Sunday, August 28, 2011

Opportunity in Bank Stocks

Warren Buffett recently invested in Bank of America and this provided renewed confidence to the public about the opportunity in the bank given the recent sell off. With that I decided to take a look at some of the banks that I have been eyeing.

Bank of America (BAC)

BAC has been the stock that has suffered the most in the recent downturn in bank stocks. The biggest concern has been the significant unknowns about its mortgage exposure. BAC has set aside almost 20Bn $ to account for losses from various settlements. However, there are significant unknowns:
  • Its settlements of 8.5Bn $ with a group of mortgage investor is currently being challenged in court.
  • There are various lawsuits by states against the big banks. NY state attorney general has been among the most aggressive and it is likely that those lawsuits can have a big drag on the bank’s results.
  • There are questions about BAC capital adequacy ratio given that BAC request to pay dividends was rejected by the regulators. This implies that regulators are not very comfortable with the capital levels.

Countering the above factors there are a few positives:
  • BAC has significant franchise earnings power.  There have been various range of estimates but in general I have not seen those estimates too far below 2$/share.
  • BAC is in all the key business areas – Retail, Mortgage, Investment Banking, Corporate Banking and Wealth Management. Thus as the US economy picks up bank has enough firepower to fire on various cylinders.
  • Tangible book value of the stocks is above 12$/share vs it current market value below 8$/share.

The recent investment by Warren provides an interesting additional pointer. While the investment in BAC has been portrayed as a good deal for BAC, I have my reservations. BAC didn’t raise any additional capital when Warren invested in BAC. Thus BAC didn’t benefit from raising the capital as both GS and GE did when Warren provided that capital. So really the purpose was to bump the stock price in the short term. However, this will have the exact opposite consequence in the long term as I prove below.

BAC gave Warren a free 10 year call option at a strike price of 7.14$. If I look at the traded price of BAC call option, a call option maturing in Jan 2013 with a strike price of 7.50 is worth 2.35$. Hence, the value of the options is significantly more than the above 2.35$ since the option doesn’t mature in 2013 but matures in 2021. Some people have estimated that the value of the option is 5.49$ at the following link. I do think the price is even higher but Black Scholes is not a good way of measuring long dated options as Warren has said multiple times.

The above coupled with the fact that Warren has taken no risk with it – Preferred shares are higher in the capital structure than the Equity Capital and yet have all the upside (because of Warrants) is classic Buffett. Buffett got the deal despite it not being 2008 is even more commendable. This also speaks poorly of the current management.

Bottom-line: I think that the current investment by Warren is a very expensive deal for BAC current shareholder.  Management has taken the deal to preserve themselves and get endorsement on them from most one of the most savvy investor. This investment doesn't do any good to the existing shareholders.

However, given the above, can we find other investments in the banking that could potentially fit the bill of savvy investments. The 2 that I have in mind are:
  • Citigroup
  • Barclays

Citigroup (C)

Citigroup went through a lot of churn in 2008. The stock price that you used to be around 50$ in 2007 has now fallen to 3$ (accounting for the 1:10 reverse split in 2011). Company also wrote down a lot of the items on its balance sheet which makes it more than likely that its current book value truly reflects the value of the company. A few key factors:
  • Tangible book value is upwards of 40$/share vs its market value of 30$/share.
  • Yearly earnings capacity of 10Bn$ vs 87Bn$ of Market Value thus resulting in PE of 8.5.
  • Extensive presence in Emerging Markets where the growth is likely to be much higher than in the more mature markets of US and Europe.

The above factors coupled with the leadership of Vikarm Pandit who has done a good job of leading the bank could provide a good opportunity to get into this bank.

Barclays (BCS)

Barclays went through a similar churn in 2008 as Citi. However unlike Citi, Barclays never required any bailout from governments. They were able to get private investors from the Middle East to enhance their capital. A few interesting factors for Barclays are:
  • Barclay’s book value is only 0.36 of its market value. While book value includes some of the intangibles that are still on the Balance sheet, .36 is a very low ratio for the bank.
  • Barclay’s market value of $30.5 Bn also includes the stake that bank in the following entities:

o   Blackrock – 19.99%. This accounts for $5.75 Bn.
o   Absa – 56.4%. This accounts for $7.3 Bn.

·         Thus market is only assigning value of $17.3Bn for all the remaining operations. Looking at PBT, Barclays is earning around 6Bn Pounds in 2010 of which 616Mn Pounds were from Absa (which we should exclude since we accounted for it above). Hence the PBT is 5.4Bn Pounds. Assuming 25% for Tax (this is the tax rate they have used for 2010) and 1Bn Pounds for non controlling interests, PAT is around 3Bn Pounds or $4.8Bn.

·         Thus one can buy Barclays at 4x Earnings given that the market value is only $17.3Bn for the remaining operations.

·         Finally, looking at the price at which some of the investors did the deal with Barclays in 2008, the warrants was received for 197 pence vs 155 pence that the share is now available on London FTSE market.

The above factors coupled with the leadership of Bob Diamond makes buying BCS a good deal. The risk is the pervading risk that Europe could go down the tube and that could impact Barclays. Bob Diamond has clarified that they don’t have big sovereign risk in Europe. The main risk is in Italy where they are the top 10 banks. However, since they are a retail bank, they borrow and lend there so the risk of getting impacted should be limited.

  • BAC is not a good investment opportunity for ordinary investors at this time. Management actions have not been shareholder friendly.
  • C is a good opportunity given that its Balance Sheet is clean and C has significant presence in Emerging Markets.
  • BCS is cheaper than C. However, BCS has higher risk as well since there could be a contagion effect from Europe situation.

Disclosure: I own BAC and C stock currently. As prices move I will look to add C and BCS.
Disclaimer: All views expressed in this article are the author’s own views. They don’t represent the views of any company or organization that the author may be affiliated with. This is not a recommendation to buy or sell a stock. You need to do your own diligence before buying or selling a stock.

Sunday, August 14, 2011



BP is one of the world’s leading international oil and gas companies. BP suffered mightily in 2010 due to Gulf of Mexico oil spill. At that time a few brave souls spoke about the value in BP. Whitney Tilson was one of them and his presentation can be found at the following link.

More than a year has now passed and a lot of uncertainty and unknowns have gone away. However, the price of the stock has not moved as dramatically as one would have expected (given how dramatically it moved after the incident). This brings us to today’s value idea.


Company operates in 2 main segments:
·         Exploration and Production
·         Refining and Marketing

Other business including low carbon footprint are clubbed under Other business and Corporate. BP makes it very easy to look at their financials as they provide a s/s. The first stop is to look at the earnings over the last 5 years.

A few key highlights:
·         Exploration & Production is a very profitable business and produces on average 30Bn $ operating profit annually.
·         Refining and Marketing is more volatile business but has been solidly profitable to the tune of 3.75Bn $ operating profit annually.
·         Gulf of Mexico has a big impact on the company and they took a charge to the tune of 41Bn $.
·         Even after the big charge, company has on average over the last 5 years provided net profit of 15.75Bn $ annually. This translate to 4.77$/ADS.

The above 5 years is a great representative years for the company because it accounts for the big changes in oil prices as well as one of the worst operational disasters in BP history. So these numbers are likely to be conservative as we look into the future.
The next stop is to understand how the company has used the above earnings.


A few key highlights:
·         Cash Flow from Operations have been a very significant 26.5Bn $ annually. At a very high level this corresponds to 15.5 Bn $ of Net Profit (seen earlier) and approximately 11Bn $ of Depreciation charges.
·         On average, Cap Ex is 19Bn $ annually. This is funded through Depreciation charge of 11Bn $, 5Bn $ of disposals (see above and net proceeds from disposals vs investments). The remaining is coming from the other operating cash flow.
·         BP has been buying around 5Bn $ worth of shares annually and a big portion of that has been funded by taking on additional debt.
·         Between share repurchase and dividend BP has returned 12.75Bn $ of value annually. At today’s market value of 126Bn, that is annual return of around 10% which is quite significant. This period includes 2010 where the dividend was cut and the company went through significant crisis.

Overall, cash flow analysis gives us the comfort that company has been regularly paying the shareholders back. A 10% yield including share buy back is pretty impressive.


Let us look at the valuation in a few different ways:
·         P/E
·         EV/EBITDA
·         P/FCF
·         EV/Reserves

A few interesting observations from the above:

·         Today’s valuation of BP is as cheap as it has been over the last 5 years. This includes year-end 2010 where the price of 46.1 was higher than the current price of 40.2.

·         On P/E metric, it was closest around end 2008 when it feel to 6. At that time, the world economy was seriously at risk of falling into a deep recession (which it did).

·         On EV/EBIT metric, it was cheaper in 2008. However, that was because the oil prices went close to 150. Currently, we are in the 80-90 range which seems more sustainable.

·         It is interesting to note that FCF is –ve in the first half of this year. However, this may be a reflection of the under investment in 2010 rather than a new trend.

·         EV/BOE is a very interesting metric. BP has been the cheapest on this metric that it has ever been. Here I have assumed that the reserves are the same as they were at the end of 2010.

Not only is EV/BOE the cheapest it has been for BP over the last 5.5 years, it is also the cheapest vs most of its other competitors. The reserve information has been drawn from PBR presentation that I recently went through. It is obvious that BP at 8.63 is half that of PBR. The next cheapest is CHK which has a highly natural gas oriented portfolio.


·         BP is a very stable and solid business that has been able to consistently earn huge amount of profits even under bad economic conditions.

·         On all the key valuation metrics, BP is extremely cheap. It is very interesting to see it trade at <6 times earnings.

·         BP has re-instated its dividend of 42cents/quarter or around 4% which allows investor to get paid while they wait for the market to unlock value.

·         BP is the cheapest of the big oil company when you compare the valuation by $/BOE. This is very interesting because BP has a significant liquid portfolio which earns a much higher return.

With the gulf coast open for business and the company available cheaply it is time to consider a slice of the petroleum pie.

Disclosure: I own BP stock and am looking to add more at the current price.

Disclaimer: All views expressed in this article are the author’s own views. They don’t represent the views of any company or organization that the author may be affiliated with. This is not a recommendation to buy or sell a stock. You need to do your own diligence before buying or selling a stock.