Making sense of BofA's Countrywide buy
Bank of America CEO Kenneth Lewis responds to critics of the $4 billion deal with a detailed look at how he plans to make the investment profitable in just a few years.
NEW YORK (Fortune) -- For Bank of America CEO Kenneth Lewis, it's been a crazy day, the ultimate in Wall Street whipsaw. Early Tuesday, the financial services giant shocked investors by announcing a 95 percent collapse in fourth quarter earnings. When markets opened, Bank of America's stock suffered a massive selloff in what looked like a black day for the country's biggest bank.
Then, in Tuesday morning's second stunning surprise, Lewis regained part of his investors' savaged faith with his promises during a conference call with analysts. The crucial pledge was that Bank of America (BAC, Fortune 500) would hold fast on its dividend, unlike rival Citigroup (C, Fortune 500). Lewis also predicted that the bank would earn $4 a share in 2008, a figure that would make its stock a screaming bargain. Result: Bank of America's stock jumped over 5 percent, to $37.86, while the rest of the market swooned.
Investors are still highly skeptical that Lewis will deliver on his profit pledge. That's why the stock continues to sell at a lowly 9 times his earnings forecast. But bargain hunters should take comfort in Lewis' most recent gambit, his deal to buy Countrywide Financial (CFC, Fortune 500) for $4 billion. I praised the takeover last week ("Why the Countrywide deal makes sense"), arguing that Bank of America is paying such a miniscule price that the deal is practically a guaranteed winner, even assuming the worst - that the Countrywide franchise shrinks substantially, and that Bank of America does little more than wring the usual, routine cost savings.
Last Tuesday, I met with Lewis at Bank of America's New York headquarters on West 57th Street, in a conference room boasting spectacular views over Central Park. During our talk, Lewis revealed his projections on the Countrywide transaction. As I suspected, they're extremely conservative, and even so, Lewis expects to recoup his investment so fast that, if he succeeds, the deal will be a steal - we'll tell you just how fast in a minute.
Lewis discussed how Bank of America bagged Countrywide after making a $2 billion investment to bail out the troubled lender last summer. Lewis says that Countrywide CEO Angelo Mozilo called him in December to discuss a sale. "It was wearing him down," said Lewis. For Lewis, Countrywide was suffering from two problems that Bank of America could fix. The first was the obvious, ruinous exposure to subprime debt, which Lewis describes as "toxic waste." It's well known that Countrywide couldn't securitize and sell that debt, a principal reason it was forced to sell to Bank of America.
The second pressing problem, says Lewis, is Countrywide's dependence on using "wholesale funding," chiefly expensive CD debt that lenders no longer wanted to extend, to finance its mortgage originations. Countrywide had to move far more heavily into top-grade loans so they would qualify for funding from its internal savings and loan. "That slowed them down," said Lewis. "They had to reduce the amount they were securitizing."
Lewis pledges to originate only prime loans, and will fund Countrywide's mortgages with the bank's deposits and borrowings that are far more reliable, and carry far lower costs, than Countrywide's funding sources. He also says that Countrywide suffered from a excessive reliance on "bulk purchases" of mortgages from brokers, chiefly adjustable-rate mortgages (ARMs) and subprime loans with poor credit quality. Lewis says Countrywide will exit the bulk business, but will keep buying from brokers that proved themselves in the meltdown by providing top quality product. He also says that Countrywide will keep purchasing mortgages from commercial banks. "That product is very good," he allowed.
One surprise is that, contrary to my prediction, Lewis won't necessarily rebrand Countrywide as Bank of America. "In spite of all the negative press coverage, when Americans think mortgages, they think Countrywide. We'll analyze it carefully," said Lewis. He pointed out that, although Bank of America usually rebrands its targets (witness Fleet and LaSalle), it's not a universal rule. He's kept the US Trust brand, which, he says, has superior cachet for Bank of America for a private bank.
What really excites Lewis is the prospect of luring mortgage customers to Bank of America credit cards, checking accounts and other lucrative products. Lewis admits that, in general, "cross-selling is very overrated." But he points to a major exception: When a Bank of America branch banker sells a customer a mortgage, the customer buys five additional Bank of America products.
"With our systems, he know where the customer does his or her banking, and which of our products would compete effectively," he said. The problem, he explains, is that most loans are made, not by branch bankers, but by mortgage reps who are well versed in rates, servicing and appraisals and yet aren't expert in selling credit cards and the like. He plans to relocate many of the reps in Countrywide's 1,000 offices to Bank of America's branches. There, they can "hand off" the customer to a branch banker equipped with a full customer profile for a round of intensive marketing.
It's not clear that the "hand-off" idea will work, given the sad history of cross-selling, and the excessive prices paid in its name. Fortunately for investors, Lewis isn't assuming any revenue synergies at all in the Countrywide deal. Here's how the numbers work: Lewis says the Countrywide≠≠≠≠ deal should close in the third quarter≠≠ of 2008 and generate earnings the following year, though he declines to predict how much.
By late 2010, Lewis expects Countrywide to post around $2 billion in after-tax profits. That figure has two sources: $1.3 billion in core Countrywide earnings, and almost $700 million in cost savings. The $1.3 billion forecast is modest: At its peak in 2006, Countrywide was earning about twice that number. Nor is the cost savings number a stretch, given Bank of America's history of paring its acquirees' overhead and systems costs. Best of all, Lewis is assuming not only no revenue improvement from cross-selling, but also no additional savings from funding - and it's obvious that Bank of America can borrow a lot more cheaply than Countrywide.
All told, Lewis expects to recoup his $4 billion investment in three years from the closing in late 2008. "That's what restaurant owners look for - a three-year payback," he said. What's reassuring about this deal is its margin for error. The price is so low, that Countrywide's comeback can be slow and feeble, and the deal can still pay off. Clearly, Lewis loved being in the kitchen for this one - not for the heat, but the can't-miss cooking.