using our own assumptions (or .74/share with BAC-MER at book and the rest at tangible book).

Source | The Brooklyn Investor | http://brooklyninvestor.blogspot.com/2012/06/stubbing-bank-of-america.html