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

Beware of Phrases Like “Cheapest in 20 Years”

This week’s Barron’s highlighted shares of entertainment giant Disney (DIS) as being the cheapest they have been in 20 years. I just wanted to remind people that arguments like this in general don’t really make much sense. This is not about Disney itself (it is not an overvalued stock) but rather the whole idea that bulls on certain stocks like to look at one particular period in the past, and assume that those conditions should apply today.

These days you hear people say that certain stocks or sectors (or the market for that matter) haven’t been this cheap since the early 1980’s, and thus conclude they should be aggressively bought. What they fail to mention is that the period from 1982 through 1999 was the greatest bull market the U.S. stock market has ever seen, and P/E ratios were in a historically high range during that time. Therefore, investors should not assume that those valuations were “normal” and therefore should and will always be applicable.

The Barron’s piece suggests that Disney’s current forward P/E of more than 14 (the current market multiple) is too low because the stock typically trades at a 30% premium to the market. Again, just because a stock traded at a 30% premium a long time ago, that multiple does not stay relevant forever. P/E ratios are largely based on future growth expectations. If Disney is going to grow earnings less robustly over the next two decades than it did over the last two, it stands to reason its P/E should be lower.

My point is not to bash Disney specifically (no meaningful opinion there), but to remind investors that current valuations are based on investor expectations of the future, not historical data. Surprisingly, many people still look at average P/E ratios from the past 10 or 20 years to determine where a stock should trade today, but I would caution you to pass on that type of valuation methodology.

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

A Fresh Look and a Possible Anecdotal Contrarian Indicator

Over the weekend I hope to update this blog’s template to make it organized a little more efficiently. I’m not a web designer, and don’t hire one, so every once in a while the site gets unappealing in my eyes and I try to refresh it a bit. I’m just letting you know so if you visit here over the weekend and things are screwy, you’ll know why and that it will be fixed shortly. And please give suggestions if you think improvements to the layout can be made.

On an unrelated anecdotal evidence tangent, I got a call today from a client who requested I slash their financial services exposure by 50% (it had been a market-weight allocation — 18%). This type of anecdotal evidence often serves as a contrarian indicator, so I am interested to see if financials bottom out here in coming weeks and months. I got the call at 2:43pm central time, when the Financial Select Sector SPDR (XLF) was trading around $26.70 so we can track this random indicator. Maybe it signals capitulation, maybe not, but it’s always amazing to see how many times capitulation indicates that a bottom is near, even in something as random as this situation.

Have a good weekend!

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

Excerpts from Bill Miller’s Latest Letter

As usual, quality insights from the manager of Legg Mason Value Trust in his latest shareholder letter dated February 10, 2008. In my view, a couple are definitely worth posting:

On the constant chatter of possible recession:

Investors seem to be obsessed just now over the question of whether we will go into recession or not, a particularly pointless inquiry. The stocks that perform poorly entering a recession are already trading at recession levels. If we go into recession, we will come out of it. In any case, we have had only two recessions in the past 25 years, and they totaled 17 months. As long-term investors, we position portfolios for the 95% of the time the economy is growing, not the unforecastable 5% when it is not.

On Microsoft’s offer for Yahoo:

The 60% premium MSFT offered for YHOO highlights what we believe are the significant opportunities present in our portfolios. Clients and shareholders are understandably disappointed when the performance of their portfolio does not keep pace with the broader market. But the price of a publicly traded security is one thing, and its value is something else. Price is a function of short-term supply and demand characteristics, which are heavily influenced by the most recent news and results. Value is the present value of the future cash flows of the business, and that is what we focus on.”

Yahoo Says “No Thanks” To Microsoft, For Now

Despite having little in the way of leverage over Microsoft (MSFT), Yahoo (YHOO) rejected the software giant’s $31 per share bid, deeming it inadequate. With no clear opposing bidders at this point, most industry sources simply think Yahoo will try its best to drum up interest from other parties, or at least that perception, in order to get a little more money out of Microsoft. Since the $31 offer is half stock and half cash, it only represents about $29 right now based on a lower MSFT share price ($28).

A Microsoft deal is still most likely, perhaps at $33 or $34 if Yahoo is lucky enough to get a higher offer. All of this back and forth commotion will likely keep Microsoft’s stock price under pressure. When it is all said and done, there will likely be an attractive entry point for that stock. Should Yahoo agree to a deal with them, the merger arbs will be shorting MSFT until the deal closes. But after that, Microsoft shares will look very cheap.

Even at current prices ($28), prior to a higher bid or arb selling pressure, MSFT sells for 14 times this year’s earnings. For a company with double digit earnings potential going forward, that’s a very reasonable price. Should it get even cheaper, more value investors will likely get involved, regardless of their opinion of a Yahoo tie-up.

Update: 8:15AM (forgot to add the disclosures)
Full Disclosure: Long shares of Yahoo at the time of writing

Straight Talk from Buffett

One of the great things about listening to Warren Buffett speak, and I suspect one reason why thousands gather each year in Omaha for his company’s annual meeting, is that despite the fact that he is a brilliant man he speaks in plain, logical language that is easy to follow and usually hard to argue with. If you want the truth, without the media spin, and in as few simple words as possible, just ask Buffett.

Here are excerpts from a Buffett blurb on from Thursday discussing current financial market conditions:

“It’s sort of a little poetic justice, in that the people that brewed this toxic Kool-Aid found themselves drinking a lot of it in the end,” he said.

“I wouldn’t quite call it a credit crunch,” he said. “Money is available, and it’s really quite cheap because of the lowering of rates that has taken place.”

He added: “What has happened is a repricing of risk and an unavailability of what I might call ‘dumb money,’ of which there was plenty around a year ago.”

He is so right on this. People in the media keep complaining that “banks aren’t lending money anymore” and the Fed has to help boost liquidity. Banks are still lending money, they are just doing so only to people who have good credit (and thus actually deserve to be given loans).

It’s funny that people complained that the banks were giving loans to anyone and everyone, and now they are upset because many people can’t get loans anymore. You can’t have it both ways.

The fact that “dumb money” is no longer available is a good thing. Perhaps retail sales drop a few percentage points and loan losses increase a few because of it, but overall our financial system will be less leveraged and healthier as a result.

If you can’t put any money down or verify your income, you can’t afford to buy a home. I’m glad the banks are finally realizing this. And for those who are credit worthy, the Fed is lowering borrowing rates so the banks can make money on the loans they are willing to extend.

Apple’s Valuation Looks Attractive Again

The recent drop in shares of Apple (AAPL) has probably been more pronounced than most expected. It’s true the stock was very expensive at its all-high of more than $200 per share (40 times forward earnings) but the catalyst for the sharp $80 per share drop we have seen recently was the company’s extremely conservative guidance for the current quarter. Apple always sandbags quarterly guidance, so this did not come as a surprise, but evidently investors were hoping they would have been a little less cautious. However, in this day and age, when quarterly guidance is given simply to help out Wall Street analysts, under-promising is the only way to go. This is true even more right now as the economic climate is highly uncertain.

Despite all the reasons to be worried, the fundamental story behind Apple is still strong. The company is gaining market share in desktops, notebooks, and cell phones, and is holding their lead in music players. The company will not be immune to a consumer led slowdown, but market share gains will allow them to hold up better than the competition. Given that, and the likelihood that Apple will earn well north of $5 per share during calendar 2008 (current consensus estimates stand at $5.27), the current share price of $119 looks very attractive is investors are willing to wait out the uncertainty in the economy.

Not only does Apple stock trade at only 22.6 times this year’s expected earnings, which will likely prove conservative as usual, but the company has quietly been building up a gigantic pile of cash. Apple hasn’t been buying back shares aggressively or making large acquisitions, so cash reserves are rising at a staggering clip. Shown below are the company’s cash balances as of the end of the last four fiscal years, as well as the last quarter. And keep in mind Apple has no debt whatsoever on its balance sheet.

Apple Cash Balances ( in millions of USD):

Sept 2004: $5.46 billion
Sept 2005: $8.26 billion
Sept 2006: $10.11 billion
Sept 2007: $15.39 billion
Dec 2007: $18.45 billion

Apple currently has $21 per share in cash, with no debt, yet another reason to be attracted to the current stock price after a drop of more than $80 from its high. Steve Jobs has been hesitant to part with his cash in recent years (the company had liquidity issues years ago before the iPod came along), but eventually he will accumulate so much that he will be forced to do something with all of it. Large acquisitions are a less likely option, but a huge stock buyback or one-time dividend would certainly excite investors.

Full Disclosure: Long shares of Apple at the time of writing

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