We have been slowly building a position in Bank of America “B” warrants since early 2014 with an average cost of

$0.75 per warrant. We think BAC’s earnings could be over $2.00 per share by full year 2018. Midpoint expected earnings with a modest 15x P/E multiple would correspond to a return between 500% and 1,400% for the B warrants.

Our 2018 model assumes a 5% growth in total bank assets and an after­‐tax return on assets more in line with BAC peers, but below BAC historical highs and best‐in­‐breed.

Background

In 2009 BAC issued “A” and “B” warrants to the US Treasury in connection with receiving a $45 billion TARP bailout package. The “A” warrants are the right to purchase BAC stock for $13.30 per share before January 16, 2019. The “B” warrants are the right to purchase BAC stock for $30.79 per share before October 28, 2018.

Unlike the A warrants, the B’s are overlooked by most BAC shareholders largely because the market cap is only $63 million. They are thinly traded, have a “penny stock” reputation, and are far out of the money. As a result, the price is often volatile and uncorrelated with BAC stock—one of largest and most liquid companies in the US market.

Turn around progress not priced in

The bank’s turnaround progress has been slow and riddled with setbacks. Interest rates have remained low, and settling the US government mortgage lawsuit took longer, and cost more, than expected. Investors are fatigued. However in our view the current valuation does not reflect the platform for elevated earnings power that has been created through years of pain.

Even in a lower interest rate environment than anticipated, earnings should rise considerably over our investment time horizon. We have been encouraged by BAC’s progress in shrinking their cost structure, improving asset quality and focusing on growth initiatives like mobile banking, increased cross selling among business units, and further leveraging Merrill Lynch.

Since 2011, headcount has been reduced by 27%, brick-and-mortar locations have been reduced by 15%, and legacy asset servicing expense (excluding litigation) has declined by 40%. We also think there will be a considerable pickup in traditional home lending over the next 12 to 24 months that will be an unexpected tailwind for BAC. It is inevitable that the industry will transition away from overly conservative requirements for a primary home loan, especially in this rising rental rate environment driven by job growth and pockets of wage inflation.

Additional value drivers through 2018 include a dramatically increased dividend payout ratio and stock buybacks. BAC’s dividend payout ratio averaged 44% of net income throughout the decade before the crisis. Today that would equate to a dividend of over 3%.

This post has been excerpted from the JDP Capital Management 2014 Letter to Limited Partners .

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