This is Part 3 of a series of articles discussing the returns on common stock and TARP warrants for a few financial institutions relative to the institution's book value. Part 1, on AIG, is located here and Part 2, on Bank of America, is located here.
During the crisis, Citigroup (C) was bailed out by the US government. As a result, the government was given two different long-term warrants in the company which they have since sold off. Both sets of warrants are now publicly traded and accessible to all investors. Series A warrants expire January 4, 2019. Series B warrants expire October 28, 2018. These warrants need to be investigated to see whether either warrant is a better way to gain long-term exposure to the company than simply buying the common stock.
In mid-2011, Citi performed a 10:1 reverse split. This had a significant impact on the warrants. After the reverse split, each warrant represents the rights to 1/10th of a share of Citi stock. The strike price of the warrants was also increased by 10x, and lastly, the dividend threshold for any strike adjustments was also adjusted for the 10:1 reverse split.
Citi stock had a good 2012, up over 60%. During the year, the company fired the former CEO and brought in a new head who appears very focused on improving shareholder value. The bank was picked this year as a favorite of many analysts based on a 'mean reversion' trade since it has been a weak bank for several years. Also, the expectation is that Citi has more unexploited ways to reduce costs and increase revenues than their competitors. The recent focus on Citi shares has helped them get off to a good start in 2013 but has also set high expectations for the company.
Citi has been declared a Systematically Important Financial Institution and as a result must submit its capital plans to the Financial Stability Board for approval. The board should release a ruling on the plans between March 15th and March 30th. Citi is expected to gain approval for a small share buyback. Citi's capital plan did get rejected last year so the company is expected to be conservative and get approval this year for a scaled-back plan. A share buyback is actually more helpful for the warrants than a dividend increase because the dividend adjustment thresholds are so high on these instruments.
Before June 1, 2015, Citi is expected to sell its remaining stake in Morgan Stanley Wealth Management to Morgan Stanley. This transaction should free up additional liquidity which will help the bank further firm up its balance sheet.
Citi does still have lingering problems though. The bank simply hasn't been well run for several years and as a result, doesn't have a positive reputation. Also, as with any restructuring, like what the current CEO is planning, there will be several one-time write-downs which will have a big impact on earnings. In 2012 Q3, the company took a $2.9 billion non-cash charge based on a revaluation of its stake in MS Wealth Management. As the restructuring progresses, there will surely be additional items which will shake up earnings.
With the recent rally in the stock as well as its performance over the past year, it is good to put the current price of the stock into perspective relative to historical valuations. Citi still trades significantly below book value. Before the financial crisis, large money center banks traded at a roughly 1.6x book value. This is a conservative assumption. Both Citi warrants have just under 6 years till expiration so these instruments have a long enough life that they should see the bank return to more normal valuations.
I don't expect valuations to return to the previous levels, but a move up to at least book value is reasonable and a move above book value isn't out of the question in a 6 year horizon.
In the table below, I list the relevant information about the warrants, the current stock price, the current stated book value (from the latest quarterly report), and two scenarios for warrant and stock returns based on price relative to future book value. I assume book value grows conservatively at 3.5% per year from current levels.
|Citi Warrant A (C.WS.A)||Citi Warrant B (C.WS.B)||Citi Common Stock (returns calculated until Series A exp.)|
|Warrant Strike Price||$106.10||$178.50||--|
|Warrant Price (for 10 warrants which equals 1 share)||$4.70||$0.60||--|
|Warrant Exp. Date||1/4/2019||10/28/2018||--|
|Time until expiration (years)||5.97||5.79||--|
|Current Stock Price||$42.34||$42.34||$42.34|
|Current Book Value per Share||$63.59||$63.59||$63.59|
|Price if stock trades at 1x BV which grows at 3.5% per year till expiration||$0.00||$0.00||$78.09|
|Historical P/B Ratio||1.6||1.6||1.6|
|Price if stock trades at historical P/B & growth in BV of 3.5% per year||$18.85||$0.00||$124.95|
|Return if stock at BV||-100%||-100%||84%|
|Return if stock at historic P/B, 1.6x||301%||-100%||195%|
Like other TARP warrants, these warrants do have some dividend protection though it is less helpful for shareholders than other warrants presented in this article series. The Series A warrants have a pre-reverse-split adjustment threshold of $0.04 per year. The Series B warrants have a pre-reverse-split adjustment threshold of $0.64 per year. Once you adjust for the split, as the annual total dividend rises above $0.40 (10:1 reverse-split adjusted), the strike price of the Series A warrants is adjusted down by the amount above that level. The threshold for Series B warrants is $6.40 annual total dividend (10:1 reverse-split adjusted). To be conservative in my return estimates in the table above, I am ignoring any potential future adjustments in the strike price.
Citi currently pays an annual dividend of $0.04. As a result of the high dividend threshold for the warrants and the long time-scale of the warrants, I'm not comfortable assuming the warrant strike price will be adjusted at all. If Citi stock does trade near $100 per share, it will probably have a dividend above the Series A warrant threshold, but I'm not comfortable making that many assumptions in this analysis. While they may not impact the warrant returns, any dividends paid out will increase the returns on common stock over what I calculate above.
Using the assumptions outlined above, both the Series A and Series B warrants will expire with no value. Over this same time period, the stock also returns 84% excluding dividends, or an 11% annualized return.
On a return to historical valuations of roughly 1.6x book value, the Series A warrants return roughly 300% and the common stock returns 195%. The Series B warrants still expire worthlessly. Unless the stock price increases above the warrant strike price, the warrants will have an intrinsic value of $0. Until that time, entire value of the warrants is time value which is subject to decay.
The company could grow faster relative to book value than assumed here, or trades above 1.6x book value. The Series B warrants don't have any intrinsic value at expiration unless this happens. As a result, the Series B warrants are only for investors who are very positive on the banking sector over the next 6 years.
Citi earnings are released Thursday, January 17th, so patient investors may want to hold off any new purchases until the earnings are released and can be analyzed.
For investors trying to gain long-term exposure to Citi, the best instrument for that is the common stock. The Series A warrants can be used in a 'lottery ticket' type holding, but investors should know the significant risks associated with both Citi warrants.