In Bill Ackman’s Q1 letter to investors, he wrote this when discussing Citigroup (C):
“In the first quarter, Citi’s share price appreciated materially from a depressed level at the end of 2011, and in recent weeks, declined back to similar levels. We have believed for some time that Citi is a well-capitalized financial institution trading at a substantial discount to intrinsic value. We have also believed that Citi’s ability to return capital to shareholders principally through share repurchases will be an important catalyst for value recognition by shareholders."
Shortly after the first quarter ended, the Federal Reserve released the results of its annual stress test for large U.S. financial institutions and Citi reported earnings. These annual stress tests attempt to determine how a severe economic downturn would impact the capital of the largest U.S. banks. In conjunction with the stress test, the banks submit a proposal to return a specified amount of capital to their shareholders over the next several years. Based on the test’s results, the Fed either approves or rejects the banks’ proposals.
We believe this year’s stress test results showed that Citi is one of the best-capitalized U.S. banks, which would make it unlikely to need to raise capital even in the event of a continued severe and long-lasting economic downturn. Unfortunately, the Fed did not approve Citi’s proposal to return what we believe was $5 billion to $8 billion of capital to its shareholders.
The Fed requires that banks maintain at least a 5% capital ratio after undergoing the stress scenarios, which is a measure of a bank’s equity capital relative to its risk-weighted assets. If Citi had been allowed to return the amount of capital to shareholders that it proposed, it would have achieved a 4.9% capital ratio, 10 basis points below the required minimum. Unfortunately, the Fed took a “thumbs-up” or “thumbs-down” approach to the capital return request – if the bank’s request was one dollar above the minimum as determined by the Fed, its request was denied.
Citi is required to resubmit a capital plan in the next few months. Based on the amount of capital that Citi generated in the first quarter of this year, the bank’s capital is now above the minimum 5% capital ratio by a wide margin if it were to resubmit the same capital request. In light of the currently uncertain environment, however, Citi has elected not to seek to return capital to shareholders in 2012, delaying a potential valuation catalyst into 2013.
In the first quarter of this year, Citi reported one if its strongest earnings results in the last several quarters. Revenue increased at a healthy rate in its core businesses, credit costs continued to improve, and capital levels continued to increase. With this progress, Citi generated a more than 15% return on tangible equity in its core business. Citi’s core businesses also generated operating leverage, as revenue grew more quickly than expenses. Citi’s historic inability to generate operating leverage in previous quarters had previously been a red flag for investors.
Citi remains extremely cheap relative to our estimate of intrinsic value – it trades at less than 60% of tangible book value, about six times last year’s underlying earnings per share and about four times normalized earnings per share after giving credit to its net tax assets and excess capital.
The intrinsic value of Citi has increased meaningfully over the course of our ownership of the bank while the stock price has declined substantially. We believe that the continued generation of profits and increase in growth of tangible book value will ultimately cause investors to revalue the bank at prices approaching its intrinsic value.”
Why do I highlight this? Well, Mr. Ackman just announced that Pershing Square has ended their position in Citigroup to fund their purchase of Procter & Gamble (PG), of which they own $1.8 billion worth of common stock. In his Q2 letter (which I don’t have a copy of; I am basing this off of quotations from reputable news organizations), Ackman said that he decided to pull the “rip cord” after “one bad night's sleep thinking about Citi.” In addition, Ackman noted that there are “much easier” ways to make money.
You don’t have to tell me that twice: I know Citigroup is outside of my circle of competence at this time, and I think that P&G is a sure thing at the valuations we saw up until this past week. I think that investors who bought in the high $50s and low $60s will see long term returns that exceed a 10% hurdle mark with almost no question.
However, that’s a very different animal from Citi; at less than 60% of tangible book and 4x normalized earnings (as estimated by Mr. Ackman), my assumption would be that his upside target was 10-12% per annum over the next ten years; he was likely thinking that Citigroup could be a 2-3x gain in the course of a couple years if thing worked out as hoped. I just find it funny that he has essentially jumped ship to an investment that appears, at least at first glance, to be very uncharacteristic of what Pershing Square tries to do (and has been successful at doing).
As noted in his CNBC interview with David Faber, Mr. Ackman believes that Pershing Square can be influential as an activist regardless of the stake in the company (which, by the way, at $1.8 billion, just exceeds the 1% ownership level); personally, I think that conclusion is highly questionable. He compares this to Canadian Pacific (CP), which was a clear case (at least from the evidence I saw) of an entrenched management team that was not operating the business at a level anywhere near its full potential.
Some people may see the same things at P&G; I think that will be a difficult story to tell, particularly when management has just laid out a plan to eliminate $10 billion in fat from the cost structure.
Time will tell whether this will be like Target (TGT) or like CP. What are your thoughts?
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.