Thursday, August 25, 2011

Buffett and Bank of America: Playing Poker with Patsies...

Warren Buffet is famously quoted as saying, "If you have been playing poker for half an hour and you still don't know who the patsy is, you're the patsy". Today, we got a glimpse of Buffett playing poker with Bank of America, and at least from my perspective, it seems clear who the patsy in this game is... it is either Bank of America's stockholders or the rest of us who attribute mystical properties (and uncommon ethics) to the Oracle from Omaha...

So, let's recap what happened. It has been a rough few months for Bank of America stock, prior to today. The stock price had halved between November and yesterday:
Macro factors (the Euro crisis and the S&P downgrade) did play a role in the price decline but the company had itself to blame as well.  It reported a loss of $8.8 billion for the second quarter of 2011, reflecting payments to settle legal claims related to troubled mortgages.While the stock price decline suggested that the market was increasingly pessimistic about the company's future profitability, the company itself indicated that it was sufficiently capitalized to make it through these travails. Earlier this month, the company announced that it would lay off 3500 employees and cut costs, but evoked little positive response from the market.

Today, we woke up to the news story that Warren Buffett, white knight extraordinaire, had ridden to the rescue of Bank of America. 
Here were the terms of the deal:
- Buffett invests $ 5 billion in preferred stock, with a 6% cumulative dividend, redeemable by the company at a 5% premium on face value.
- If Bank of America is unable to pay the preferred dividend, not only do the dividends cumulate but they do so at 8% per annum and the bank is restricted from paying dividends or buying back stock, in the meantime.
- Buffett get options to buy 700 million shares in BofA at $7.14/share, exercisable any time over the next 10 years.

Let's see what Buffett gets out of the deal. Valuing the options with a strike price of $7.14, even using yesterday's low price of $6.40/share, an annualized standard deviation of 50% in the stock price (significantly lower than the 3-year historical standard deviation of 79% and the implied standard deviation in excess of 100% from the option market)  and a ten-year maturity, I estimate a value of $4.30/option or an overall value of approximately $ 3 billion (700*4.30) for the options. (I know.. I know..  Buffett does not like using the Black-Scholes model for long term options...Perhaps, he sold Bank of America's managers on the idea of using the famous Buffett-Munger long term option value model to derive a value of zero for these options...) Netting the $ 3 billion value of the options out of the $ 5 billion investment in the preferred stock makes it a $ 2 billion investment, on which $ 300 million is being paid in dividends. That works out to an effective dividend yield of 15% on the investment. By exercising his veto power over dividends and stock buybacks, Buffett can ensure that he is always the first person to be paid after debt holders in the firm. To cap it off, Berkshire Hathaway will be able to exclude 70% of the dividends received from Bank of America in computing taxable income (this is the rule with inter-company dividends), when paying taxes next year.   That is an incredibly sweet deal! 

What did Bank of America get out of this deal? Let's look at what it did not get first:
  1. It did not get Tier 1 capital (the most stringent measure of bank capital), which includes only common equity, and thus does not get any stronger on that dimension. (Update: I have been getting mixed responses on this issue from those who are well versed in bank regulatory capital rules, some saying that I am right and others that I am wrong. The fact that it is cumulative preferred stock, according to some, makes it ineligible for Tier 1 capital, whereas others note that Citi was allowed in 2008 to count cumulative preferred as Tier 1. Here is one article that seems to provide clarity  on the topic. My final response. Whether this passes the regulatory rule requirement or not, it does not pass the common sense rule for Tier 1 capital. If financing results in a commitment of $ 300 million each year that you have to meet, or roll over, it cannot be true Tier 1 capital, no matter what the rules say... )
  2. It gets no tax deductions, since preferred dividends are not tax deductible. So, the $ 300 million in dividends will have to be paid out of after-tax income.
  3. It risks losing flexibility on dividend policy and stock buybacks, as a consequence of the restrictions imposed on this deal.
The only conceivable benefit I see accruing from this transaction to the company is that Buffett has provided some cover for the managers of Bank of America to make two arguments: that the bank is not in immediate financial trouble and that it is, in fact, a well managed bank. I, for one, am not willing to accept Buffett's investment (or his words) as proof of either, and the way the deal is structured is not consistent with any of the arguments I have been hearing all day (from those who think it is good for Bank of America stockholders).
  • First, let us assume that the bank is not in financial trouble and that the market has run away with its fears over the last few months. But, why would a bank that is not on the verge of collapse agree to raising capital at an after-tax rate of 15% and give up power over its dividend and buyback policy? And given the extremely generous terms offered to Buffett on this deal, how can this action be viewed as an indicator of good management? 
  • Playing devil's advocate, let's look at the other possibility, which is that the bank has been hiding its problems and is in far worse shape than the rest of us think. If so, perhaps the terms of the deal make sense to Buffett (high risk/high return), but the deal still does not make sense to Bank of America. If the bank is in that much trouble, it should be raising tier 1 capital, and adding $ 300 million in preferred dividends to its required payments each year makes no sense. And, if it is in fact the case that the bank is in a lot more trouble that we thought, how can Buffett in good conscience then claim that BofA is a "strong, well-led company"?
Either the terms of deal are way too favorable to Mr. Buffett or he is not being forthright in his description of the company... In either case, this does not pass the smell test.

I know that there are some who are comparing Buffett's deal with Bank of America to his earlier deal with Goldman Sachs. But there is a key difference. The Goldman deal was entered into at the depths of the banking crisis, and in a period where liquidity had dried up, Buffett was providing capital. Even in that case, you could argue that Goldman Sachs paid a hefty price for taking money from Buffett to shore up their standing... Perhaps, this has become Buffett's competitive advantage. Rather than buy and hold under valued companies, which is what he used to do, he focuses on companies that have lost credibility and he sells them his credibility at a hefty price.  I know that Buffett has accumulated a great deal of trust with investors over the decades, but even his stock will run dry at some point in time, especially if he keeps dissembling after each intervention about the company, its management and his own motives.

In summary, is this deal good for Buffett? Absolutely, and I don't begrudge him any money he makes on this deal or the fact that the tax law may work in his favor. Does the deal make sense to Bank of America's stockholders? I don't think so, notwithstanding some of the cheerleading you are hearing from some equity research analysts and the market's positive reaction. Is Bank of America a "strong, well-led" company? Only if you have a very perverse definition of strong and well-led... 

Friday, August 19, 2011

Trapped Cash: Measurement and Consequences

It is an open secret that US companies have accumulated huge cash balances over the last two years. In fact, there were a few mentions that Apple's cash balance of $76 billion gave it more cash than the US treasury a few weeks ago, and I did a post on a while back on whether Apple had too much cash. While this "sitting on cash story" is an interesting one, there is a sub-story that we need to pay attention to and that may affect how we value companies. Not all of cash balances are equally benign. In fact, a significant portion of the cash balance, at some companies, may be "trapped" and thus not easily accessible, either for investments or paying dividends.

What is trapped cash?
Trapped cash refers to the portion of a company's cash that is held a company that is held in fully-owned foreign subsidiaries or units of the company. Note that there is nothing illegal or even unusual about this phenomenon. All multinationals generate revenue, earnings and cash flows in foreign markets, and those cash flows are held (at least temporarily) in those markets. As US companies generate larger proportions of their revenues overseas, the cash flows they generate from foreign markets has also increased.

Why is it trapped?
There are four reasons why cash may be trapped in foreign subsidiaries:
a. Operating reasons: To the extent that there are significant growth opportunities in foreign markets (especially in Asia), the cash is being held in abeyance to cover investment needs in these markets. 
b. Foreign restrictions: In some markets, the country in question has put significant restrictions on remittances from that country back to the United States. To be fair, these restrictions are sometimes tied to incentives or favorable tax treatment offered to the company for investing in the country.
c. US tax laws: Income generated by US companies in foreign countries is first taxed by those countries, when it is earned. However, it is not subject to US taxes until it is remitted back to the United States, with foreign taxes paid allowed as a credit. Thus, if a US company generates $ 1 billion in taxes in China, it will pay the Chinese corporate tax rate of 25% on this income. When that income is remitted back to the US, the income will be taxed at the US corporate tax rate of 35%, with the $250 million in Chinese taxes paid already as an offset. The net tax paid to the US government at the time of remittance will therefore be $100 million. By letting the cash accumulate in the foreign subsidiary, the company will be able to delay paying taxes to the US government. Since the US has one of the highest marginal corporate tax rates in the world, cash accumulation in foreign subsidiaries is a given, with the accumulation being greatest in countries that have marginal corporate tax rates much lower than the United States.
d. Accounting: Adding to the tax law is a GAAP accounting requirement that US companies with foreign income recognize the US taxes that they would have to pay on that income, in the period in which the foreign income is generated (rather than wait for remittance). There is, however, an exception. If the company makes the assertion that it never intends to bring the cash back home, it does not have to recognize US taxes. Not surprisingly, many US companies make this assertion to reduce taxes paid on income statements (and increase after-tax income).
Thus, there is both a cash flow and a reported earnings rationale for holding cash in foreign subsidiaries and the cost of remittance will increase over time, as the foreign cash balance increases.

How big is the trapped cash balance?
There are estimates floating around the blogosphere that put the total trapped cash well in excess of a trillion; a JP Morgan Chase analyst report estimated that 519 US multinationals alone accounted for about $1.4 trillion in trapped cash. The truth is that no one has a precise estimate because US companies are not required to reveal how much of their cash is held in foreign subsidiaries. There are three ways of estimating the amount of trapped cash:
a. Public reports: While companies are not required to break out their trapped cash, some companies do so voluntarily. For instance, Apple in its most recent 10K explicitly broke out the portion of its cash balance that was held overseas; it specified that more than $30 billion was invested overseas (Update: It is estimated that $41 billion of Apple's cash balance of $76 billion in mid-2011 is invested in foreign units). You could extrapolate from the numbers reported by these companies to the rest of the market. Thus, if 55% of the cash balances at companies that report foreign cash balances explicitly is trapped cash, you could assume that a similar proportion applies to companies that are not explicit. The danger, of course, is that companies that are not explicit about their cash holdings may be very different in their behavior than firm that are.
b. Operating exposure: Companies do report what proportion of their revenues and operating income is generated in foreign markets, In 2010, for instance, S&P estimated that 46.3% of revenues of the S&P 500 companies were generated overseas. One could argue that 46.3% of the cash balances of these companies are trapped, though that requires heroic assumptions about earnings and cash remittances at these companies.
c. Effective tax rates: If we assume that companies that trap cash in foreign subsidiaries also adopt the consistent accounting rule (of asserting that they do not plan to bring that cash back to the US), the effective tax rate of a company should provide some information on its cash trapping practices: the more cash that is being trapped in foreign subsidiaries, the lower the effective tax rate for the company should be.
No matter how you measure the magnitude of the trapped cash, we know that it is a very large number. How? Well, companies are spending millions of dollars lobbying Congress to change the tax laws on remittances and they would not be doing this, if there were not billions at stake.

So, what if cash is trapped?
Now, to the billion dollar question. Why does it matter whether cash is trapped or not? Put in more general terms, does this trapped cash have any consequences for corporate finance, valuation and the general well-being of US companies? I think it does and here are some reasons why:
a. Trapped cash may be wasting cash: In most valuations, we treat cash as a neutral asset, i.e., we value a dollar of cash at a dollar and add the cash balance on to the value of operating assets to arrive at firm value. However, cash is a neutral asset only if it earns a fair market return, given the risk and liquidity of the investment. Investments in treasury bills and commercial paper may earn a low rate, but a fair rate, of return and are thus neutral investments. Cash trapped in some emerging markets may not be as easily invested in fair market return investments. In fact, it is possible that the closest selection to a liquid, risk less investment is a bank deposit delivering interest income much lower than justified. That cash will have to be discounted and the value of the firm will decrease as a consequence.
b. Trapped cash may create financial constraints (and costs): It is possible that a company that has significant portions of its cash trapped in other markets may have to raise new financing (debt or equity) to carry out transactions or worse still, not take good investments because it does not have the capital available to do so. Thus, you may have the oddity of a company like Google with $20 billion in a cash balance issuing $ 3 billion in bonds to make an investment. The value of the firm will be reduced by the transactions costs associated with the new financing (if new financing is raised) or the value lost by turning down good investments (if investments are rejected).
c. Trapped cash may induce "bad" investment decisions: Companies with significant trapped cash may jump at the chance of using that cash, even if the investments taken offer sub-par returns. The defense will be that they have nothing better to do with the cash. This is the rationale that was offered by some for Microsoft's acquisition of Skype, a Luxembourg based company that allowed Microsoft to use up $8.5 billion of its trapped cash. I have argued earlier that Microsoft over paid for Skype. The fact that they were able to use trapped cash is small consolation and does not alter the value destructive aspects of that transaction.

How can this cash be released?
If you accept the premise that trapped cash can be value destructive, at least for some companies, then the question becomes one of how best to "untrap" this cash. Here are the options:
a. The punitive solution: The tax law can be changed to require that all income generated by US-based corporations will be taxed at the US tax rate, when the income is generated, even if it is in foreign subsidiaries. While this solution may be appealing to those angry at corporations, it will be counter productive and may very well backfire. In particular, note that a multi-national does not need to be US-based and it is conceivable that many multi-nationals will chose to switch their incorporation to a more benign tax regime rather than pay billions more in taxes each year.
b. The benign solution: The tax law can be changed to eliminate the "differential tax" (reflecting the difference between the US corporate tax rate and the foreign corporate tax rate) when income is remitted back to the United States. That will eliminate both the tax and the accounting rationales for trapped cash but will be a tough sell politically.
c. The bad solution: The worst solution to adopt is one that provides the illusion of being punitive without the tax revenues to go with the punishment. That is effectively what we have right now, where remitted income is subject to a differential tax but where every decade or so, we have a tax holiday where companies are allowed to bring trapped cash home without paying the differential tax. 
What do I see happening? I think that there will be a tax holiday, either explicitly or implicitly allowing companies to bring trapped cash home without the differential tax bite (or at least a fraction of the tax bite). The legislation will be accompanied by face saving adjuncts: a requirement (toothless and unenforceable) that companies that bring home cash invest in "job creating" investments and a promise that this will be the last tax holiday ever (Yeah... right...) The stock price impact of the legislation will be minimal even for companies with large trapped cash balances. The day after the tax holiday firms will go back to accumulating more foreign cash and waiting for the next tax holiday.

If the cash is released, what will happen?
As talk of a tax fix fills the air, proponents of the tax holiday are already thinking about what they see emerging in the aftermath, with each group seeing their preferred option winning out.
  1. The first group believes that the freed cash will be used by companies to make new investments and "create jobs". In my view, that's not going to happen! US companies have plenty of cash on hand already and are not taking new investments. Why would adding to the hoard change that? The roots for sagging real investment in the US are in a stagnant economy with excess capacity on most fronts, where good investments are scarce. I know that there is talk of linking a change in the tax law to "forced investment", where firms will have to invest remitted cash into job-creating investments to qualify for the tax benefits. That will create more harm than good.
  2. The second group is convinced that they will see stock prices pop up for companies with significant cash balances, as the discounts that markets have applied to the trapped cash disappear. That too is a misconception. To the extent that the expectation that the tax law will be changed has already been built into market prices, the actual change (if and when it happens) will not be a surprise. 
  3. The third group sees the released cash as potential dividends and buybacks. History suggests that they have some reason to be optimistic, since that is exactly what happened the last time there was a tax holiday for foreign cash. While the higher dividends and buybacks will increase cash returned to stockholders, it will be partially (or perhaps even fully) offset by a decrease in equity value as cash leaves these companies.
In summary, a tax holiday is likely to be a non-event for markets and have little impact on corporate investment or economic growth. 

    Monday, August 8, 2011

    Momentum versus Contrarian: Two Reads of the ERP

    I am not much of a market timer but there is one number I do track on a consistent basis: the equity risk premium. I follow it for two reasons. First, it is a key input in estimating the cost of equity, when valuing individual companies. Second, it offers a window into the market mood, rising during market crises.

    For the ERP to play this role, it has to be forward looking and dynamic. The. conventional approach of looking at the past won't accomplish this. You can however use the current level of the index, with expected cashflows, to back out an expected return on stocks. (Think of it as an IRR for equities.) You can check out the spreadsheet that does this, on my website ( on the front page.Here is the link for the July 1 spreadsheet. Just replace the index and T.Bond rate with the current level and use the Goal seek in excel:

    A little history on this "implied ERP": it was between 3 and 3.5% through much of the 1960s, rose during the 1970s to peak at 6.5% in 1978 and embarked on a two decade decline to an astoundingly low 2% at the end of 1999 (the peak of the dot com boom). The dot com correction pushed it back to about 4% in 2002, where it stagnated until September 2008. The banking-induced crisis caused it to almost double by late November 2008. As the fear subsided, the premium dropped back to pre-crisis levels by January 2010. I have the month-by-month gyrations on my site, also on the front page.

    Now, to the present. The ERP started this year at 5.20% and gradually climbed to 5.92% at the start of August. Today (8/8/11) at 11.15 am, in the midst of market carnage, with the S&P 500 at 1166 and the 10-year T. Bond at 2.41%, the implied ERP stood at 6.62%.

    So what? If you are a contrarian, you could view this as an opportunity: a return to past norms (4-5% ERP) would translate into a 30-40% jump in the index). If you are a momentum investor, you see the thundering herd and join in, selling short or buying puts. If you are a fence sitter, you are liquidating your stocks and holding cash, waiting for steady state (which may be a long time coming). My last post should provide enough clues as to where I stand but if you are in one of the other camps, I will not try to convert you. Different strokes for different folks!

    Saturday, August 6, 2011

    Chill, dude! It is not the ratings downgrade.. It is how you react to it!

    Sorry about the title, but I am in Southern California, in surfer terriotory! I guess that the debt ceiling debate was not the end game it was made out to be. In spite (or perhaps because) of the fact that the debt ceiling was raised by Congress, S&P decided to downgrade the sovereign rating for the US from AAA to AA+. As the headlines trumpet the news and the airwaves are filled with self-styled experts telling us how this will change the world as we know it, it is useful to step back and ask a few questions about yesterday's momentous events:

    1. Was there  "information" in yesterday's ratings change?
    Let's see. S&P's rationale for the ratings change is that the US has a lot of debt, that it is adding to with large continuing deficits, that are perpetuated by a dysfunctional political system. Duh! I don't think any of us needed S&P to tell us this... I don't see any news in this ratings change. You may wonder why that rationale cannot be applied to any ratings change, for corporates as well as sovereign ratings. And it can... For well-followed corporates, ratings changes are almost never big news with the bulk of the effect occurring before the change is made. The confirmation of conventional wisdom does carry some weight, but not very much. Ratings agencies are like those guests who show up at the party just as it is breaking up, too late to join in the fun and not early in to make a difference.

    2. What do ratings agencies do?
    Ratings agencies are "measurers", not "diagnosticians": they can tell you (they think) that something is wrong but they are not very good at telling you why or what to do about it. I think that S&P is pointing to the fact that the default risk in US government debt has increased over the last year and I think that they are right on that count. Beyond that, though, I would not lend too much credence to any of the policy changes that they feel will alleviate the problem... and the answers to the next two questions should explain why...

    3. Can bad things follow this downgrade?
    Of course, but it is not the downgrade itself that would worry me.. it is the reactions to the downgrade. We have seen the script before and here is the most negative (and unfortunately, most likely scenario). First, you will have representatives of the downgraded entity (in this case, the US treasury) argue that the ratings agencies got it wrong. Second, the same entity will do everything in its power to make the ratings agencies happy so that they can reclaim lost glory.
    I cannot predict the end result here, but corporations that have played this game have almost always lost. Fighting a ratings agency just prolongs the effect of the ratings action and gives the ratings agency even more power. You cannot run a healthy business (or economy) with the objective of keeping ratings agencies happy. After all, if a business were run with the sole objective of minimizing default risk, it would not borrow much, it would never take risky investments or pay dividends. It would just be a pile of cash backing up debt obligations. The bankers will be happy but who else would gain? You can draw the analogies to an entire economy yourself....

    4. Can good things follow this downgrade?
    In a perverse way, a ratings downgrade can free decision makers to focus on what matters. With a business, this would translate into decisions that maximize the value of the business rather than maintain a high rating. An interesting article in the NY Times a few days ago highlights this proposition:
    Note that this does not mean that default risk is not a factor in decision making but rather that ratings are an artificial constraint.
    Can the same rationale be applied to a government? I don't see why not. Now that the bogeyman of "losing the AAA rating" is out of the closet, it can focus on policies that make the economy more vibrant, with the constraint of keeping default risk (and deficits) under control. If I were Tim Geithner, on Meet The Press tomorrow, I would not waste my time arguing with S&P about whether the ratings downgrade was merited on or not. Instead, I would accept it as a fait accompli and move on to set the agenda for what I would do in terms of economic policy. Am I hopeful that this will happen? Not really... but I am glad that I am not the Secretary of the Treasury at the moment...

    At the risk of adding my voice to the cacaphony, here is what I would suggest. The worst thing that investors, analysts, legislators and policy makers is to change the tried and the true (ways to invest, analyze companies or set policy) because S&P has changed a rating. The best thing that they can do is to realize that the world has not changed over the last 24 hours and to use common sense as a guide to good practice. For investors, this will mean staying diversified across asset classes and globally in their asset allocation decisions, and due diligence in picking companies. For analysts, it will require going beyond assuming that the government bond rate is the riskfree rate and using historical risk premiums. So, my advice is that you skip the S&P press conference on Monday, stop reading newspapers for a couple of weeks and take a break... I am...