Is Citi the Ideal Speculation Play?

“But now there are only two banks left that need to issue stock to get out from under TARP, Citigroup and Wells Fargo, which denies it has to. But give me a break…With this stock offering, you’re getting Citigroup in a price that is far more beaten down than it deserves to be. And you have to take advantage of the discount…I want you to buy, buy, buy Citigroup.” — CNBC’s Mad Money 12/14/2009

Recently, the largest banks in the country are following Bank of America’s (BAC) lead and exiting the TARP program through massive secondary offerings. The latest to announce their intentions to repay the government loans are Wells Fargo (WFC) and Citigroup (C) and both will require billions of dollars of capital in order to accomplish this feat. On Monday night’s Mad Money, Jim Cramer discussed why he thinks investors should buy into Citi on the secondary offering rather than Wells Fargo. The Citi offering will be a gigantic $20.5 billion which dwarfs even Wells Fargo’s need for $10.4 and both of these will further dilute existing shareholders. With the banks eager to lift the yoke of the increased government oversight that comes with TARP, it is a signal to the market that these formerly hobbled banks are returning to health.

Among Cramer’s reasons for buying into Citi over Wells is the banks strong presence overseas where the bank is respected far more than its tarnished reputation at home in the USA. Furthermore, Wells has too much exposure to mortgage loans in California and other troubled mortgage loans through its acquisition of an east coast mortgage giant, Wachovia. Cramer believes that the price, currently well below $4, is attractive and still far less than the company’s book value. Cramer believes that this stock will triple by 2012 as the book value continues to improve along with its debt portfolio, and called the bank the “ideal speculation play”. He continues, “It’s like a lottery ticket with better odds of winning.”

Despite Cramer’s enthusiasm for Citi, there are plenty of analysts who are not so bullish on this move. Repaying TARP could in fact hurt the bank and there shareholders, as an article from Time Magazine suggests.

“But analysts say Citi’s rush to repay the assistance it got through the government’s Troubled Asset Relief Program (TARP) will make the bank weaker, not stronger. The move will reduce Citi’s capital ratios and hurt earnings; it may also accelerate a retreat of foreign investors from the company’s shares. Worse, the government is demanding stricter terms from Citi than it did from Bank of America on the repayment deal it struck just a week ago. The different treatment shows that the government remains more concerned about Citi’s finances than those of its rivals.

Veteran analyst Richard Bove of Rochdale Securities, who had been recommending Citi’s shares since the summer, downgraded the stock on news that it was going to repay TARP from a “buy” to a “sell” rating. “What does it do for the company? Management can increase [executive] salaries,” says Bove, referring to the fact that Citi will now be free of the government’s compensation rules. “What else? Nothing.” – Citi’s TARP Repayment: The Downside for a Troubled Bank, Time Magazine

Citi’s balance sheet will actually suffer as a result of the repayment instead of improving. Recently recovered capital ratios will drop back to risky levels and no longer having government guarantees on some of the riskiest loans make the bank far more vulnerable to losses. From a shareholder’s perspective, the massive dilution of this secondary offering is likely to reduce earnings per share by about 20% going forward.

At Ockham, we have had an Overvalued stance on Citi for the last few months. This is not because the price is expensive because it clearly is not, but rather the fundamentals have been so hampered that the stock was at risk of a pull back. Not to mention there has been massive dilution through all of the capital raising efforts that losses have necessitated. Analysts anticipate earnings per share in fiscal 2010 of 7 cents, which makes the forward looking P/E multiple hardly cheap at more than 50x. Any worsening in the condition of their debt (no longer guaranteed by the government) would put those slim profits in jeopardy, so even though Citi will now lose the stigma of substantial government assistance there is more risk to shareholders than before. As Cramer suggests, this stock will almost undoubtedly be higher in 2012 and could very feasibly triple, but in the meantime it may be a bumpy ride.

Is Citi the Ideal Speculation Play?

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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