I have received a ton of mail regarding my recent article "When Whitney Attacks," mainly from a rabid assortment of her supporters.
I do apologize to Ms. Whitney as it does turn out that CIBC divested her division to Oppenheimer, so she is now an Oppenheimer analyst who only used to work (as of last November) for CIBC. It may not sound like a big deal to you, but it seems to be vitally important to others (like Toronto’s Globe and Mail) that this fact be ironed out lest my entire defense of the financial sector be deemed invalid.
Perhaps they are touchy about the fact that I pointed out that foreign banks, in addition to the usual suspects, stand to benefit from Citigroup’s (C) troubles. The last I heard was that they did all compete in the international markets and Citigroup was, and still is at the moment, the 800-pound gorilla of the financial industry.
Rather than allow this to degenerate into a war with the Whitney camp, I’m just going to make a simple case for Citigroup (most data from Yahoo Finance and Investools) as an example of how this bank bashing has gone too far:
Citigroup has $2.1 trillion in assets, with some of those assets in the dreaded subprime category. The company wrote down $1.56 billion in Q3 2007 in CDOs and an additional $1.35 billion of "leveraged finance commitments." This dropped Q3 net income to "just" $2.2 billion on $43.2 billion in sales vs. $5.5 billion earned in Q3 2006. In November, CEO Chuck Prince resigned and was replaced by Vikram Pandit. I predicted at the time that they would throw the kitchen sink into Q4 so they could put it all behind them, and the bank indeed came through, writing down $18 billion worth of debt, turning Q4 into a $9.8 billion loss.
At the time, Citigroup said its total exposure to sub-prime was $55 billion, INCLUDING $43 billion of CDOs. Remember this is out of $2,100 billion in total assets! While all this was going on, Citi’s business was going gangbusters, with 5% growth in overall revenues, led by a 29% growth in International revenues - beating out competition like… oh, let’s say CIBC.
As a rapidly expanding bank, Citi finds itself vulnerable to the old Mr. Potter attack strategy of fomenting panic in the markets, as the bank has a very high, but usually manageable, loan/deposit ratio:
click to enlarge
Since a large portion of its money is lent out, it is very damaging to Citi if, suddenly, a lot of people ask for their money back. A lot of this is payback for Citi’s aggressive marketing, that has driven internal revenues up 30% in 2007 and it finished the year, despite $20 billion in write-offs, with a profit of $3.6 billion on $159 billion in revenues. In order to shore up its reserves, the bank sought and quickly received $12.5 billion in capital in exchange for convertible preferred shares and also sold $7.5 billion worth of stock to Abu Dhabi. The company also cut its $10 billion dividend by 40% and announced plans to lay off 4,200 out of 374,000 employees.
It must be nice to be able to snap your fingers and get $20 billion dropped into the vault! After writing off $25 billion of the $55 billion of total questionable debt (which, of course, gives them a pass on taxes for quite some time) the bank was only down 50%. Also at that time (January), the attacks stepped up significantly. Now without going into it all here, let’s just concede that ALL $55 billion of sub-prime and CDO assets turn out bad, then how bad could it be?
Remember we’re taking about $2,100,000,000,000 in assets with $55,000,000,000 being written off, that’s 2.6% of the assets which will ultimately become a tax benefit against the bank’s net income of $20 billion a year. The bank has already written off half of it and the knock on Citi is that it didn’t write the whole thing down. It seems reasonable to assume that the bank will ultimately be able to sell the homes for 50% of their loan value, it’s just that other banks have written down more aggressively by comparison.
It is unclear how Ms Whitney sees a write-down of another $18 billion of paper assets will impact the $39 billion of cash flow from operations generated by Citigroup last year. Even with the $25 billion in write-downs in Q4 and the $10.8 billion dividend payout, the company generated $11.7 billion in free cash flow in 2007. However Ms. Whitney states:
"We estimate that Citigroup will actually earn $1.43 per share shy of its dividend payment this year. In other words, C will pay out $1.43 per share more than it earns this year. How anyone, let alone C’s management and the board, can believe that its dividend is safe given this earnings scenario is beyond our comprehension."
That revenue estimate is miles below the $1.73 average estimate AFTER DIVIDENDS that are expected by the other 16 analysts who follow the stock and have an average price target of $27.64. Oppenheimer has one of the two sell ratings on the stock, so they are either ahead of the pack or out on a limb with this one.
The premise for Whitney’s super-bear attitude is that the ratings agencies may write down more structured bonds - haven’t we heard all this before with ABK and MBI? - causing the banks to hold more capital reserves and crimping revenues. Remember that C was the most aggressive lender by a mile and may stand the most to lose. Based on the same premise (double dipping), it then follows that the banks will be forced to write down these assets too, leading to another round of losses.
However, it should be noted that Citi has been acting aggressively to address its precarious capital position. According to its annual earnings report filed this February, it has raised $30 billion in qualified Tier 1 capital since last November (which is the same amount Whitney said back in October that Citi would need).
At this point it looks like the bank is marginally OVERcapitalized. As it points out in its annual report, "To be ‘well capitalized’ under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 Capital Ratio of at least 6%, a Total Capital Ratio of at least 10%, and a Leverage Ratio of at least 3%." According to that report, it has a Tier 1 ratio of 7.12%, a total capital ratio of 10.7%, and a leverage ratio of 4.03%.
So let’s say Citi does only earn $1.49 per share and can’t pay its dividend, and let’s say that its losses are so severe that they don’t recover until 2010 and, even then, earnings don’t get past $2 per share. How much should we pay for $2 per share forward earnings? The average p/e in the banking sector is 12.7. Even at $1.49, that’s $18.92 in Meredith’s worst case scenario. Citi was trading down to $20.83 Friday, close enough for us to have piled in on leaps and shorter calls (just on the very slight off-chance that Ms. Whitney is wrong).
Maybe it’s just me, but I see a bank with $2.1 trillion in assets and 200 million depositors in 50 countries with 4,700 locations and 120 million credit card clients - more than MA, which is valued at $28 billion just for that segment - selling for a total of just $108 billion after earning $24 billion in 2005, $21 billion in 2006 and $3.6 billion in 2007. That is AFTER paying out $10 billion in dividends and $10 billion in taxes.
So no thanks bears, I think I’ll take my chances that the entire financial system won’t go down the toilet. Yes, you have BSC to point to, but that too was an engineered failure, brought on by panicked investors causing a liquidity crisis in an investment house that was already having troubles. BSC was beholden to a fairly small group of wealthy investors, and you can organize - oh sorry, I promised to call it a coincidence - withdrawals that can cripple the firm, but no matter how many TV shows you go on, I don’t think you can take down a diversified financial the size of Citi. Either way, it’s going to be an interesting couple of weeks until earnings.
