Citigroup's (NYSE:C) B warrants sold off significantly in the June treasury auction, falling 87% to just 3.5 cents. Despite a reasonable set of second-quarter results from Citi, the "B" warrants have continued to fall - selling at just 2.9 cents today (7/16). Investors believe it is very nearly impossible that Citi shares trade above $178 by October of 2018. While I certainly think it is highly unlikely, I think that the probability is greater than that which is currently being assigned by the market. As such, I've taken a very, very small investment (one-tenth of a percent of my portfolio, to be exact). While this is a very small investment and not something I would typically spend this much time thinking about (let alone writing about), I find the asymmetry here to be particularly interesting.
The premise for my investment is very simple. First, Citigroup may experience an improvement in operating results - a few things come to mind:
- Wind-down of excess costs related to the litigation that the bank has experienced since the crisis.
- Cost-cutting beyond decrease in litigation expenses - the largest opportunity for expense reductions is in IT (almost a rule of thumb for all financial institutions, particularly large banks).
- Release of potential excess loan loss provisions - As the economy has inched forward and housing markets have bounced back, I believe there is a strong probability Citigroup has excess reserves. The tail on this can be long (look at the Swedish banks, who had write-backs for over a decade following the crisis of the early 1990s).
- Increase in spread income - as interest rates rise, Citi (and many other banks in the US) will benefit from higher spreads. In a zero-rate environment, banks aren't realizing much benefit of their low-cost demand deposit base (banks pay basically nothing for checking accounts, but now are only able to loan the money at 2%-4%; were Citi instead able to pay nothing and lend at 5%-6%, this would give net interest income and overall results quite a boost).
With most of the litigation behind the company (fingers crossed) and an excess capital position (Tier 1 Common ratio of 10.6%), I expect Citi to start returning capital to shareholders and think it is likely we could see meaningful buybacks in the coming years. Buybacks at a discount to book value (Citi trades at less than 90% of tangible book value) lead to book value accretion. Coupled with improved operational performance (as outlined above), I think we could see Citi compound book value at 13% over the next 4.4 years (until warrant expiration).
If Citi is able to compound tangible book value at 13% for 4.4 years (faster in out-years), it would have a tangible book value of $97.50. This would mean that total book value is $107 (there are nearly $10/share of intangibles - let's assume they are not written off). What multiple might Citi trade at? Looking back in time, I see that Citigroup traded at 1.9x-2.2x book value in 2005-06. Is it within the realm of possibility that Citi might trade there? While I certainly wouldn't pay that multiple for the bank, if I'm sure about anything, it is that markets have short memories. It is very difficult to assess what may be going on in the economy or at Citibank 4+ years in the future. However, it is possible that the economy has picked up (and that investors expect further growth). Further, Citi may be coming off a banner year (the 13% was an average ROE estimate during the period - perhaps it will be 11% in 2014/15 but 15%-16% by 2017/2018). Excited investors expecting a 16% on total book value for 2019 would expect $17.30 in EPS. Assuming investors were willing to pay 12x forward EPS, Citi could trade at $207 per share (that would equate to 1.9x total book and under 2.1x tangible book value). Note that the resumption of a meaningful dividend at Citi would hamper book value growth (protection here is weak vs. A warrants) so owners of "B" warrants are much better off with buybacks than dividends. That said, deep value investors in Citigroup are likely to push management toward buybacks rather than dividends.
In this instance, the warrants would trade at a whopping $2.90 each (each warrant entitles the owner to 1/10th of a share), representing a 100-fold increase in your investment (ok speculation). What about downside protection? There isn't any! Expect to lose everything you invest. That said, the market tends to be myopic, and I believe these warrants to be mispriced.
Disclosure: The author is long C. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long the B warrants, also the A warrants.