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Summary

  • First we'll compare the features of both the Class A and Class B warrants, including strike price, expiration date, and adjustment terms.
  • Next we'll try to find a reasonable forward price target for the common stock through 2018.
  • Finally, we'll compare the returns of the common stock to those of the Class A and Class B warrants.

Warrant Terms

Citigroup Inc. (NYSE:C) has two outstanding issues of warrants, Class A and Class B, in total representing the right to purchase 46.5 million shares of Citigroup common stock. The warrants represent 1.5% of shares outstanding. Since Citigroup underwent a 1 for 10 reverse stock split back in 2011, I'll be using the post reverse split adjusted terms of the warrants. So if you notice any discrepancies between the original prospectuses and the terms used below, please take into account the reverse split.

C WS AC WS B
Exp. DateJan. 4, 2019Oct. 28, 2018
Years Until Exp.4.3444.161
Strike Price$106.10$178.50
Div. Adj. Threshold$0.10$1.60
Warrant Premium107.1%245.7%
Shares/Warrant1.0001.000

Like other TARP warrants, both issues of Citigroup warrants offer strike adjustment features to account for dividends paid out to common stock on a quarterly basis in excess of the dividend adjustment threshold noted above. In any quarter where the dividend payout exceeds the respective threshold, the strike price will be adjusted downward in accordance with the following formula:

Additionally, in the case where the quarterly dividend exceeds the dividend threshold, the number of shares purchasable per warrant increases as follows:

Since Citigroup has not yet exceeded the dividend threshold, both the strike price and shares purchasable per warrant remain unchanged.

Common Stock

To place a value on these warrants, we have to come up with a reasonable price target for Citigroup common stock by the time of expiration. Today the stock trades at a pretty steep discount. At $51.65 per share, that puts the stock at 0.77x book value and 9.6x forward earnings. Over the past year, Citigroup has significantly underperformed its peers and the overall market. This can probably be attributed to the company's inability to gain approval to increase stock buybacks and dividends, as we clearly saw through its March CCAR results in which Citigroup's plan to increase stock buybacks to $6.4 billion and its quarterly dividend to $0.05 was shot down. While this is obviously depressing short-term news for shareholders, we're more interested in the longer term picture of where the stock is headed.

To paint that picture, we'll be taking a look at a few things: 1) The company's equity growth rate. 2) The market's valuation of the company's equity. 3) Quarterly dividend payouts. Below I'll discuss how I calculate these assumptions to come up with a target price.

1) To come to a book value per share figure, I'll be borrowing Josh Arnold's forecast, which I find to be suitable for this model considering that he takes a relatively conservative approach to this. Though in his analysis, Arnold calculates book value on an annual basis, I'll be calculating book value on a quarterly basis. I do this because warrant adjustments take into consideration the share price at the time of the dividend payout, which takes place on a quarterly basis. In Arnold's forecast, book value is projected to grow at a quarterly rate of 1.8% through 2018.

2) Citigroup's current .77x P/B multiple is historically low, especially considering that the company consistently traded above 2x book value leading up to the financial crisis. I don't think Citigroup will be hitting 2x book anytime soon, but I think it's reasonable to assume that book value increases to around 1.2x by the end of 2018. For our calculations, we'll assume that the P/B multiple increases 0.025 points each quarter through 2018.

3) Dividend estimates can be especially sticky, especially considering the company was just denied approval for a dividend hike. Again I'll be referring to Arnold's estimates. I think they're reasonable, and potentially understated, which is good for this model because I don't want to overstate the warrant adjustments. For 2014, we'll assume that the dividend remains at $0.01 per quarter, then increasing to $0.05 per quarter for 2015. Thereafter, the dividend will increase $0.05 per quarter starting at the beginning of each year.

Under these assumptions, the stock would have appreciated nearly 117%, including dividends, to $111.86 per share, which we'll assume the stock maintains from the expiration of the Class B warrants through the expiration of the Class A warrants. Below are the stock returns relative to book value.

(click to enlarge)

Warrant Returns Relative To Common

CC WS AC WS B
Start Value$51.65$0.86$0.04
End Value$111.86$7.12$0.00
Gain ($)$60.21$6.26($0.04)

Gain(%)

116.6%727.9%(100.0%)

(click to enlarge)

These returns consider strike price and shares per warrant adjustments. Under our model, since the quarterly dividend never exceeded the Class B threshold of $1.60 per share, no adjustments were triggered. However, under the given scenario, the Class A strike price was adjusted downward by $0.66 and the shares purchasable per warrant increased from 1 to 1.0063. These adjustments may seem to be quite paltry, but should the dividend increase at a faster rate than we used, then the warrant adjustments will be much more significant, though it seems very unlikely that the Class B warrants will be adjusted at all. You should also note that, as evidenced by the above graph, the Class A warrants will be cutting it pretty close to the time of expiration to break into positive intrinsic value.

Final Thoughts

As I've mentioned in every one of my articles on warrants, there is significant risk involved in investing in them. While the leverage might make your mouth water, there is still the chance that these warrants become worthless. In the case of the Class B warrants, it seems as though that's a very distinct possibility considering how far out of the money they are and how high the dividend threshold amount is set to. The Class A warrants are much more likely to at least reach the money, but there is still risk involved and I strongly encourage you to weigh your risk tolerance before making an investment decision, especially considering that, out of all TARP warrants currently trading, Citigroup warrants trade farthest out of the money.

Source: Loving The Leverage: Citigroup

Additional disclosure: I may initiate a long position in Citigroup Class A warrants (C WS A) over the next 72 hours.