Citi Keeps it Retail Partner Card Division
Oct/110
This post about Citi’s Retail Partner Card Division originally ran on MarketWatch.com on October 28, 2011.
In Citigroup’s recent earnings release, Citi’s CEO Vikram Pandit announced that the company would move its Retail Partner Cards division from Citi Holdings to Citicorp. This effectively means the company has decided to keep the division as a core business and is no longer trying to exit through a sale.
This is good news for Citigroup shareholders because it is a good strategic and capital allocation decision by management.
Citi’s Retail Partner Cards division’s business has improved, so it makes sense to keep the business. When management placed the division into Citi Holdings in 2009, it was not profitable and credit quality was weak with credit losses over 13%. However, there has been a turnaround in the past two years. According Citi’s third-quarter financial supplement , the division made $476 million pre-tax in the quarter. The division is earning a return on assets (ROA) of 2.7% (assuming 38% tax rate and $41 billion in assets.) If Citi employs 10x leverage, this is a 27% ROE business. Both of the ROA and ROE estimates are significantly higher than the current corporate average.
There was no obvious buyer for the business. Citi is one of the largest players in retail partner credit cards, so it would take another player with a large balance sheet to buy the business. The largest competitors in retail credit cards are GE Capital, JP Morgan and Capital One. Capital One is in the process of buying HSHB’s credit card division, so it couldn’t bid on Citi’s unit. GE has been on record of wanting to reduce the size of GE Capital, so it would be unlikely to pay a premium for the business. JP Morgan was probably unlikely to acquire Citi’s business for a premium. Without an obviously buyer, Citi would probably have had to cut its price to complete a sale.
By keeping the Retail Partner Cards division, Citi will not leak value from a forced sale. By not forcing the sale, Citi will not take a write-down to enable the sale. The exact opposite happened in September 2010 when Citi took a $500 million charge to earnings to complete the sale of Student Loan Corp to Discover and Sallie Mae. I wascritical of the Student Loan sale because I believed Citi could have realized the full value of the student loan business by holding onto that asset. By keeping Retail Partner Cards, Citi is not taking a write-down in order to sell the asset.
Citi will be able to use some of its excess capital by keeping the business. Citi is generating excess capital by winding down Citi Holdings. As assets from Citi Holdings are sold or pay off, the capital used to hold these assets becomes excess capital. Also, Citi is generating excess capital as it realizes portions of its deferred tax asset each quarter as it generates income. I am anticipating that Citi will start to deploy this excess capital by announcing a large stock buyback in March 2012 when the Fed completes updated stress tests for each of the systemically important banks. It is unlikely that the Fed would allow Citi to use all of its excess capital in a stock buyback. By keeping the Retail Partner Cards division, Citi deploys some additional excess capital that would have otherwise been trapped by regulators.
The decision to keep the Retail Partner Cards division signals that regulators are letting management make good strategic decisions. For me, one of the most important aspects of the decision to keep the Retail Partner Cards division is it appears that regulators are taking a balanced approach to Citi’s strategic decisions. They are not ruling with an iron fist and forcing Citi to divest this division because two years ago management earmarked it for sale. New facts have appeared in the form of the business turning around, so management changed their minds about how the business fit with its core operations, and the regulators allowed them to implement the new strategy.
Overall, Citi’s management made the right decision to keep the Retail Partners Cards division. It is good to see Citi make good strategic decisions. This is also a better capital allocation decision. Moving the division back into Citicorp from Citi Holdings also shows good character on the part of management. They were flexible in their thinking when new facts appeared.
This commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
AUTHOR DISCLOSURE: Long C, JPM, COF
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.
Citigroup: A Bet Against the End of the World
Sep/112
This is the first of a three part posting on Citigroup. The second part compared the opportunity in Citigroup to Bank of America. The final part will review a list of reasons why investors avoid Citigroup and how I overcome these objections.
Betting on the End of the World by shorting the major U.S. banks is not a winning strategy. This is not to say investors should blindly depend on policy makers to bailout the financial system every time there is an issue. We have clear, recent evidence from September 2008 that bailouts do not always come for investors. Also, I fear we will have a repeat of September 2008 in the future as anti-bailout proponents continue to gain power in Washington. However, the current financial policy makers (Geithner and Bernanke) will not repeat the mistakes of September 2008, so shorting the major U.S. banks now is a losing strategy.
The sellers of bank stocks at these levels fear the financial system will collapse if there is a hard default by Greece. Their thesis is if Greece defaults, major European banks will take losses directly and suffer additional counterparty losses from the failure of smaller banks. As the European banks take losses, risk aversion will rise and liquidity will drain from the system. Lower levels of liquidity will drive asset prices lower causing losses in both U.S. and European banks. These additional losses may cause a major a European bank to fail, and U.S. banks will suffer additional losses as a result. If the losses for the U.S. banks rise to a high enough level, we may see a major U.S. bank have to fire-sale assets and/or raise capital at dilutive stock prices.
I disagree with several parts of this thesis. Most important, I believe the current policy makers learned an important lesson from September 2008 and will not compound a crisis by letting their financial institutions fail due to a lack of liquidity. Plus, the major U.S. banks have liquidity and capital levels that will allow them to survive a severe downturn in the financial markets. I have been expressing my view by adding to my position in Citigroup.
My preferred way to implement my view that the financial system will not collapse is to own shares of Citigroup. I believe all of the large banks are attractive, including JP Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley and Wells Fargo. I own most of them, but my largest position is in Citigroup. My preference for Citigroup is due to its low valuation and its ongoing corporate restructuring which is generating excess capital.
I do not think the financial system is going to collapse due to the current European crisis. Political leaders have learned important lessons from the Lehman Brothers bankruptcy that orderly wind-down of major financial institutions is needed. I believe the distress in the financial system in September 2008 is etched on the minds of Geithner and Bernanke. They will not allow a major financial institution to fail due to a shock from Europe.
Treasury Secretary Tim Geithner consistently shows in his speeches and interviews that the lessons learned from September 2008 are well in grained. On September 19th, Geithner said in a Bloomberg interview, “I think you’re going to see them draw on the lessons of our crisis, draw on the lessons of things that worked here in the United States. I think you’ll see that reflected in some of the choices they make.”
In the end, I believe the European leaders have learned these same lessons. They will protect their own country’s banks from losses. It may be bumpy trip, but we see evidence that European political leaders are starting to get it. Merkel and Sarkozy released a joint statement saying that they “are convinced that Greece’s future is in the eurozone.” At the recent G7 meeting, the finance ministers stated their support for the banks, “We will take all necessary actions to ensure the resilience of banking systems and financial markets,”
In addition to the support from political leaders, I believe Citigroup is approaching a potential Greek default with much more solid liquidity and capital positions than. Here’s a look at the high level numbers:
| Dec 2007 | June 2011 | |
| Cash as % of Assets | 10.2% | 16.7% |
| Reserves/Loans | 1.9% | 5.3% |
| Deposits/(Loans+Securities) | 79% | 89% |
| Tangible Common Equity/Tangible Assets | 1.6% | 7.3% |
These are clearly stronger numbers and position Citigroup to handle a stressful environment better than 2008. In addition, Citigroup has spent the past 3 years reducing risk within its loan book. With the credit quality metrics declining, I get the sense that management has a much better sense of its balance sheet and the risks than it did 3 years ago.
I believe Citigroup is well positioned here to survive a stressful period in the markets due to a Greek default. With the stock at 60% of tangible book value, I believe it is an attractive stock. The reason it is at these low valuation level is the potential for potential problems in the financial system due to a Greek default. I do not believe
Disclosure: Long C, BAC, WFC & MS
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.
Time Arbitrage with Primerica
Jun/110
There is an opportunity to time arbitrage the stock market by owning shares of Primerica. The market is not assigning any premium to the expected low-risk growth at Primerica over the next 5 years. The growth is expected because Citi shrunk the size of Primerica prior to the IPO. Over the next few years, Primerica will replace the term life policies that were removed with new policies. This will translate into attractive earnings growth, but Primerica trades for 1.1x book value and under 9 times this year’s estimated earnings per share. Buyers of the stock can earn an attractive return assuming no multiple growth by relying on the expectations for earnings growth in the coming years.
Last July, I wrote a bullish article about Primerica. I saw an opportunity because the company’s balance sheet was restructured prior to its April 2010 IPO. Through March, the investment thesis played out as Primerica reported 4 quarters of better than expected earnings. The stock rose from $20 last July to $26.
In April, Citigroup announced that it was selling a second tranche of Primerica, which has beaten up Primerica’s stock as the market has struggled to digest the additional supply of shares. This recent decline is an opportunity to buy shares in a company with solid earnings growth prospects at a low valuation. At these levels, I believe there is assymetrical risk / reward in the shares of Primerica.
Read the rest of this post which has my investment thesis on Primerica at Seeking Alpha.
Primerica: Earnings Growth Regardless of the Economy
Jul/103
Primerica (NYSE: PRI – $20.98)
Introduction
I recently purchased shares of Primerica, which is a life insurance and mutual fund marketing company. Primerica was recently IPO’d by Citigroup (C) as part of Citi’s balance sheet reduction program. It has been one of the best performing IPO’s of the year so far. I believe Primerica’s shares are undervalued because investors are not factoring earnings growth that will be stronger than published Street expectations.
Company Background
Primerica provides financial products and services to middle-market America through a salesforce of independent producers. The company’s two main products are term life insurance and 3rd-party mutual funds. The company was formerly run by the legendary salesman A.L. Williams, who used inspiring motivational speeches to energize the salesforce. Sandy Weil bought the company in the early days of creating his Citigroup empire.
Main Investment Thesis
My main investment thesis is the current valuation does not factor earnings growth that will be stronger than the Street’s published expectations.
Why do I think earnings growth will be stronger than the Street estimates?
Prior to the IPO on April 1, 2010, Primerica entered into a reinsurance transaction with Citigroup that took about 80% of Primerica’s existing term insurance book off of its balance sheet and put it onto Citi’s balance sheet. This dropped the existing term life in-force block to drop from $650 billion to $130 billion. This also caused a one-time step down in Primerica’s earnings from to a $500 million annual run-rate to a $150 million annual run rate. Going forward, Primerica still has the same salesforce that was selling enough term life policies to grow a $650 billion term life block 3% annually. This salesforce producing the same amount of business can grow a $130 billion term life block at 51% annually.
How does 3% growth become 51% growth?
Primerica’s reinsurance transaction with Citigroup reduced the company’s existing block of term life insurance from $650 billion to $130 billion, but it did not diminish the capabilities of the company’s salesforce from adding new policies. In 2009, Primerica had a 10% lapse rate on its term life policies and added $80 billion in new term life policies. This led to a 3% growth rate.
In 2010, if will assume a continuation of the 10% lapse rate and another $80 billion of new term policies, the new $130 billion block of term life policies will grow to $197 billion or a 51% growth rate.
How does this growth translate into earnings?
The term life insurance division accounts for about 60% of the pre-tax earnings. I think this segment can grow 40% in 2011. The mutual fund sales can grow 5% a year, which assumes no in-flows and 5% market appreciation. Combined, I believe earnings in 2011 can be north $2.40 for a growth rate of over 20%.
Why don’t investors see this potential earnings growth?
Primerica’s potential earnings growth is hard to see because the reinsurance transaction with Citigroup is confusing and not what investors normally encounter.
Does Primerica have the capital available to support this level of growth?
Yes, Primerica has extra capital currently. The risk-based capital ratio is estimated to be north of 450%. Plus, the mutual fund savings division generates capital equal to its net income because it does not need capital for growth. Lastly, Primerica is only going to pay a token dividend while it is in this high growth mode.
Other Positive Parts of the Primerica Story
Plain vanilla business with no legacy issues – Primerica’s business is simple to understand. It is mainly a salesforce distributing straightforward term life insurance and a 3rd party mund funds. Term life insurance is one of the easiest forms of insurance for a life insurance company to manage on its balance sheet.
Potential for management to respond to improved incentives – Primerica’s management team should be motivated to show good results out of the gate from the IPO. This is an organization built on motivation and financial incentives. When the company was a subsidiary of Citigroup, I’m sure management had financial incentives, but the were still paid partly with options on Citigroup overall. It was impossible for them to move the needle on Citigroup’s stock. Now as an independent company, Primerica’s management team can directly impact the stock price by delivering strong results.
Ownership presence of Warburg Pincus – As minority shareholders, we are helped by Warburg Pincus’s ownership stake and presence on the board of directors. We can expect Warburg Pincus to focus on shareholders returns. With Warburg’s presence, we also expect management compensation to be under control and expect no value destroying acquisitions.
Leverage will add to returns – As part of the spin-off from Citigroup, Primerica took on some modest leverage at the holding company level that will improve equity returns. Since Primerica’s business seems stable and cash producing, I am comfortable the modest leverage will enhance returns without adding to the risk of financial distress.
Valuation
I believe Primerica is undervalued. At $21 per share, Primerica trades at 1.4x tangible book value and 9.5x the Street’s 2011 EPS estimates. These valuations are in-line with their life insurance peers. However, I believe the Primerica story is cleaner than the rest of the industry because they have fewer legacy issues (such as the investment portfolio at Aflac (AFL) or commercial real estate at Principal (PFG)) and are not dependent on the stock market for earnings growth (such as Prudential (PRU), Ameriprise (AMP), Hartford (HIG) or Lincoln (LNC)) Plus, with the reinsurance transaction with Citi, Primerica will have attractive growth for the next 5 years.
In addition, I believe Primerica could earn as much as $2.40 (or 22 cents more than consensus estimates) in 2011 as they regrow their term life book. As analysts increase estimates, the stock may attract attention from investors attracted to companies with rising estimates. The stock’s multiple could rise to 12x leading to a $29 stock price.
Risks
The main risks to my investment thesis on Primerica are: 1) I am overestimating the potential for earnings growth and 2) the market already recognizes the potential earnings growth and has appropriately priced the stock.
Primerica does have at least one potential issue with a reinsurance company facing financial difficulty. It has about $50 million reinsurance recoverable exposure to Scottish Re, which is in run-off. If they had to write-off this amount, it would be equal to a quarter of earnings. I believe the market would look through this issue if it happened.
I discount some commentators’ views that the Primerica salesforce is a risk. I believe the Primerica salesforce is a vital asset of the company. Yes, they recruit heavily and have high churn, but financial sales is not easy and not every recruit is able to make in sales. I think of Primerica’s salesforce as similar to Aflac’s. Both are high energy, depend on multi-level principles and have high turnover. While I wouldn’t succeed as a Primerica salesman, I admire the results of the organization. As Phil Fisher wrote, you want to own companies with outstanding salesforces.
Conclusion
I purchased shares of Primerica recently because I believe the shares do not factor in the potential earnings growth of the company. The business is a plain vanilla term life insurance business with some 3rd-party mutual fund sales. The earnings growth is not dependent on the stock market improving, rather, it just depends on Primerica’s salesforce delivering similar results to the recent past.
Disclosure: Long PRI, PFG
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