Explaining the Citi Arithmetic

Since I’ve been writing about preferred and common stock so much this week, I thought I would just try to explain the arithmetic of the Citigroup deal announced today. (By the way, it isn’t a done deal: All it says is that Citi is offering a preferred-for-common conversion to its outside investors, and the government will match them dollar-for-dollar, although the WSJ says that several investors have agreed to participate.)

Right now, according to Google Finance, Citi has 5.45 billion common shares outstanding. It is offering to convert up to $27.5 billion of preferred shares held by “private” investors other than the U.S. government (like the government of Singapore and Prince Alwaleed) into common shares, at a conversion price of $3.25. That would create another 8.46 billion shares. For every dollar that is converted, the U.S. government will also convert one dollar of its preferred stock, up to $25 billion; that is the $25 billion from the first round of recapitalization back in October, which is paying a 5% dividend. (Fortunately someone realized we should convert that before converting the second chunk, which pays 8%.) That would create another 7.69 billion shares. So if everyone converts as much as possible, there will be 21.60 billion shares outstanding, of which the U.S. government will own 7.69, for an ownership stake of 36%, the number you read in the papers. (Actually, if the private investors convert exactly $25 billion and not $27.5 billion, the government would own 37%, but that’s a detail.) The other private investors would own 39%, and current shareholders would own 25%.

The government got some warrants on common shares in connection with the earlier recapitalizations. I assume the warrants it got for the first investment will no longer exist (because that first investment is being “paid back”), but the warrants on the second investment, if exercised, would presumably push the government up a couple percentage points.

Where did the $3.25 price come from? Who knows. Yesterday’s closing price was $2.46. If that price had been used, the government’s target ownership percentage would have been 38% instead of 36%, which seems immaterial. Presumably it was the product of a negotiation, since it’s hard to see how the investors involved - especially the ones that are not the U.S. government - would have wanted to pay more than the current stock price for a company that is clearly in trouble. At least they didn’t use $3.46, which is the price that any future Citigroup convertible preferred stock can be converted at.

And why did the stock plummet (now $1.57), despite the fact that the preferred shareholders are “paying” $3.25 per share? Probably because the common shareholders realize this is largely an accounting game, and the preferred stock wasn’t worth its face value to begin with. The current shareholders’ ownership stake could fall from 100% to 25%, but the stock is only down 36%. This implies that the market thinks that the total common shareholders’ stake will more than double in value, but won’t quadruple in value (the amount required to offset the dilution). Their stake increased in value because (a) Citigroup can avoid paying dividends on all the preferred stock that gets converted and (b) that much less money will have to get paid back to preferred shareholders in case of liquidation. But there’s still a large cloud hanging over Citi, and it’s on the asset side of the balance sheet.

Comments

[John Lounsbury]

Baseline Guys - - -

Thanks for going through the numbers. I haven't had time to try to figure out what was involved in the deal, so I appreciate your work.

This movement into common stock for C is following the same general path that was used with AIG. Let's hope it doesn't go as far, because that would mean that C really isn't rescuable and we have wasted a lot of money trying to rescue that which we have to dismantle.

2009 Feb 28 01:38 AM

[logicalthought]

I still find this reasoning a bit puzzling, because from an "enterprise value" standpoint, the above-market conversion price is accretive to the common stockholders. And in a potential liquidation, whether or not the common holders thought the preferred had been worth "par", it still would've been one more piece above them in the cap structure which (theoretically, at least) would've had to have been paid off in full before the common holders got anything.

I think the stock got slammed because the common holders were considering their stock to be sort-of a cheap, "highly-levered call option" (in case the equity value of Citi could one day get back to near what it used to be), but due to this massive dilution, even if that happens, the stock price will be worth a heck of a lot less.

2009 Feb 28 07:31 AM

[bungaloo]

I thought I heard that Abu Dhabi was one of the converters. If I recall, the initial investment they made had a lower conversion band in the high teens and was a mandatory convert after a certain number of years. They are getting a very beneficial conversion in this offer...several times the common they were supposed to get under the original terms.

2009 Feb 28 08:50 AM

[mavericks]

I think a more likely scenario for C is the old Ma Bell, AT&T. Once the Govt. gets control, they will break it up and start new banks by geography.

Just for fun...and to remind us of the disaster that created them, they should be called by the natural disasters prone to that area...for example, the NE zone will be called the Bank of the Arctic, the SE zone will be called the Bank of the Hurricanes, the Midwest zone will be called the Bank of the Tornados, the SW zone (inc. California) will be called the Bank of the Earthquakes and the NW zone will be called the Bank of the Volcanos.

Then once the banks become profitable and the stocks soar, the Govt. will cash in and not long after that...voila, the banks will begin to merge again. But instead of the old Citigroup name, the new consolidated name will drop the natural disaster approach and take on a more warm and personal approach and they will call it...Titigroup. And you can imagine what the names of the new banks will be when THAT ultimately fails.

2009 Feb 28 11:02 AM

[john s. gordon]

mavericks - an interesting suggestion. convert that which is too big to fail into an assortment of things of more manageable size.
> jack

2009 Feb 28 01:00 PM

[john s. gordon]

i see in today's paper that Fred the Shred (Royal Bank of Scotland) was requested to forego some of his ill gotten gains and declined.

the wall st. virus of excess has leaped across the pond/
> jack

2009 Feb 28 01:24 PM

[Misha]

Preferred to common conversion is a vote of confidence by preferred holders. They concluded (presumably, with government assurance) that common is not going to zero and should appreciate with time. Also note that with Friday’s deal, Citi is now healthier by several measures than many better liked banks:

online.barrons.com/art...

2009 Feb 28 06:57 PM

[mikeliu]

Citi's True Value for existing shareholders Assuming Citi's existing shareholders will hold 26% of the restructured company, based on the current outstanding shares of 5.4 billion, there will be 20.77 billion shares outstanding after the restructure. Assuming further Citi will be able to earn $10billion in net profits after preferred payment ( which is not very large in normal circumstances given Citi's $1.3 trillion asset base and close to $1 trillion earning assets), its per share earnings will be 48 cents. Applying Citi's historical PE multiple of 13X, in a turnaround situation, each share will be worth $6. That's four times of the closing price of $1.5 per share on last Friday. The above projection, of course, assumes Citi will be able to recover. Citi has a great franchise in its international reach which provide a unique platform for mulitnational companies and wealthy individual clients. Given its large mark downs which will be marked up in a recovery scenario, the real upside would be more than $6 in the above scenario. A perpetual option for a minimum 4 times return is indeed a good value buy, if you believe in the turnaround story.

2009 Feb 28 10:18 PM