Citigroup: Collateral Damage from Bank of America
Sep/111
This is the second of a three part posting on Citigroup. The first part explored how I own Citigroup and other large banks despite the risk of a systemic collapse if there was a hard Greek default. The final part will review a list of reasons why investors avoid Citigroup and how I overcome these objections.
Bank of America has been in the headlines about its mortgage exposure and capital situation. Its stock is down 42% this quarter through September 23rd, but Citigroup, which I do not believe has similar problems, is also down 40%. In fact, the two stocks seem to be perfectly correlated. It appears that investors are making macro trades against the banking sector without doing fundamental research on the individual companies within the sector. I do not know whether investors are just scrambling to hedge exposures using any bank stock they can find or whether they are expressing their views mainly through sector ETFs. However, good stock pickers appear to have an opportunity within the banking sector since the stocks have moved in such close correlation during the quarter.
I have been adding to my Citigroup position at recent levels. It has a tangible book value of $48.75 as of June 30th, but is trading around $25, or at about 50% of tangible book value. It trades at this discount to book value in spite of reporting profits the last six quarters, having improving credit metrics, building capital, an improving its business mix, and potentially beginning a stock repurchase program next spring.
Bank of America trades at a similar 50% of June 30th tangible book value despite what I perceive as having much higher uncertainty about legacy mortgage costs and having recently diluted common shareholders through the preferred stock and warrant sale to Berkshire Hathaway announced in late August.
It seems to me that Citigroup is being unfairly tarnished by Bank of America’s problems and is a better stock to own at the same valuation. An investor could own Citigroup and short Bank of America as a hedged pair trade. I own both stocks, but my position in Citigroup is much larger than my position in Bank of America.
A Classic Turnaround
I believe Citigroup has all the ingredients of a classic turnaround situation. A large conglomerate with an iconic brand performs poorly because it has become too unwieldy to manage. A new CEO comes in and implements a new strategy to exit non-core assets and businesses. The capital generated from the asset sales has been earmarked for share repurchases. The remaining core businesses operate more profitably and grow faster than before because management can now focus resources on these businesses.
Citigroup’s CEO Vikrum Pandit is executing this turnaround. It has been more difficult than normal because of the difficult economic environment, the need for government assistance at the height of the credit crisis, and the massive size of the organization. That being said, it appears from the outside that things are on track. Management has split the company into two segments: one segment (named Citicorp) holds the company’s three core businesses and the other segment (named CitiHoldings) holds various businesses and assets that Citigroup management has decided they no longer want to own. The assets in CitiHoldings have been declining steadily (see slide 13 on Citigroup’s 2nd Quarter Earnings Presentation.) Although I have thought that Citigroup has given up too much value during some of the asset sales, the management has made steady progress with the asset sales.
I project that Citigroup will generate about $15 billion of excess capital over the next two years. I expect the main source of the excess capital will be from the proceeds of asset sales from the wind down of CitiHoldings. Plus, I estimate that Citigroup will generate more capital than required for growth of its core business. The final piece of the turnaround may come by April 2012 when I expect Citigroup will get approval for a stock buyback program with the excess capital it has generated in 2011. Of course, this approval will be dependent on the operating environment and Citigroup’s results and regulators assessment of Citigroup’s capital and risk positions.
After exiting most of the assets in CitiHoldings and hopefully shrinking the outstanding share count substantially, I believe that investors will be attracted to the remaining Citigroup businesses which are currently in the Citicorp segment. These three businesses are the global retail bank, the corporate bank and institutional securities unit, and the transaction processing business. I believe these remaining three businesses are all good franchises and have the ability to produce attractive growth and returns for shareholders. The corporate structure should be much simpler to understand and analyze.
Global Retail Bank
Of the three core businesses within Citigroup, I believe the global consumer banking franchise is the most attractive business and a unique world-class asset. In my opinion, Citigroup has the only global consumer banking brand with possibly only HSBC as a distant #2. This positions Citigroup for better long-term growth prospects than its U.S.-centric peers (BAC, WFC and JPM.)
The global nature of the Citigroup’s consumer banking franchise positions it for better loan growth than a typical domestic bank. The retail bank benefits from the fast growing economies of the emerging markets. Plus, Citigroup has the option to redirect resources to or from any particular market based on whether that market’s prospects are attractive. With stronger economies outside the U.S., I believe Citigroup’s consumer banking franchise will generate attractive profits and growth and investors will one day give it a premium valuation compared to its domestic peers like Bank of America.
Comparison to Bank of America
I believe Citigroup should trade at a premium to Bank of America because it doesn’t have the same legacy mortgage and capital issues that I believe have been pressuring Bank of America’s stock in Q3. Here’s a look at some statistics that directly compare the two companies:
| Citigroup | Bank of America | |
| YTD Repurchase Provisions | $352 million | $15 billion |
| Mortgage Servicing Portfolio | $571 billion | $2,003 billion |
| Delinquency Rate in Loan Servicing | 8.1% | 13.7% |
| P/E 2012 | 5.0x | 5.2X |
| P/TB | 50% | 51% |
| Market Cap | $75 billion | $64 billion |
| P/E 2012 | 5.0x | 5.2X |
Source: SEC filings, Yahoo! Finance
I believe that Bank of America’s mortgage issues are an order of magnitude worse than Citigroup’s. Bank of America, including its acquisitions of Countrywide and Merrill Lynch, originated a higher amount of the mortgage loans in the worse vintage years of 2006-2008. Bank of America has realized more mortgage losses so far in 2011 than Citigroup, and it has a mortgage servicing portfolio almost three times the size of Citigroup’s.
Do You Believe the Bond Market or the Stock Market?
The bond market is telling us that Citigroup’s stock is undervalued. Ed Najarian, Head of Bank Research at the ISI Group, wrote an interesting note earlier last week showing the strong relationship between the major banks’ Price-to-Tangible Book ratio compared to where their CDS spreads are trading. Wells Fargo and JP Morgan trade with the tightest spreads and the highest P/TB ratios. At the other end spectrum, Bank of America and Morgan Stanley trade with the widest spreads and the lowest P/TB ratios. In the middle, Goldman Sachs and Citigroup trade with CDS spreads about equivalent to each other. Goldman’s P/TB ratio is perfectly between JPM and WFC on one end and BAC and MS on the other. The interesting part is Citigroup doesn’t have a P/TB close to Goldman’s; rather, it has the same P/TB as Bank of America and Morgan Stanley, which both have wider spread levels.
As of 9/20/11:
| P/TB | CDS Spread | |
| WFC | 1.40x | 126 bps |
| JPM | 1.03x | 127 bps |
| GS | 0.84x | 233 bps |
| C | 0.55x | 231 bps |
| MS | 0.57x | 320 bps |
| BAC | 0.55x | 339 bps |
Source: Bloomberg, SEC filings
As a believer that the bond market is collectively smarter than the stock market, I believe the bond market’s assessment of Citigroup’s risk is more accurate, and Citigroup is undervalued by the stock market.
Citigroup is a classic turnaround. They are selling non-core assets and I expect the management to use the proceeds to repurchase stock at attractive valuations. I believe the core businesses within Citigroup, especially the global consumer bank, appear attractive and could generate high levels of profitability and growth than their U.S.-centric peers. I believe investors are unfairly penalizing Citigroup for Bank of America’s woes.
Disclosure: Long C, BAC, MS, WFC
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Citigroup. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
Short-Term Opportunity in FFBC Warrants
Nov/100
There is a short term trading opportunity in First Financial Bancorp warrants (FFBCW). A large holder of FFBC warrants is liquidating his stake. FFBC reported a good 3rd Quarter and the stock is rising, but the price of the warrants is flat to down as the holder sits on the offer side of the market. I estimate this large holder has sold ½ to 2/3 of his position. He could finish selling his position Monday or Tuesday. After he is “cleaned up” I would expect the price of these warrants to recover to higher implied volatilities.
The large holder of FFBC warrants could be Castle Point, which is run by Todd Combs. Combs was recently hired by Warren Buffett to run a sizeable portion of Berkshire Hathaway’s investment portfolio. Combs is liquidating Castle Point. According to Castle Point’s 13-HF filed in August, Castle Point owned 304,917 FFBC warrants. There are only a total of 465,117 FFBC warrants outstanding. Castle Point owned 65.56% of the issue!
I estimate Castle Point has sold most of its holdings of FFBC warrants. Since the announcement of Buffett’s hiring of Combs, the volume of FFBC warrants traded has risen substantially. The total FFBC warrants traded since the October 22nd announcement is 220,697. Assuming that a very high percentage of these were sold by Castle Point, the firm could be as much as 50% or 2/3 done selling its position.
I expect the warrant’s price to return to higher implied volatility once Castle Point has completed its selling. Below is a table showing FFBC’s stock price, warrant price and warrant implied volatility on different dates. The first date was June 2nd, which was the date when bids were due in the Treasury auction of FFBC warrants to the public. The next date is September 30th, which was the most recent quarter end and a day when some volume of FFBC warrants traded. The last day is last Friday, November 5th.
| 6/2/10 | 9/30/10 | 11/5/10 | |
| FFBC Stock Price | $15.87 | $16.68 | $17.69 |
| FFBC Warrant Price | $6.70 | $7.65 | $7.00 |
| Days to Expiration | 3084 | 2964 | 2928 |
| FFBC Warrant Implied Volatility | 40.69% | 43.65% | 34.91% |
In the table, we can see the current implied volatility of the warrants is lower than it has been on the previous dates. I believe once Castle Point is doe selling its position that the implied volatility of the FFBC warrants will slowly rise back to somewhere in the low-40’s. If I am correct, a low-40’s implied volatility at the current stock price would imply that the warrants would rise between $1.00 and $1.50. This would be a 14% to 21% increase in warrant value.
My suggestion is to wait on the bid side of the market and let the large seller push the price down to your bid. If the seller does not hit your bid in the next two or three days and volume of the warrants approaches 100,000, then you may want to get more aggressive with your bid. Once the large seller is done liquidating his position, I expect the volume of FFBC warrants to decline materiallyand will be difficult to buy. It is possible that future traded volume will be higher than it was prior to the Castle Point liquidation because the outstanding warrants will be held more widely. Another consideration is hedging your warrant purchase to protect against the stock declining. FFBC has rallied since reporting a decent quarter last week. It is not clear whether the rally will continue or if the recent price move was blip. I would argue the recent rally in the stock has allowed the large seller to exit his position for a decent nominal price even though the relative value price based on implied volatility is low.
Disclaimer: This is not investment advice. Investing in warrants is risky. Please see your financial advisor for independent investment advice. I do not have first-hand knowledge that Castle Point is responsible for the recent selling of FFBC warrants. I have used the mosaic theory to make my conclusions based on Castle Point’s SEC filing, Berkshire Hathaway’s press release, articles in the Wall Street Journal, and volume data from the NASDAQ. If you first read this post after November 9, 2010, the opportunity in FFBC warrants is likely gone.
Disclosure: Long FFBCW
You Don’t Want Berkshire to Pay Dividends
May/090
This year Carol Loomis asked the question whether Berkshire should start paying dividends since the stock price hasn’t risen in 5 years. This was in reference to Buffett longstanding quote that he will pay a dividend when he thinks he can’t create at least $1 of market value for each $1 of retained earnings. Jeff Matthews refers to this as a question that Buffett avoided answering in this thought provoking blog post.
My opinion is who cares whether Buffett answered the dividend question. If you are even asking the question, you should sell your Berkshire stock. The reason to own Berkshire is to get access to Buffett’s capital allocation decisions. Based on his well-documented track record and his well-know thought process, most Berkshire investors think Buffett can make better investment decisions and/or has access to better investment opportunities than they do. The last thing Berkshire investors should want is to have Buffett return the cash back to them in a taxable transaction. Then, the investors will have to decide how to allocate the returned cash.
Historically, investors have wanted management teams to pay dividends because they don’t trust management to spend the free cash flow from the business wisely. The business may be not need capital reinvestment, like Coca-Cola, or it may be a business in secular decline where the best thing to do is harvest the cash rather than reinvest. Shareholders of these businesses probably want managements to pay dividends to make sure they don’t destroy value.
Since the main reason to own Berkshire is to get access to Buffett’s capital allocation skills, if an investor wants Berkshire to pay dividends, then they should sell the stock instead because they obviously don’t believe in Buffett’s ability to create value by allocating capital.
There is a scenario where it makes sense for an investor to want Berkshire to pay a dividend. Maybe an investor thinks Buffett destroys value but think Berkshire is so undervalued that they can make a return by owning the stock and getting him to change his dividend policy. I don’t think Berkshire is anywhere close to a valuation level where this would make sense. At $91,500 per share, Berkshire trades at 1.4x tangible book. It would have to trade below tangible book value for this strategy to make sense.
The reason to invest in Berkshire is get access to Buffett’s skills as a capital allocator. If you want him to pay a dividend, you shouldn’t own the stock. You should ignore the 5-year rolling test about whether he adds more $1 of value for each $1 of retained earnings. He is never going to pay a dividend because he’ll never admit that he can’t add value. If he ever does decide to pay a dividend, you won’t want to own Berkshire.
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Signals from Berkshire Hathaway’s Buyback Announcement
Sep/113
Yesterday, Berkshire Hathaway announced a share repurchase program. This is an important milestone announcement in the history of the company because it signals many things to current and prospective shareholders. It signals that the Oracle of Omaha thinks his stock is undervalued. It signals that the stock may perform well over the short-to-medium term. The most important signal is Buffett has setup a framework for buybacks that his successors could use in the future.
Buffett Thinks His Stock is Undervalued
To me, the buyback announcement clearly shows that Buffett thinks Berkshire’s stock is undervalued. On a price-to-book ratio, the stock is the cheapest it has been in the past twenty years. Buffett would not repurchase shares unless
he was getting more value than he was paying. I think this is an uncontroversial point and has been made by other commentators such as Morgan Housel’s Buffett Gets Bullish at the Motely Fool and Jason Sweig and Jonathan Cheng’s Buffett Spots Fresh Bargain: Shares in His Own Company at the Wall Street Journal.
Potential stock outperformance
The last time I can remember Buffett offering to repurchase Berkshire shares was in the 1999 Annual Report which was issued on March 11, 2000. In the 1999 Chairman’s letter, Buffett included a section (starting on page 16) with his views about share repurchases. The letter is famous among value investors because not only did it mark the bottom in Berkshire’s stock, but it also marked the all-time closing high in NASDAQ Composite Index at 5048.62.
The March 2000 mention of share repurchases by Buffett was a great signal to buy Berkshire’s stock. Here’s a table comparing Berkshire’s stock to the S&P 500 over the next few time periods
In 2000, the stock had strong performance over the next year on both a relative and absolute basis. Even though the stock was up 8.6% yesterday, which is weirdly similar to its 1-Day performance after the 2000 repurchase offer, the stock could go on to additional gains in the coming time periods. I believe this is due to the market anomaly that stocks under react to good news because investors have a tendency to sell shares to lock-in gains in spite of good news.
Allocate Capital from the Grave
The most important signal from Buffett’s announcement of a stock repurchase plan is it sets up a major part of Berkshire’s capital allocation framework for the post-Buffett time period. In Buffett’s announcement of the share repurchase, he added three unique guidelines that:
The combination of these three guidelines will allow the Board and his successors to execute the share repurchase program after Buffett has passed without argument or second-guessing.
The worse scenario post-Buffett for Berkshire shareholders would be for the stock to trade at a discount to intrinsic value and have a Board argue that the company shouldn’t implement a stock repurchase program because Buffett had never had one. The cash would continue to pour into the company’s coffers and be trapped. The stock would trade at a higher and higher discount as cash was trapped. Even worse, his successors could try to use the capital to make acquisitions when repurchasing the stock would be a better capital allocation decision. The only way out of such a situation would be the break-up of Berkshire Hathaway.
This announcement takes away this downside risk of Berkshire’s Buffett premium turning into a post-Buffett discount. Buffett’s successors will have a clear framework as to how to evaluate stock repurchases. It could put a floor on the company’s valuation. I believe it could put the company’s capital allocation decisions on auto pilot for decades. If the stock trades close to book value, Buffett’s successor will probably use excess cash to buyback more and more shares and not make additional acquisitions.
Changes My Opinion of Berkshire’s Stock
The Berkshire share repurchase announcement changed my opionion of the stock. Prior to yesterday’s announcement, I had thought Berkshire’s stock was uninvestable due to Buffett’s inevitable death. With the framework that Buffett setup for share repurchases, the downside scenario of Berkshire trading at a steep discount to intrinsic value post-Buffett is nearly eliminated.
Based on how the stock performed in 2000 after Buffett’s last repurchase offer, I would guess there is still more upside to the stock.
If you have a different opinion or perspective please comment.
Disclosure: Long BRK-B
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Berkshire. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.