CIT Group: Back From The Brink With An Exciting Future

Jul.30.12 | About: CIT Group (CIT)

CIT Group Inc. (CIT) sits in a perfect niche business as a leading provider of financing and leasing capital to small businesses and middle market companies. CIT operates in five different lines of business including: 1) Corporate Finance, 2) Trade Finance, 3) Transportation Finance, 4) Vendor Finance, and 5) Consumer Finance. Larger banks have been pulling back from these customers as increasing capital requirements and regulatory ambiguities have forced a deleveraging process, providing opportunity for well-financed, smaller competitors to expand relationships and profitability. We haven't bought CIT Group for our clients or ourselves due to other excellent opportunities in the financial sector, but we've been following the company closely for many years, and would look to purchase on weakness. During the Financial Crisis the company's reliance on short-term financing, and exposure to troubled consumer credit such as mortgages, caused the company to eventually file for bankruptcy. Through a bankruptcy driven restructuring of the balance sheet resulting in a lower cost of capital, CIT offers a cheap play on above average commercial financing growth, that has the potential to bring shareholders 10-15% compounded returns moving forward.

When CIT quickly emerged from bankruptcy in late 2009 the company was saddled with expensive debt and a lack of clarity at how the company would be able to reduce its cost of capital to be able to lend profitably in a low interest rate environment. CEO John Thain embarked on an ambitious program to prepay as much of the high-cost debt as possible, while building out CIT's bank deposit platform to provide a more stable source of low-cost funding which should prove more reliable the next time credit markets freeze up. In addition CIT shed some of their consumer businesses to focus more on corporate clients where the company believes it can find better risk adjusted opportunities. Financing and leasing are attractive businesses to be in as they usually entail secured transactions, with more lucrative margins than traditional bank loans can offer. Scale, cost of funds, and customer relationships are the keys to competing effectively. While record low interest rates have hurt net interest margins for just about every lending institution, CIT has benefited from the huge costs savings that the company has been able to manufacture from refinancing its debt. These refinancing operations incur certain accounting costs associated them which make looking at CIT's earnings very misleading.

Just in the 2nd quarter CIT redeemed at par approximately $4.1 billion of 7% Series C notes and repurchased at a slight discount approximately $140MM of 7% Series C notes. In addition the company issued $2 billion of senior unsecured debt, which consisted of $1.25 billion of 5% notes that mature in 2017 and $750MM of 5.375% notes that mature in 2020, and also issued $753MM of secured debt through a Vendor Finance equipment lease securitization that had a weighted average coupon of 1.45%. CIT also raised $1.1 billion of deposits, where 75% were raised through more rate sensitive internet channels. Due to these recent actions and those done over the last couple of years CIT's weighted average coupon rate on outstanding deposits and long-term borrowings was 3.83% at June 30, 2012, improved from 4.24% at March 31, 2012 and 5.11% at June 30, 2011. Just in July, CIT completed a $511 MM Canadian Vendor Finance receivable securitization with a weighted average fixed coupon of 2.285% and announced that it will redeem $600MM more of the 7% Series C notes maturing in 2016 on August 20, 2012. These actions would have reduced the weighted average coupon rate to 3.77%. Currently deposits represent 23% of total funding, unsecured debt is 44%, and secured debt is 33%. I'd look for the company to aggressively continue to hack away at the remaining $4 billion of 7% debt that sits on the books.

On July 30th, 2012 CIT reported a 2nd quarter loss of $71MM or $-0.35 per diluted share, primarily due to $286MM in debt refinancing charges. Pre-Tax income was actually $245MM excluding the $286MM of refinancing charges which was related to the prepayment for $4.2 billion of high cost debt. The company experienced very strong growth in new business with funded volume of $2.4 billion, up 19% sequentially, and 38% YoY. Committed new business volume of $2.7 billion increased 31% sequentially, reflecting growth in Corporate Finance, Vendor Finance, and Transportation Finance. Commercial Financing and Leasing Assets increased $0.6 billion sequentially, and CIT's bank reached $2 billion in online deposits and $10 billion in assets. All 4 core businesses were profitable on a pretax and pre-debt repayment basis. Currently 90% of CIT's U.S. funding volume is being originated by CIT Bank, exhibiting the strengthened business model post-bankruptcy. The Transportation division has been a real source of strength with adjusted pretax income increasing to $129MM, reflecting lower funding costs, higher net rental revenues, and lower credit costs. Aircraft utilization is 99% and rail fleet utilization is 98% exhibiting the strength of CIT in a business with fewer competitors due to deleveraging.

CIT had $42.8 billion in total assets as of June 30, 2012, down $1.4 billion from March 31, 2012, and $5.4 billion YoY. Commercial financing and leasing assets increased to $29 billion while consumer assets declined largely due to the sale of $1.1 billion of student loans. Total loans of $20.1 billion declined $2.2 billion from a year ago, and $0.4 billion sequentially. Operating lease equipment increased $1 billion YoY to $11.9 billion reflecting aircraft and rail car deliveries and was basically flat with the prior quarter. Cash and short-term investments decreased $0.3 billion sequentially to $7.0 billion as the company paid down high-cost debt. Average earnings assets were $32.2 billion in the 2nd quarter and included $27.3 billion in commercial earning assets. Excluding net FSA accretion and debt prepayment costs, the finance margin was 3.02%, up from 1.4% YoY and 1.97% sequentially. The financing margin has been improving primarily by lower funding costs, a reduction of low yielding assets, higher prepayments and interest recoveries, and the benefit from the suspension of depreciation on operating lease equipment held for sale. Operating lease rental income has been increasing from prior periods due to higher asset levels and improved railcar utilization.

Similar to other banks credit quality continues to improve for CIT. Net charge-offs were $17MM, or 0.33% as a percentage of average finance receivables, down from $55 million (0.95%) YoY, and $22MM (0.44%) sequentially. The commercial segment continues to see solid improvement as charge-offs were 0.42%, improved from 1.38% YoY, and 0.56% from the 1st quarter. The provision for credit losses was $9 million, down from $84MM YoY, and $43MM in the 1st quarter. Non-accrual loans were $455MM or 2.26% of finance receivables as of June 30, 2012, down from $1.1 billion (4.77%) YoY, and $482MM (2.35%) in the 1st quarter. The allowance for loans losses was $414MM at the end of the quarter, or 2.06% of finance receivables, and compares to $424MM (1.9%) last year at the same time, and $420MM (2.05%) in the prior quarter. A weak economic environment could increase credit costs particularly in Latin America and Europe, but the current balance sheet is conservatively managed through fresh start accounting from bankruptcy.

CIT has extremely strong capital ratios with preliminary Tier 1 and Total Capital ratios at 18% and 18.9% respectively, as of June 30, 2012. CIT has a book value of $41.73 and tangible book value of $39.87. When the company is able to exchange the $4 billion of 7% bonds remaining for a lower coupon, the company will likely save $100-$200MM more in annual interest costs. CIT should have no trouble compounding book value by 10-15% assuming no dividend payments. The company hopes to be able to issue dividends next year pending approval from the Federal Reserve. A ROE of 12-15% on tangible book is certainly within reach, pegging normalized earnings somewhere between $5-6 per share. While I do think John Thain has done an exceptional job with CIT, I believe he would be very smart to look into a merger of equals with an established retail banking franchise. A partnership with a company such as Regions Financial Corp. (RF) would drastically reduce CIT's cost of capital, while leveraging both companies corporate Rolodex's to increase market share in financing and leasing to small and middle market businesses. Both companies trade near tangible book value making a stock based acquisition reasonable, and although CIT might want to follow their own path, the savings from increased scale and funding costs would be so beneficial to both companies that it is worth looking into. Regardless, CIT is a compelling play in an attractive business for the patient long-term investor.

Disclosure: I am long RF.