Why the Countrywide deal makes sense

Whether Wall Street likes it or not, Bank of America's Ken Lewis is getting a good deal, according to Shawn Tully's number-crunching.
By Shawn Tully

(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 Fleetนs 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 Countrywideนs 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.

BofA's awesome Countrywide tax break

Brace yourselves, taxpayers of America. You're going to help Bank of America finance its $4 billion buyout of Countrywide.
By Allan Sloan

NEW YORK (Fortune) -- Guess who's helping Bank of America pay for its $4.1 billion purchase of Countrywide Financial? Answer: The taxpayers of the United States.
That's because Bank of America (BAC, Fortune 500), which is solidly profitable, will be able to use some of Countrywide's losses to offset its own taxable income. The tax break could total about half a billion dollars over the first five years, according to an estimate by tax guru Robert Willens, who left Lehman Brothers Friday after a 20-year run and will be in business as Robert Willens LLC starting next week. The losses could be worth considerably more to Bank of America starting in the sixth year, depending on how big Countrywide's losses are when Bank of America formally acquires it.
At this point, of course, no one knows how much in losses Countrywide has run up since the junk mortgage market began souring and defaults accelerated. Countrywide (CFC, Fortune 500) itself probably doesn't know. But it seems almost certain to ultimately be in the billions.
In tax circles, Bank of America is famous for its 1988 purchase of the failed FirstRepublic Bank of Dallas, which was being auctioned off by federal regulators. Bank of America, then known as NCNB Corp., the parent of North Carolina National Bank, discovered a way to structure the deal to save $1 billion of taxes, using a convoluted strategy that none of the other bidders knew about. That allowed NCNB to outbid its rivals for the bank, and still come out way ahead.
The Countrywide tax break isn't in that league, but it would still be worth a lot of money. Willens estimates that Bank of America will be able to deduct $270 million of Countrywide's losses annually for the first five years it owns the firm.
That's based on a $6 billion purchase price - $4 billion to Countrywide's common stockholders, plus the $2 billion of preferred stock that Countrywide sold to Bank of America in August. Willens says that you multiply that $6 billion by 4.49 percent - the so-called "long-term tax-exempt rate" - to calculate how much of Countrywide's losses Bank of America can deduct annually for five years after the purchase.
A $270 million annual deduction would save Bank of America something more than $100 million a year in federal and state income taxes. The long-term tax-exempt rate, which is based on Treasury rates and other things so complicated that they make my teeth hurt. The rate changes each year, Willens says, but not by much. When I asked how it's calculated, Willens, a master of tax arcana, threw up his hands. (Metaphorically, of course.) "It's like the formula for Coca-Cola," he said, "no one outside the circle knows it" and it's so complicated that, "no one else wants to find out."
So over the first five years, Bank of America can use a total of $1.35 billion of Countrywide's losses to shelter its income. (That's five years of $270 million annual losses.) If Countrywide's embedded losses when Bank of America buys it exceed $1.35 billion, Willens says, the bank will be able to deduct the rest of the losses, without limit, starting in the sixth year.
Isn't life fun?

Apple: What've you done for me lately

Shares of the iPod maker more than doubled in 2007. With Macworld coming up, what can Steve Jobs and Apple do for an encore this year?
By Kenneth Musante

NEW YORK (CNNMoney.com) -- Apple had a banner year in 2007. The stock more than doubled thanks to strong sales of the new iPhone, revamped iPods, and updated Macs.
But that was last year. Now investors want to know if Apple can live up to Wall Street's lofty expectations for 2008.
Tech stocks have taken a big tumble so far this year and Apple (AAPL, Fortune 500) is no exception, with shares falling about 10 percent.
With that in mind, investors will be paying a lot of attention to what Apple chief executive officer Steve Jobs has to say during his keynote address at the company's Macworld show on January 15th.
Last year, Jobs unveiled the iPhone at Macworld. So Wall Street is hoping Jobs can once again deliver some exciting news to get the stock back on track.
A new 'Touch' for the iPod
Investors will definitely be looking for any announcements about updates to the company's popular iPod. Despite that product's runaway success, some analysts say that Apple has started to reach the saturation point with its portable media player. "Everyone who wants one has one," said Technology Business Research analyst Ezra Gottheil.
Morgan Keegan analyst Tavis McCourt also wrote in a recent report that he's concerned about slowing growth in iPod sales.
He cited the fact that the number of iPods sold in the company's fiscal fourth quarter, which ended in September, increased just 17 percent from a year ago, down from 50 percent growth in unit sales in the company's fiscal first quarter.
But just before the holiday season, Apple released the iPod Touch - basically an iPhone without the phone. The device's ability to access the Internet and its emphasis on video makes it more than just a standard iPod. So analysts said they are confident the iPod Touch could rejuvenate sales growth for the iPod product line in 2008.
Apple could also benefit from falling component prices. McCourt noted that NAND flash memory chips, which are used in the iPhone, iPod Nano, iPod Shuffle, and iPod Touch, have been getting steadily cheaper, which could boost the amount of profit Apple generates from the iPod and other consumer electronics devices.
And analysts said that other announcements from Macworld may also be viewed positively by investors. Trip Chowdhry of Global Equities Research, predicts Apple will unveil an update to Apple TV, a device that lets people view videos stored in their iTunes library on their television sets.
There has also been speculation that Apple will announce plans to allow movie rentals on iTunes through a partnership with News Corp.'s (NWS, Fortune 500) Fox studio. Gottheil said that even though revenue from iTunes is still relatively small, anything that can help increase movie and music downloads would be helpful since this should also boost demand for new iPods.
Thin is in
Of course, Apple still relies heavily on computer sales -- even though the company dropped the word "Computer" from its corporate name last year and now generates more than half of its total sales from non-Mac products.
At this year's Macworld, analysts suspect the company will round out its MacBook line with a new ultra light notebook.
A highly portable computer with long battery life and a flash drive instead of a delicate hard disk is something that Apple doesn't have right now, said Chowdhry.
He argues that if Apple unveils a new MacBook, that could open Apple's laptop line even further to new customers.
Gottheil disagreed with the idea that an ultra portable would bring in new customers. Still, he said that even if Apple simply got existing Apple fans to buy newer MacBook models, this would still benefit Apple because the new MacBooks would likely generate higher profit margins.
And that would be good news for Apple shareholders since Mac sales have been what's really driving growth for the overall company lately.
In the company's fiscal fourth quarter, Mac sales rose 40 percent from a year earlier to $3.41 billion. iPod sales, on the other hand, increased only 4 percent to $1.6 billion. So if the iPod Touch isn't as big a hit as analysts expect, the company will need to depend even more on the Mac to keep sales and profits growing.
No worms in this stock
With all this in mind, how will Apple's stock fare this year. David Bailey of Goldman Sachs wrote in a report earlier this month that he doesn't believe 2008 will be as "explosive" as last year, but that Apple's stock should head higher over the next twelve months.
He expects Apple's upcoming fiscal first-quarter earnings announcement, which includes sales during the key holiday shopping season, to prove that Apple is still a great growth stock.
Apple will report its results on January 22. Analysts predict revenue will grow 32 percent to about $9.4 billion and that profits will soar 40 percent to $1.60 a share.
Apple's string of healthy results come at a steep price, however. The stock trades at nearly 35 times fiscal 2008 earnings estimates.
That's much higher than the valuations for rivals Microsoft (MSFT, Fortune 500) and personal computer maker Dell (DELL, Fortune 500), which trade at 19 times and 13 times earnings forecasts for this fiscal year respectively.
Still, Apple has consistently smashed Wall Street's earnings per share estimates over the past year. And the company's projected earnings growth rates of 30 percent this fiscal year and 22 percent a year, on average, for the next few years, is much higher than most other large tech companies.
Chowdhry said investors should probably not try and make short-term trades on the stock though. He warns that investors who buy now just because they think Jobs will make an announcement at Macworld that will send the stock higher could be setting themselves up for disappointment.
But analysts said Apple is a good buy for long-term investors who can avoid being influenced by day-to-day volatility. Investors who want to make a bet on the company's ability to keep coming out with the hottest new gadgets and delivering strong earnings will eventually be rewarded.
Analysts quoted in the story do not own shares of Apple.