Citigroup Break-Up Analysis – Part 3

I posted my extremely conservative valuation on Citigroup (C) last week and promised a more aggressive version in order to try and quantify not only a potential floor in the stock ($22?) but also a reasonable ceiling ($41?). Below in graphic form are three scenarios; my first one (conservative) as well as a moderate and more aggressive case. I will revisit these projections after Citi reports first quarter numbers, which might shed some light on their normalized earnings power.

 

 

 

 

 

 

 

Full Disclosure: Still no position in Citigroup at the time of writing

Related Posts:
Citigroup Break-Up Analysis – Part 1
Citigroup Break-Up Analysis – Part 2

Citigroup Break-Up Analysis – Part 2

Okay, so after looking over Citigroup (C) net income by segment over the last four years (see prior post), it’s time to make some projections about the future profitability of the company. First, I am going to do an extremely conservative valuation to try and find out what our likely downside is with the stock. Clearly, these are simply educated guesses at this point, so they could prove way off base.

Nonetheless, if I make a point to be both very conservative and realistic, it will likely be a valuable exercise. As Citigroup reports future earnings (first quarter numbers are due in April), I can see how the projections are holding up and making adjustments if needed.

Sticking with the conservative view, I am going to use a price-earnings ratio of 10x for each of Citigroup’s businesses. One can certainly argue that some divisions are worth more than that, but I’ll factor that into my more aggressive valuation model later on. For now, conservatism means 10x earnings.

As you saw from Citigroup’s historical net income data, two of the four divisions are much easier to predict than the other two. Both the international retail banking operation and the global wealth management business don’t see much volatility in earnings. Let’s project those two areas first.

International Retail Banking:

Net Income in millions of USD (2004-2007): $3880, $4098, $4017, $4193

Conservative estimate going forward: $4000

Assuming no growth, since recent years have hovered around this level


Global Wealth Management:

Net Income in millions of USD (2004-2007): $1209, $1244, $1444, $1974

Conservative estimate going forward: $2000

New assets coming in, coupled with population growth, make this area a fairly consistent grower

*The next two areas are far more volatile, but again, I’ll try and be overly conservative:

U.S. Retail Banking:

Net Income in millions of USD (2004-2007): $8010, $7173, $8390, $4108

Conservative estimate going forward: $3000

Although 2007 was really ugly, let’s assume things get worse before they get better


Corporate/Investment Banking & Alternative Investments:

Net Income in millions of USD (2004-2007): $2810, $8332, $8403, ($4581)

Conservative estimate going forward: $2000

This is the toughest to estimate. Let’s assume the structured finance boom days are over, go back to the 2004 number and slash that by another 30% or so.

Where does this leave us?

If these profit estimates are met, and Citi trades at a 10 P/E, the company is worth about $110 billion. Based on their share count of 4,995 million I get a fair value of $22 per share. The stock currently trades at $25 so we have about 10% of downside to my conservative estimates.

This is why I am starting to be intrigued by Citigroup as an investment in the mid to low 20’s. The odds of somewhat limited downside (and tremendous upside) look pretty good. In coming days I’ll post a more aggressive (but reasonable) set of assumptions so we can try and see what the upside is if Citigroup rebounds nicely in coming quarters and years.

Full Disclosure: No position in Citigroup at the time of writing

Related Posts:
Citigroup Break-Up Analysis – Part 1
Citigroup Break-Up Analysis – Part 3

Citigroup Break-Up Analysis – Part 1

Long before the sub-prime debacle really got going, shareholders of Citigroup (C) were clamoring for the company to break itself up into several pieces. The argument for such a move stemmed from the fact that enormously large companies get very difficult to manage. By splitting them into smaller free standing operations, they not only can be managed better, but stand a greater chance of growing if they are let loose on their own with separate management teams acting autonomously.

Although I was/am not a Citigroup shareholder, I can certainly understand this concept and think it has a lot of merit. Of course, Citigroup did not break itself up, and now the sub-prime crisis has depressed the share price so much that many pieces of Citi are doing well, but have been ignored as writedowns take center stage.

Doing some kind of break-up analysis can go a long way to figuring out how much each business unit within Citigroup is worth. This would make it easier to figure out if the current share price ($25) is too depressed, or if meaningful downside remains looking out the next year or two.

For the purpose of this exercise, I am going to split Citi into four separate businesses (domestic retail banking, international retail banking, corporate investment banking and alternative investments, and global wealth management) and attempt to value each of them on a standalone basis. That should help us determine if value investors should be intrigued by Citi’s current $25 stock price or not (or at least give us some more data points to use when trying to figure that out — it’s not an easy question).

To avoid a very long post, I’ll split this analysis up over several days (may as well stick with the break-up theme). Feel free to post your thoughts on Citi’s valuation as well. Perhaps we can form a consensus view.

To wet your appetite, below are some important data points on the past profitability of Citi’s four business units. We can use this information, plus our opinion about what the future might look like, to figure out how much Citi could earn in the future, and thus how much the stock might ultimately be worth down the road. (Update: My plan is simply to project both net income and an earnings multiple for each unit and add them up to estimate total company value. Citi’s current market value at $25 per share: $125 billion). I’ll post my opinions in the coming days, and please add your own if you have any strong views one way or another.


Related Posts:
Citigroup Break-Up Analysis – Part 2
Citigroup Break-Up Analysis – Part 3

The Power of the Capital One Stock Buyback

Some investors love them, others hate them, but regardless of which camp you find yourself in, the reality is that share buybacks have an ability to boost shareholder value significantly. The news out of Capital One Financial (COF) last week hardly got any attention, but I wanted to point it out in the face of all the negativity surrounding the banking sector.

Despite the gloom and doom forecasts that the U.S. consumer is dead and everybody is facing home foreclosure and default on their credit card and student loan debt (exaggeration intended), Capital One announced a $2 billion share buyback and a dividend increase of 1,289% (to $1.50 per share annually). One has to think the COF board thought long and hard before increasing the company’s annual dividend from 0.2% to 3%. If there was any reasonable chance of a capital shortfall in the future, they would have surely treaded more slowly. The only thing worse than cutting your dividend is doing so only months after initiating one (the prior $0.11 annual dividend was immaterial).

At the beginning of 2007, a $2 billion buyback would have only retired 6% of COF’s shares, but today it represents 11% of the company (nothing to sneeze at). How much of an impact can a buyback like this really have in such a negative environment for financial stocks? Isn’t news of a buyback irrelevant when we are facing the increasing loan losses in 2008?

You might be quick to answer “yes” but looking back at 2007, it appears that the 38% drop in Capital One’s stock was severely overdone. How can that be? Believe it or not, Capital One’s book value per share rose by 1% during 2007. An even more important metric, net tangible assets per share (book value excluding goodwill), rose by 9% during 2007. This was due to a combination of large stock buybacks and lower than anticipated deterioration in Capital One’s asset base.

As the data I have compiled here on COF shows, there is plenty of value in the financial services sector, despite almost constant fear that the financial services industry in our country is falling apart.
Below are Capital One’s shareholder metrics for the twelve months ended 12/31/07. Similar numbers in 2008 would not surprise me, although most of Wall Street seems to think otherwise.

Full Disclosure: Long shares of Capital One at the time of writing

JPMorgan Chase Shines In Otherwise Ugly Financial Sector

Of course, a shining performance is all relative when we are talking about the banking sector right now, but still, JPMorgan Chase (JPM) has really navigated this rough environment well so far. I don’t own the stock, but certainly wouldn’t mind being a shareholder right now. This morning the company reported that 2007 earnings rose 15% to $4.38 per share. Fourth quarter numbers were down sharply, not surprisingly, but overall the company is faring much better than competitors like Citigroup (C).

Not only does JPM have much less CDO and sub-prime mortgage exposure, but their credit card portfolio is holding up very well too. Their credit standards clearly have been more conservative than other players. For the fourth quarter, card delinquencies reached 3.5%, up from 3.1% in the prior year, and net charge-offs were 3.9%, versus 3.5% in 2006. While these figures did rise year-over-year, they remain very low for the industry, where many are reporting figures above 5% in recent months.

JPMorgan’s management team, as well as their shareholders for betting on CEO Jamie Dimon, should be congratulated for posting a 15% increase in 2007 earnings per share. There are few banks out there that will be able to claim that feat when earnings season is over later this month. The stock, meanwhile, yields nearly 4% and trades at less than 10 times earnings. The shares will likely continue to outperform their peers going forward.

Full Disclosure: No position in C or JPM at the time of writing

BAC/CFC Baseball Analogy

Sometimes baseball analogies work as well as anything to help explain something. With Bank of America (BAC) buying Countrywide (CFC) for $6.1 billion ($4.1 billion in stock plus the $2 billion in cash they invested last year), one came to mind. I think this is a lot like when a major league pitcher hurts his arm badly and elects to have “Tommy John” surgery. You have to sit out a full year, but the club is banking that an extended period of time off will result in maximum recovery, resulting in the player pitching like this old self when he returns the following year. You sacrifice the near-term in order to maximize long term upside potential.

Bank of America was already the largest mortgage player among the big diversified banks. Adding Countrywide (the largest independent mortgage company) makes them the Goliath in the industry. In the short term, this will hurt them. More losses, more write-downs, more delinquencies until the cycle hits bottom and stabilizes. It won’t be pretty. But when the cycle does turn, losses have largely been absorbed, and we (hopefully) get back to a time when you put money down and get a fixed rate mortgage to buy a home, the BAC/CFC combo could be a home run.

To put the purchase price of $6 billion in perspective, Countrywide earned between $2.2 billion and $2.7 billion in profit every year between 2003 and 2006. Obviously the later years were more “bubbly” in nature, but if you look out several years, when the overall mortgage market will be larger in volume terms (despite lower margins most likely as ARMs dissipate), the CFC deal could easily add $2 billion in annual profit to BAC’s business after you factor in cost savings from the merger and cross-selling to a new customer base. That puts BAC’s cost basis at 3x earnings, even after factoring in the $2 billion convertible preferred investment last year. Clearly that is what Bank of America CEO Ken Lewis is banking on, pun intended.

Full Disclosure: Long shares of Bank of America at the time of writing

U.S. Bancorp Raises Dividend by 6%

That is not a misprint. There are banks in this country that are raising their dividends. U.S. Bancorp (USB) now yields more than 5% on the new annual payout of $1.70 per share. The lack of worry on their part stems from a very conservative business model. They are simply content growing at a slower rate, and avoiding aggressive lending practices, as opposed to the strategies that other large banks have adopted in recent years. This is evident from USB’s press release, which points out the company has raised its dividend for 36 straight years, and has paid one in 145 consecutive years.

If you are looking for a high yielding, lower risk bank stock, USB is a solid option in the second tier of companies (large banks, but not the giant banks). Warren Buffett recently upped his stake in the firm, so he obviously likes management here quite a bit. The stock isn’t dirt cheap at 12 times forward earnings and about 3 times book value, but sometimes you have to pay a bit more for safety, and the stock certainly is not overpriced by any means. Take a look at it if you want to venture outside the Big 3 in domestic banking.

Full Disclosure: No position in USB at the time of writing

Keep Money Market Fund Worries in Perspective

The media tends to over-hype news. Things are presented as better than they really are in good times and worse than reality in bad times. Recent worries about money market funds that have invested in subprime mortgage-backed securities are just one example. There has been speculation that small investors face the possibility of losing significant amounts of money in their money market investments, despite the appearance of such funds as being very low risk in nature.

Yesterday we learned that in fact Bank of America (BAC) was shutting down a $34 billion money market fund. The headlines were grim, but once one actually reads the facts of the situation, it is apparent that it is no big deal at all.

First of all, the fund in question is not a typical money market fund. It was an “enhanced” fund that knowingly took on more risk than the average money fund, hence the subprime exposure. As a result, only institutions were allowed to invest (since they understood the risks were greater) and the minimum investment was $25 million, so individual investors are not exposed.

Secondly, and more importantly, the losses the fund sustained before being shut down by BofA were barely noticeable. Investors in the fund were able to redeem their shares at a rate of 99.4 cents on the dollar. That’s right, despite the gloomy headlines in the media, investors in this risky fund lost less than 1 percent of their original investment. And this fund was risky!

So for all of you out there who are spooked about money market funds, perhaps this data point can ease your concerns.

Full Disclosure: Long shares of Bank of America at the time of writing

Forget Writedowns, Bank of America Gets $16B Writeup!

From the Financial Times:

BofA set to gain $30bn on CCB stake

Tuesday Nov 13 2007

Bank of America (BAC) on Tuesday said it was sitting on a potential gain of more than $30bn on its investment in China Construction Bank, highlighting the paper profits some western banks have made on holdings in their Chinese counterparts.

BofA paid $3bn two years ago for an 8.5 per cent stake in CCB and an option to increase to 19.9 per cent at a very low price. The bank plans to record a gain of about $16bn on its existing stake in the fourth quarter.

“On paper we have a potential gain in excess of $30bn,” said Joe Price, BofA’s chief financial officer, adding that it would be able to cash in some of its holding over the next 2 to 3 years.

Not only does BofA have less subprime mortgage and MBS CDO exposure than other big banks, but they also have done some smart things which will certainly help them weather the storm.

Full Disclosure: Long shares of Bank of America at the time of writing

Countrywide Predicts Trough, Shares Soar 24%

Gauging the outlook for pure mortgage lenders like Countrywide (CFC) is a tough game and one that I am choosing not to play. The company is predicting that the third quarter was the trough and profits will return in Q4 and 2008, but nobody really knows for sure. Delinquency rates are still rising at CFC, standing at 7.1% as of September 30th, up from 5.7% three months before.

Until there are signs of stability and that stability hangs around for a while, I’m not going to bottom fish in mortgage-related companies like pure lenders or mortgage insurers. Honestly, those stocks are down so much, trading far below even recently slashed book values, that I think eventually there will be plenty of upside without even needing to time the bottom of the cycle.

Until then, I continue to like the bigger diversified banks with fat dividend yields. With these stocks yielding more than treasury bonds, I think you can justify buying low and being patient, knowing that calling a bottom is essentially impossible. I would, however, start making a list of the kinds of stocks you might want to target when things start to rebound. You won’t be able to time a purchase perfectly, but there is no way that most of the home builders, mortgage insurers, and big lenders won’t survive and be consistently profitable when the markets get back to some sort of more typical environment.

There will be money to be made, but I’m not comfortable jumping into pure plays just yet. Hopefully by sometime in 2008 things will stabilize and we’ll have a better idea of what “normal” conditions look like. At that point, making bets will be much more prudent.

Full Disclosure: No position in Countrywide at the time of writing