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Several months ago we profiled CIT Group Inc. (CIT) as an attractive niche business that was trading at a discount to intrinsic value. Since that time the stock has appreciated materially, and was recently in the news with Charlie Gasparino's report that CEO John Thain is potentially shopping the company to larger banks. In our earlier article we argued that CIT's ability to pay off high-cost debt, and build its deposit franchise would eventually lead to much higher levels of profitability. This is the case because CIT's business of middle market and small business lending often produces attractive yields. Therefore some basic liability management would drastically improve the net interest margins.

There has been speculation that Wells Fargo & Co. (WFC) would be a good fit, due to its current financial strength, and low-cost funding. CIT has raised deposits through channels such as the internet, which aren't nearly as sticky as core retail deposits, and often have slightly higher rates. The company has been trying to expand its bank, and John Thain has spoken openly that acquiring a bank would make considerable sense. Currently there is a significant valuation disparity between regional banks and the big money-center banks such as WFC, JPMorgan Chase & Co (JPM), Bank of America Corp. (BAC), and Citigroup Inc. (C). Many of the regional banks are trading at premiums to book and tangible book value because of their lack of capital markets business, which are not in vogue due to a more punitive regulatory environment, and volatile macro-economic conditions. This makes it difficult for CIT to be the acquiree, therefore the big money-center banks do make logical sense as acquirers.

Several months ago JP Morgan dominated the headlines with the problems in their CIO division, which is responsible for investing some of the company's excess deposits. Leveraging CIT's relationships and higher yielding asset portfolio would create significant opportunities for JP Morgan or any of the other large banks. Wells Fargo executed a large and extremely complicated integration of Wachovia bank which dramatically increased the size and earnings power of the company. During the process Wells beat what at first seemed to be relatively optimistic synergy goals. Wells Fargo seems to make great sense as the acquirer because they are very strong in the leasing and middle market lending markets that CIT is good in. They have one of the very lowest costs of funds, and Wells Fargo is one of the few banks that trades at a premium to book value, therefore issuing stock to pay for the company would make sense. Often middle market and small business lending relationships evolve into a full-line banking relationship where deposits are moved over, and the banks are all searching for high quality yield expansion.

Because CIT has extremely strong capital ratios with preliminary Tier 1 and Total Capital ratios of 18% and 18.9% respectively as of June 30, 2012, the large banks could pay a reasonable price without hurting their own capital ratios. Reducing funding costs would be extremely easy putting an immediate boost to earnings and returns on equity. For a company such as Wells Fargo with a strong presence in activities such as leasing, synergies could likely be maximized throughout the related businesses. After the 2nd quarter CIT boasted book and tangible book values of $41.83 and $39.87 respectively. CIT also has about $4 billion of net operating loss carry forwards, which could most certainly be used by Wells Fargo considering the company's robust profitability.

At $41.25 any price above 1.2 times book value would seem quite expensive relative to other recent banking transactions, but I believe if Wells Fargo paid that by issuing stock, which for them is trading at 1.4 times book value, the deal would make a lot of sense. While some investors might want to buy call options or the stock to speculate on a buyout, I believe a smarter and more conservative play would be selling the January 14 $40 puts for about $425 per contract. If a buyout goes down at a greater price you should be able to exit quickly with a great profit, and if nothing happens and the stock ends up dropping you'd still be acquiring the company at a nice discount to tangible book value. If the stock expires above $40 your return would be $425 or 11.88% on the maximum risk of $35.75 per share, or $3,575 total, which also would be your breakeven price if you were to end up owning the stock. John Thain doesn't strike me as a man that wants to take 5-10 more years to build CIT into something far greater than it is, and I think a quick and lucrative payout could really incentivize him. CIT would be better off under the guidance of one of the larger banks, and I think the odds of a deal going through at some point in the next year are greater than 50%.

Source: CIT Group Is An Attractive Catch And Here Is A Way To Play It