Why the Countrywide deal makes sense

(Fortune) -- Bank of America's $4 billion deal to rescue Countrywide Financial is getting decidedly mixed reviews from Wall Street. Investors fret that CEO Ken Lewis is overpaying for a ruined franchise to save face, following his ill-timed $2 billion investment in Countrywide late last year.

The markets are hardly cheering: B of A's stock has dropped as much as 2% today to $38.40, its price in early 2002. But the best guide to gauging the probable success or failure of this deal is studying the numbers: they show that, barring absolutely disastrous writedowns, this deal will prove a winner.

Before we get to the all-important math, let's examine two other important reasons to endorse this deal. The first is Ken Lewis' consistently underrated record as an acquirer. Investors accused Lewis of overpaying for Fleet BankBoston in 2004, but Lewis recognized what the market didn't: That Fleet¹s earnings were poised for a sharp rebound following years of huge credit losses. B of A also generated far bigger cost savings than Wall Street, or even the bank itself, anticipated by shuttering inefficient branches and combining computer systems.

Skeptics are leveling the same charges against Lewis in his $21 billion purchase of La Salle, a deal that gives B of A a huge footprint in a market where it was heretofore weak, the Chicago region. But once again, it's probable that higher-than-anticipated cost savings will save the day. It's more likely that Lewis is following his usual course of weighing the numbers rather than making an irrational, emotionally charged decision.

A second reason the deal makes sense is the branding issue. To be sure, Countrywide (CFC, Fortune 500) established a powerful brand name in the mortgage boom. But its image is now severely tarnished. The lender is now a poster child for all the excesses of the real estate bubble. Sure, it's possible that the Countrywide name could be revitalized. But why take that chance? The best way to extract value from buying Countrywide is to keep its powerful origination and servicing franchises, and re-brand its product to erase the unsavory associations that the Countrywide name now raises with America's borrowers.

Of all the big banks, B of A is in the best position to do that - for a simple reason. It boasts the strongest brand in banking. Its Hispanic customer base, the biggest source of its growth, has great confidence in the Bank of America brand, and B of A has shrewdly targeted its offerings to that market. It's inevitable that B of A will rebrand Countrywide as Bank of America (BAC, Fortune 500). As a result, what's now a fallen name will quickly take on new luster.

Now, let's examine the make-or-break numbers. B of A is paying around $4 billion for a franchise that was worth over $20 billion just a year ago. Sounds like it's paying a cheap price. But is the price really cheap? The best way to find out is to use the discounted cash flow technique you learn in Econ 101, and that still proves a valuable guide to estimating the future returns on investments.

To play it safe, let's make some highly negative assumptions. Say that Countrywide takes a $3 billion writedown for 2008, or $2 billion after-tax, and makes no money at all in 2009. Starting in 2010, it returns not to its peak earnings, but to the profits it was generating in the 2003 and 2004 period, around $2 billion a year. Also, let's say that Countrywide's profits remain flat from then on, simply increasing with inflation.

Given those assumptions, what's the present value of Countrywide's estimated earnings if B of A is to achieve a 10% return, and how does it compare with what Lewis is paying? By my calculations, Countrywide's earnings stream is worth around $13 billion. B of A is paying $4 billion. Sure looks like a winner.

But let's say the writedowns are far bigger than anticipated, and that Countrywide faces heftier payoffs on class action suits than Lewis is predicting. Fair enough, but Lewis enjoys just what Warren Buffett calls the most important thing in investing, a big margin for error. Put simply, Countrwide could suffer another $9 billion in after-tax losses, and B of A would still make a 10% return.

B of A could get an additional margin for error by trumping the highly negative assumptions. When you invest at a low price, the bar is set far lower for future performance, so any improvement makes the stock worth far more. For example, it's highly unlikely that Countrywide's earnings won't grow at all once it recovers. Lewis could also gain big economies of scale that could actually boost Countrywide¹s profits above the $2 billion mark, by cutting overhead and combining Countrywide outlets with B of A's network of over 6000 branches.

The mortgage industry is still a lot like the banking industry was when Lewis was vacuuming up regional banks under Hugh McColl at NationsBank. That fragmentation led to inflated costs, just as it did in banking before the massive consolidation of the last decade and a half. Sure, this deal could still fail. But the numbers sure look good.