"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 their 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.

Bloomberg opinion columnist Jonathan Weil has a talent for navigating balance sheets of often complex financial firms.  In his latest piece, he writes about Wells Fargo (WFC), the bank who rejected the idea that it needed TARP funds in the first place, yet has to date neglected to repay the government for the loan.  It is an interesting point as many investors, including a big one out of Omaha, have bought the stock of Wells Fargo because it held the mantle of conservative management among the too big to fail set.  Whether it is because of worse than expected loans made by Wachovia or their exposure to the real estate market particularly in California, the bank has not been among the first group to repay the TARP.  The Wachovia acquisition came with a large amount of loan guarantees from the government, so WFC lessened their risk where possible.

As Weil explains, the reason for the delay in repayment of government funding is plainly obvious when you start digging just a bit in the balance sheet.  Quite simply they haven’t got a significant capital cushion to pay back the TARP in a way that leaves them adequately capitalized for any future weakness.

Taking Account

Wells had about $37.4 billion of tangible common equity as of Sept. 30, by my math. Yet even that number is frothy, because it doesn’t take into account the fair-market values for most of the bank’s financial assets and liabilities, which the company discloses in the footnotes to its quarterly reports.

Factor in those adjustments, and Wells’s tangible common equity falls to $14.3 billion, or just 1.2 percent of the bank’s tangible assets. The main reason for the difference is that Wells said its loans as of Sept. 30 were worth $22.1 billion less than the carrying amount it showed on its balance sheet.

How can Wells repay its TARP money, when its capital cushion on a fair-value basis remains so thin? A Wells spokeswoman, Mary Eshet, responded to that question by saying: “We will work closely with our regulators to determine the appropriate time to repay TARP while maintaining strong capital levels.”

She added that “our capital position is improving,” which is true, even using the bank’s fair-value numbers. So far this year, Wells has raised $8.6 billion in a common-stock offering, reported a $4.9 billion increase in retained earnings, and slashed its common dividend.  — Bloomberg.com 11/18/2009

This is probably not news to anyone who follows Wells Fargo closely, but it does demonstrate that there is still quite a bit of risk in many financial stocks.  The last few years have left many of them much worse for wear and still vulnerable to any downturn in the market.  Not to mention that the relaxing of mark to market accounting rules has made their financial statements that much more difficult to decode.

Famed banking analyst Meredith Whitney has turned bearish and recently said that most banks are “grossly overvalued.”  She has become more bearish of late because she believes that the markets are pricing in a stronger 2010 than will actually happen.  In general, we tend to agree with her that the market has viewed the next few quarters with probably too much optimism for what we are seeing in the so-called real economy.  However, when it comes to Wells Fargo, we have a Fairly Valued rating on the stock for a long term investor.  Although, as Weil points out, the company may need to raise capital in order to be able to comfortably repay the TARP loans which would clearly be considered unfriendly to current shareholders.

“AIG has been what we call in the business an up stock, meaning it has been one way up since they did the split, the 20 for 1 reverse and that’s because of endless unconfirmed rumors and just gossip, gossip that something good is about to happen. Emanating, frankly, from someone who should be made to, let’s say, be quiet immediately.

He’s the man who sewed the seed for its destruction.  Even though he created the company, he’s the one who set up the rogue London office. He’s the one who commanded the company to insure financials. I urge you to go back to the 2007 analyst meeting to see how long this company was doing stupid, stupid things like ensuring banks to allow them to get around European capital requirements. Greenberg somehow takes no responsibility whatsoever, is never called out on this, and shamelessly hypes the company as undervalued to every media outlet imaginable. This man is really off the reservation.” — CNBC’s Mad Money 9/23/2009

Without naming names, the often fiery and always controversial Jim Cramer turned his outrage on another controversial titan, AIG’s (AIG) founder Hank Greenberg.  The problem as Cramer views it, is that Greenberg was the one that lead the company into its risky derivatives business, but he rarely takes any heat for these decisions.  Furthermore, Greenberg has proposed a plan to reduce AIG’s debt to the government, and with the stock surging more than 20% on Monday he is being hailed in some circles as a potential savior to the company.

As everyone is well aware, AIG was bailed out to the tune of $85 billion the day after Lehman Brothers fell, and they have since been bailed out three more times.  To date taxpayers have lent AIG $182.3 billion, and after asset liquidations AIG still owes the government about $120.7 billion.  Of course, there are doubts about whether AIG will be able to pay back the taxpayers anytime soon as they have sold off many valuable assets at fire sale prices.  As Greenberg said in his statement back in April,

“Since the day the treasury announced its plan to liquidate AIG, value has been destroyed because AIG’s people and their relationships — AIG’s business — are leaving. The evidence is overwhelming and indisputable that the American taxpayer is an investor in a steadily diminishing asset.”

Greenberg’s plan is to ask for mercy from the government in the form of lower interest rates and a longer time-table for repayment.  Rep. Edolphus Towns’ House Oversight Panel is reportedly going to push for up to 20 years to repay the restructured debt, instead of the original 5-year term.  In so doing, there is a better chance that taxpayers get paid back, and AIG would have a much better opportunity to survive as a healthy business.  Cramer’s outrage stems from the fact that you are rewarding the shareholders of this corporation that took far too many dangerous risks.  Primary among the shareholder beneficiary is none other than Maurice “Hank” Greenberg, who is estimated to have made $588 million on the stock’s 21% rise on Monday.

While we understand Cramer’s concerns that a bad actors get rewarded, this is what happens in the aftermath of the “too-big-to-fail” moral hazard.  Greenberg should take much of the blame for his leadership of AIG that led them to need for unprecedented government bailouts.  However, as taxpayers, we should all demand repayment, especially those of us who disagree with how the situation was handled in the first place.  We doubt that the original plan to sell off AIG in bits is going to be able to get that money back (as the GAO stated in its latest report), so perhaps Greenberg’s approach would make the best of a terrible situation.  Whether the government will bite on this deal is an different matter, considering Credit Suisse (CS) analyst Thomas Gallagher calls the Greenberg plan “farfetched” saying the terms of the loans are already favorable for AIG.

“Let me look at the Carmax results, when it came out to its earnings, higher on its earnings, better than expected figures. Ex-items for accounting purposes once you work through that come up with a comparable number, $0.44 a share versus an estimated $0.18, revenue better than expected, $2.08 billion given in large part by the cash for clunkers program. The used car retailer is doing very well, the stock has more than doubled.” — Fox Business Network 9/22/2009

Carmax (KMX) rode improved unit sales in both used and wholesale vehicles to a much better quarter than Wall Street had expected.  In the company’s second quarter ended August 31, sales were up 13% to $2.08 billion easily outpacing estimates for a drop of 4% that analysts had expected.  Same store sales rose by 8%, which is far better than the 17% declines seen in the first quarter. 

Some of the credit for this is attributed indirectly to cash for clunkers.  One analyst speculated that some of the increased foot traffic was from buyers who were interested in purchasing a car on the government’s program, but some of these interested buyers were unable to qualify for the credit.  As the theory goes, some of those buyers turned to the cheaper alternative of Carmax to scratch the car-buying itch.  The store traffic and sales numbers seem to back up this indirect benefit.

No matter the reason, the results are tough to dispute.  Carmax’s earnings rose more than 7-fold to $.46 per share compared to the extremely weak quarter a year ago which netted the company only 6 cents per share.  Analysts had expected more modest earnings growth to 18 cents per share.  Also, KMX was helped by much better performance from Carmax Auto Finance unit which saw net income of $72 million compared with a loss of more than $7 million last year.  Adjustments to loans originated in previous quarters resulted in a large one-time gain of $36.2 million.

Better sales and strict cost controls enabled Carmax to outperform analysts expectations, and the indirect effect from the government’s Cash for Clunkers program was bigger than almost anyone had imagined.  Not surprisingly, the stock has roared higher today, up more than 9% in midday trading.  At Ockham, we are reiterating our neutral or Fairly Valued rating at this time.  The results for the quarter were far better than we had anticipated, but much of that performance is already reflected in the price.  Given the current fundamentals, we think that a price around $19 would be reasonable to expect going forward.

Furthermore, we have concerns that Carmax could experience some clunky sales going forward as a hangover from Cash for Clunkers.  A report from Edmunds.com shows that post-clunker sales have hit a 28-year low to a rate of 8.8 million units per year.  This is a 38% plunge from last month, and suggests that the government’s incentives simply pulled demand forward.  This effect will likely be less direct for Carmax than it will be for the new car dealers, but as we saw with this quarters results Carmax is not immune from the effects of government intervention on the car-buying market.

Carmax could certainly benefit from U.S. consumers saving more and spending less, which would translate to more modest car purchases.  However, with a very rich valuation multiple of 33x based on trailing four quarters, we would recommend taking profits in a stock that is up more than 200% in less than a year.  It will take some mighty impressive quarters to simply maintain this price, much less continue higher.

“Citigroup under fire for potentially selling more shares to help buy back some of the government’s stake in the bank. The move to damage the already battered stock with more dilution, even as the troubled institution prepares for potential loss in the fourth quarter. And that’s the least of its worries. Liz McDonald is here with all the worries…

You know, I was on the phone with sources at the bank and also, Vikram Pandit will be speaking to institutional investors at a closed door meeting at one o’clock today at Barclays Capital. I’ll be in on that call. Here is what’s going on at the bank and now, the bank understands, you know, any shares that they want to sell to pay back the government, will be dilutive to existing shareholders and that’s the case for Citigroup for a while.

Citigroup’s Vikram Pandit says he’s dealing essentially with the equivalent of a 100 year flood and Citi’s market value has dropped below Home Depot and UPS, and the stake in Citigroup has been moving underwater and moving to unload assets bigger than the side of GE Capital and that’s the focus that they’re trying to unload into the market. So, what they’ve done in the interim is they’ve been moving rapidly to down size. They’ve cut off- they’ve cut out 96,000 jobs, they’ve brought their employee base below 300,000, they’ve cut 23% out of their cost structure. So, those costs have come down by 23%. And basically, they’ve gotten the FDIC to back its debt and the FDIC’s guaranteed debt program, that’s about $55 billion there.

But what’s going on is the Fed’s debt program is set to expire and if the FDIC chooses to extend it, those fees will go up for that back stop from the FDIC, so, all the cost cutting that Citigroup is doing right now could be undone by more expensive borrowing down the road, so that is still a problem at Citigroup though and if Vikram Pandit is racing rapidly to try to either earn his way out of the mess and you know, the last two quarters we saw accounting on is one off. Basically help Citigroup hit the bottom line.

He’s trying to unload, again, asset sales and trying to down size, but he’s trying to gain favor with institutional investors owning a 10% stake in if you get the underinvestment, institutional investor back in, maybe they’ll be tempted by the underwater, you know, book value. With Citigroup trading below book value, so, but the institutional investor knows this, $200 billion dollars in toxic assets. Still sitting there at Citigroup, swapping the tangible book value, and $1.3 trillion off the balance sheets and some of those items could come back on to the balance sheet down the road if the new accounting rule takes effect early next year.  Banks have been lobbying to fight that new rule and that will crush its capital reserve ratio and set aside more capital. Citigroup is in a bind. It’s trying to maintain the status quo and a still frozen over credit market and an asset market where it can’t unload. So, you know the 1 p.m. call will be interesting to see what Vikram Pandit says.” – Fox Business Network 9/16/2009

On Wednesday, the Wall Street Journal reported that Citi (C) is considering a offering of about $5 billion worth of stock to the public in order to buy out the same amount of shares held by the U.S. government.  Just last week, the government exchanged some of its preferred shares for 7.7 billion shares of common stock in the bank.  Clearly this preferred for common swap was highly dilutive to shareholders and shares have sold off by about 15% since last week.  In addition to the dilution, the market fears what control the government will wield over Citi in day to day operations.

At the Barclay’s (BCS) conference, Citi’s Vikram Pandit further illustrated his plans for buying out the government’s stake.  He plans to divest the rest of Citi’s remaining stake in Smith Barney as well as selling off other business units including CitiFinancial and Primerica over time.  Citi’s stock is up by about 4% today, as investors are glad to hear that management is taking seriously the task of getting the government off of their back.  However, the bailouts of Citi, which came in three massive tranches, now total about 34% of the value of the company.  It is going to take some serious maneuvering to completely buy out the government at this point.

In all of the talk about paying off the government’s loans, there is no talk about earning their way out of this mess.  The debt is just too great and the earnings potential is still pretty murky at this point.  For example, Citi is expected to lose about 14 cents for full fiscal 2009, and consensus analysts are for profits of just 9 cents per share next year.  It will take a few quarters of stability in order to count on paying back the government from profits.  This is bad news for shareholders as they will have to either further raise capital, or sell of productive assets (probably both) in order to fill this gap.

At Ockham, we are reaffirming our Fairly Valued rating on Citi, and we view today’s announcement as neutral for investors.  Citi is planning to exchange about $5 billion of government held equity for $5 billion in privately held equity.  The move does not effect Citi’s available capital, all it does is change the ownership.  The recent conversion from preferred to common stock has been highly dilutive, and we are unconvinced that the dilution has ended.  Furthermore, with Pandit eager to unload assets in order to pay back government loans, no one knows how much it will effect the company’s ability to generate earnings.  We continue to believe that there is still plenty of risk in Citi, and the uncertainty more than outweighs the seemingly cheap nominal price.