For the first time in the current crisis, the US government has managed to rescue a financial institution without severely diluting the common shareholders. In this case, the shareholders of Citigroup were luckier that those of Bear Stearns, Freddie Mac, Fannie Mae, and AIG. Perhaps the government finally realized that short sellers are going to keep attacking financial institutions, and private investors are going to keep avoiding financial stocks like the plague, if every time the government decides to rescue a bank deemed too-big-to-fail, it wipes out the shareholders. Then again, it might have something to do with the fact that Prince Alaweed of Saudi Arabia is a 5% shareholder, and burning him will probably scare off the all the sovereign wealth funds from the Middle East. This new government policy, coupled with the Federal Reserve’s new program to purchase up to $800 billion in asset-backed securities, may mean that financial stocks have finally seen the bottom. Therefore, I decided to consider if an investment in Citigroup may be worth it.
Although Citi has $306 billion of toxic assets ring-fenced and guaranteed by the government, there is a big chance that Citi will incur further write-downs requiring additional capital from either government or private sources. Firstly, even with the ring-fenced assets on the balance books, Citi will have to take $29 billion of the initial losses and 10% of the remaining losses. In addition, there is also the non-trivial matter of the $1.2 trillion in off-balance sheet assets that will eventually have to be brought onto the books. However, if the government has truly established a new principle for financial rescues and will minimally dilute shareholders in the future, then Citi can keep going back to the government for capital, and these write-downs will not impact Citi’s viability as a business.
Of course, these rescues come at a cost and will affect free cash flow. Between the initial $25 billion TARP injection at 5% interest and the more recent $27 billion rescue at an 8% interest rate, Citi has to pay out $3.4 billion a year in interest payments to the government alone, before shareholders see any profit at all. In 2007, Citi’s Smith Barney brokerage alone provided $1.3 billion of profits, and its total global wealth management business (including Smith Barney) provided about $2 billion in profits. Citi’s global consumer lending provided another $7.8 billion of profits, for a total of $9.8 billion in profits, which was offset by $5.2 billion in losses due to a write-down of its subprime mortgages, for a net income of $3.6 billion. In other words, Citigroup generates about $10 billion in profits annually ($1.83 per share), which is used to offset large non-cash losses in its loan portfolio. While these losses may cause Citi to drop below required capital ratios, as long as Citi can raise sufficient capital, the underlying business will continue to generate cash. In the near future, Citi will probably report more losses due to further mark-to-market deterioration in its portfolio, so this cash flow must be severely discounted to reflect the fact that shareholders will not see any profits for quite some time. The problem is that no one is sure how big the losses will be, and therefore no one is sure how long shareholders have to wait to actually begin seeing profits, therefore choosing an appropriate discount factor is tricky. As part of its rescue package, the government required that Citi issue $2.7 billion worth of warrants at a strike price of $10.61. This suggests that the government views $10.61 as a reasonable fair value for Citi, which implies a multiple of about 6 times of Citi’s underlying profit. Personally, faced with such uncertainties, I require a larger margin of safety. In my opinion, C is a buy at any price below $5. With this view, I have recently sold some Jan 2009 put options in C with a strike price of $5.
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