Citigroup released Q2 earnings this morning. The shares reacted positively at the open, but sold off during the morning. Tangible book value increased to $48.75, so the stock trades at 80% of TBVPS. Credit continues to get better. Here are some of my thoughts on the release and the conference call:
1. Credit losses declined 18% Q/Q and 35% Y/Y. Loan Loss Reserve release declined to $2B from $3.3B in Q1, so earnings are higher quality compared to Q1.
2. One negative that I see throughout the release is the negative operating leverage across the businesses. In the Citicorp segment, revenues declined 1%, but expenses increased 5%. It seems like Citigroup continues to have an elevated level of investment spending in its core business. We’ll have to wait until 2012 to see how this translates into revenue growth. on the conference call, there were many questions about expenses. management called out three drivers of high expenses: 1) adverse FX moves, 2) higher legal costs, and 3) investment spending. I think the FX issue is a little smoke and mirrors because there should be offset revenue gains. The legal costs will eventually go away and are certainly not as problematic as BAC’s issues. The last is investment spending. They said they expected Latin america and Asia to show positive operating leverage in Q4 this year. The other businesses will not show operating leverage until at least 2012, but probably late 2012.
3. In Citicorp, managed loans grew 27% Y/Y which is both exciting and troubling. It could reflect Citi taking advantage of the faster growth of these markets and their strong global brand. On the other hand, the most dangerous banks are the ones that are growing fast in risky lending segments. I would define lending in emerging markets as risky.
4. The story in CitiHoldings is improving rapidly. Net loss in this segment declined to $200M. They are steadily reducing assets in this segment through paydowns and sales.
5. Several times in the press release and the investor presentation, management makes comments about returning capital to shareholders in 2012.
6. One of the side benefits of Citigroup reporting profits is it utilizes its deferred tax asset (DTA) so it improves the quality of the company’s capital.
7. As Citigroup winds down the assets in CitiHoldings, it is reducing its risk-weighted assets. This will make compliance with Basel III capital requirements easily attainable.
8. On page 26 of the attached earnings presentation, there is a review of Citigroup’s exposure to the PIIGS. It does not appear outsized.
9. I believe Citi should retain the retail partner cards business. Although the CFO stated the business does not fit with Citi strategically, it is simply not the right time to be marketing this business. The business is profitable and generating $3 billion in pre-tax net income. They should retain it for a few years, use the pre-tax profits to absorb so of their DTA, and sell it down the road when the market again places a premium on credit card receivables.
Overall thoughts: At 80% of of tangible book value and with as much as $30B in excess capital, it is difficult to see how there is much downside to C’s stock price relative to the overall market. The credit improvement has been rapid. At the current stock price, the if the company can repurchase stock in 2012, it will be materially accretive.
Disclosure: Long C
Disclaimer: This is not investment advice. This intended to be a window in my analysis of C’s earnings report. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
This post is an excerpt from the 1st Quarter Investor for my hedge fund. If you would like to receive a full copy of the letter, please send me an email at derek.pilecki@gatorcapital.com.
I started a short position in Walter Investment during the last week of the quarter when they announced a huge unexpected acquisition. Walter Investment was successfully spun-off from Walter Energy in early 2009. The company operates a sub-prime mortgage servicing business that had been an affiliate of its former parent’s home building division. Walter closed the home building division prior to the spin-off. Walter Investment’s servicing platform has a good system for collections, and the company had always retained its own loans, so underwriting stayed strong compared to the rest of the industry.
Since the spin-off, the company had been looking for a way to grow. Because Walter had closed down its home building business and lending platform, the company did not have a natural way to originate or add loans to its servicing platform. The existing portfolio of loans throws off attractive but declining cash flows, so Walter pays an attractive dividend but cannot increase it. The company’s strategic plan had been to purchase small portfolios of mortgage loans from distressed banks in the Southeast to grow its portfolio of loans. Management thought they could find some bargain portfolios to purchase and use their strong mortgage servicing platform to rehabilitate the purchased mortgages.
Although it had completed a small deal or two in this area, late in the 1st Quarter, the company announced the very large acquisition of Green Tree Credit Solutions, which owns a mortgage servicing portfolio and platform focused on special servicing of problem mortgages. Special servicing is a high-touch servicing of delinquent loans. In its investment presentation, Walter points to the growth of special servicing business and the large earnings per share accretion in the deal as compelling reasons for the acquisition. I believe Walter is making a poor strategic and financial decision by acquiring Green Tree. Here’s my short thesis:
1. Buying Green Tree at the Peak of the Cycle – The special servicing business has grown as the balance of outstanding delinquent mortgage loans has grown. However, we are seeing delinquencies decline industry-wide as the flow of newly delinquent loans slows. Walter’s own investment presentation shows slowing growth of the addressable market as the flow of new mortgage delinquencies declined from $1.9 trillion in 2009 to $1.7 trillion in 2010 and is projected to further slow to $1.4 trillion in 2011, $1.0 trillion in 2012 and $0.8 trillion in 2013.
2. The Acquisition creates Massive Tangible Book Value Destruction – Walter’s management team points to the earnings accretion from the deal, but the book value destruction of the deal is devastating. Walter’s current tangible book value is $21.54 per share. I estimate that the book value will drop close to zero per share. The payback of book value from the earnings accretion will be 15-20 years.
3. Sellers are Taking 97% of Deal in Cash – The current owners of Green Tree do not see the value of holding a stake in the combined entity. Instead, they are willing to pay taxes to get cash now. I suspect they see their growth slowing and are happy to walk away with a decent multiple on peak earnings for a very cyclical business.
4. Green Tree’s platform duplicates Walter’s existing platform – Walter gains close to nothing with this acquisition because Green Tree’s servicing platform is so similar to Walter’s existing platform. Plus, the expense synergies are almost completely wiped out by higher taxes as Walter moves from a REIT to a C-corp.
Walter is trading at only 7x pro forma earnings, so the stock is inexpensive if I am wrong that these are peak earnings for Green Tree. However, Walter’s management is buying upwards of $1 billion worth of intangible assets on a $500 million equity base. The margin for error here is low with little downside protection.
Texas Capital Bancshares (TCBI) is an interesting organic growth banking story, but the bank’s declining credit metrics make it a better short from here. The bank is 12 years old and has grown by lifting out relationship bankers from the big banks. These relationship bankers bring their best customers over to TCBI. This is an efficient and capital friendly growth strategy. This strategy also allows the bank to grow even in periods of weak loan demand.
However, the credit metrics of the bank have deteriorated significantly over the past 4 quarters. The only potential catalyst that matters is a sign stability in the bank’s credit metrics. The next data point won’t be for another 7 weeks when the bank releases Q3 numbers.
Here’s a look at the credit numbers for TCBI
| |
2009 Q2 |
2009 Q3 |
2009 Q4 |
2010 Q1 |
2010 Q2 |
| Loans Outstanding |
$4,211 |
$4,290 |
$4,457 |
$4,443 |
$4,463 |
| |
|
|
|
|
|
| Loan Loss Provision |
11.0 |
13.6 |
10.1 |
13.1 |
15.7 |
| Net Charge-Offs |
6.8 |
2.8 |
8.0 |
9.3 |
12.6 |
| Loan Loss Reserve |
54.3 |
65.8 |
67.9 |
71.7 |
74.9 |
| |
|
|
|
|
|
| Non-Accrual Loans |
49.6 |
85.3 |
95.6 |
115.9 |
138.2 |
| Other Real Estate Owned |
31.4 |
34.7 |
27.3 |
28.9 |
42.1 |
| Non-Performing Assets |
81.0 |
119.9 |
122.9 |
144.8 |
180.3 |
| |
|
|
|
|
|
| Non-Accruals/Loans |
1.18% |
1.99% |
2.15% |
2.61% |
3.10% |
| Reserves/Loans |
1.32% |
1.54% |
1.55% |
1.63% |
1.68% |
| Reserves/Non-Accruals |
109% |
77% |
71% |
62% |
54% |
| |
|
|
|
|
|
| Tangible Common Equity |
456 |
466 |
473 |
491 |
504 |
| Texas Ratio |
16% |
23% |
23% |
26% |
31% |
TCBI’s numbers are showing a disturbing trend. Non-accrual loans have accelerated the past two quarters. Plus, it looks like management has not been adding to the loan loss reserve aggressively as non-accruals have climbed.
One could argue that TCBI has been under reserving for loan losses during the past 4 quarters. The loan loss reserve to non-accrual loan ratio has declined from 109% to 54% over the past 12 months. If management had kept this ratio constant, TCBI would have report a losses instead of profits over the past 4 quarters.
TCBI shares trade 1.15x tangible book. I think the profitability of the bank is questionable given the declining reserve ratios. If you add in the worsening credit metrics, I think TCBI will have a lid on its stock price until it reports a quarter with stable credit metrics. Since TCBI is well-capitalized, the viability of the bank is not in question. But, the decline in the credit quality suggests that the credit issues are open-ended. I think investors should demand a discount to book value to own a bank stock with credit quality continuing to worsen at rate like this. At 70% of tangible book, the stock would trade at $9.50 or a decline of 35% from the current price.
This weekend’s New York Times had a flattering Andrew Martin article on BB&T’s John Allison. I think it is joke for Allison to benefit from a huge government subsidy like FDIC insurance and at the same time, to present himself as anti-government/objectivist. His thought process is intellectually dishonest. He talks as though banks are purely private institutions and would still exist in their current form without FDIC insurance. I have news for him: banks exist today only because of the federal government provides backstop FDIC deposit insurance.
FDIC insurance is a large government subsidy program to help bankers attract deposits. FDIC insurance is critical to a bank because most of the value of a bank comes from its deposit base. With FDIC insurance, bank customers (depositors) are indifferent to the safety of the bank. Instead, depositors base their choice of banks based on rates offered, levels of customer service and branch locations. Without FDIC insurance, banks would have to run with much lower levels of leverage and much high levels of liquidity to attract deposits based on safety and stability. These measures would guard against bank panics or runs; however, lower leverage and higher liquidity would also dampen profitability for the bank.
Another beef I have with Allison is his blaming the housing crisis on Fannie and Freddie. It has been well documented that Wall Street led the credit bubble in the housing market with the expansion of the non-agency mortgage market, specifically the explosion in subprime and Alt-A lending. Fannie and Freddie lost market share from 2002 to 2007. If they were losing market share, how did their actions lead the housing market to its bubble status? See the series of articles on Univ. of Oregon Prof. Mark Thoma’s blog for a more complete discussion on how Wall Street led the mortgage market to a credit bubble. Allison’s blame of Fannie and Freddie seems like a convenient, popular position that fits into his distorted anti-government view.
If Allison truly wants to prove he lives his life abiding by Ayn Rand’s objectivist philosophy, he should have BB&T’s board vote to renounce the company’s bank charter. Then, we’ll see how long a bank run by an objectivist is able to maintain its depositor base and remain in business. I suspect the bank wouldn’t last long.
