Description

I am recommending CIT as a long at 68% of GAAP tangible book value and at 57% of adjusted tangible book value (which excludes fresh start accounting marks).  While many banks are trading below tangible book value today, CIT stands out for two reasons: (i) it has a large margin of safety given its highly liquid and unlevered balance sheet, and given the fact that the balance sheet was marked to market during the bankruptcy process in late 2009, and (ii) it has several "internal" catalysts from re-optimizing its balance sheet and exiting regulatory purgatory which should help increase profits and unlock value over the next two years.  In terms of liquidity and capital, CIT has almost 40% of its assets in cash and government guaranteed student loans.  Its tier 1 common ratio is 19.1%, which is more than double most banks.  CIT will create a lot of value simply by redeploying excess liquidity and capital more productively, which I expect will be a combination of loan growth and buybacks.  Accordingly, the discount to book value should decline overtime. 

CIT is well known within the value investing community (four prior VIC write-ups) and was widely held by hedge funds during and after its bankruptcy.  However, as 2011 has progressed, I think CIT is finding itself somewhat orphaned, having been sold by hedge fund types, but not yet embraced by traditional investors.  In addition, the management has been focused internally for the last year and not out telling the story.  The stock started trading post bankruptcy at $29 in late 2009, it peaked at $48 earlier this year, and it was pitched at the Ira Sohn conference in May when it was in the low-40s.  Now, the stock is back to the $29 level at which it exited bankruptcy despite the fact that its balance sheet and operations have significantly improved.  Notably, the CEO bought $1.2mm of stock in the open market in late August at a similar price.

Overview

CIT is a diversified commercial lender serving primarily small and mid-sized businesses.  CIT emerged from bankruptcy in December 2009 and has been undergoing a major restructuring.  The highlights are:

• It has an entirely new management team since the start of 2010, led by CEO John Thain (former Co-President of Goldman Sachs, CEO of NYSE, and CEO of Merrill Lynch).
• It has divested non-core ops and reduced headcount by 14%.
• Repaid or refinanced several series of high cost debt totaling over $15bn
• Started to originate the majority of new loans within a deposit funded bank
• Making progress satisfying regulators: FDIC terminated a Cease and Desist on CIT bank in April 2011. Working to address Written Agreement with Fed by yearend 2011 relating mostly to internal controls.

CIT has $48bn of assets, including $10bn of cash and a $35bn financing portfolio consisting of:

• Corporate Finance (23%): It is a mix of asset based lending and cash flow lending for mid-market businesses. Targets businesses with <$50mm of EBITDA which are not served by the syndicated bank loan market. Peers include GE Capital, Heller Financial, Foothill and Capital Source.
• Transportation Finance (35% including operating lease assets). One of the top aircraft (#4) and rail car (#3) lessors.
• Vendor Finance (14%): partners with companies primarily in IT and telecom to finance equipment sales to customers.
• Trade Finance (7%): the largest factoring company in the US, focused on the retail supply chain.
• Student loans (22%): liquidating portfolio of largely government guaranteed student loans.

CIT's $48bn in assets are currently funded by $4bn in brokered deposits, $11bn in secured debt, $21bn in unsecured/2nd lien debt, and $9bn in equity ($3bn of other makes up the difference).  The unsecured/2nd lien debt has staggered maturities, with the earliest maturity in 2014, which it can easily meet with existing cash.  Overtime CIT wants to move its funding mix to 35-45% deposits, 25-35% unsecured debt, and 25-35% secured debt.  Fixing the funding mix is the key to creating value and to taking earnings from roughly break-even today to "normal" profitability in 2-3 years.  I as describe below, I believe that fixing the funding mix is primarily about continued management execution, with only minimal dependence on cooperation from the capital markets.

Valuation:

• CIT trades at 68% of GAAP tangible book value (TBV) of $43. Excluding fresh start accounting adjustments of $8 per share, which accrete back into equity overtime, it trades at 57% of adjusted TBV of $51.

• I look at CIT's valuation on a sum-of-the-parts basis:

• First, there is "core" book value and "excess" book value. CIT targets a 13% tier 1 common ratio vs. its current level of 19%, which implies that $14 per share of its TBV is "excess," which I expect will be used for a combination of buybacks, once approved by regulators, and loan portfolio acquisitions. "Core" book value is $29 per share, which represents the amount of equity capital that CIT needs to run its business. The portion of "excess" capital increases overtime as assets shrink.

 

• Next, there are the fresh start accounting adjustments (FSA) of $8 per share. To oversimplify, this represents mark-to-market hits to the loan book, and does not include permanent write-downs which were also recorded during the bankruptcy. These write-downs accrete back into earnings overtime, and I assume at present value of $4 per share. (The financial exhibit at bottom breaks out the components of the FSA and my estimate of how they accrete overtime.)

 

• Finally, CIT has a large deferred tax asset with a present value of ~$4 per share. I actually then haircut that by 50% to $2 because I think the public market rarely gives credit for the full value of DTAs... just trying to be realistic.

 

• So, if you take the current share price of $29 and back out the DTA ($2), back out the fresh start adjustments ($4), back out the excess capital ($14), you are left with $9 of value for the "core" business. On a P/E basis, this implies CIT's "core" business is trading at 3-4x normalized earnings of $2-$3 per share.

 

• My price target is approximately $46 per share by the end of 2013, for 60% upside. This is based on valuing the core business at 8x normalized EPS of $2.50, equivalent to 80% of "core" book at 2013, and then adding the value of the excess capital, the FSA adjustments and the DTA at that time (as shown in the exhibit below). Note, I am giving credit in the valuation for the per share amount of excess capital as if it will be sitting on the balance sheet in the future, but in reality I expect the excess capital will have been deployed via buybacks and loan portfolio acquisitions. I am effectively assuming that each $1 of excess capital deployed will generate $1 of value for shareholders regardless of whether that excess capital is sitting on the balance sheet, is used for buybacks, or is used to acquire loans. I think this is a reasonable assumption, but I acknowledge that there is a range of outcomes whereby excess capital could be used to add or subtract incremental value.

Profitability Improvement:

• Management targets a return to "normal" profitability by 2014, including an ROA (net income/assets) of 1.50%-2.00%. This is consistent with long term historical levels for the business. With a target for 7x leverage vs. 10x pre-crisis, management targets an ROE of 10-15%, slightly below historical levels. I conservatively assume and ROE of 8% in 2013 and 9% in 2012 on the "core" book, so below the target range. I think these ROEs should justify a P/B for the "core" business of 0.8x which I use for my target price.

• The main driver of improved profitability is re-optimizing the balance sheet to earn a higher "finance margin" (i.e. lending spread). Management targets a 3.00%-4.00% finance margin, consistent with the historical average of 3.70%. The finance margin is currently 1.45%. The path to improving the net finance margin largely depends on reducing high cost bankruptcy debt through a combination of: redeeming debt using cash and run-off student loans, replacing high cost debt with deposits, and continuing to opportunistically tap the unsecured debt market. Since the end of Q2, CIT has already redeemed or refinanced $4.8bn of debt, adding ~50 bps pro forma to its net finance margin, and closing about one-third of the GAAP between its current net finance margin (1.45%) and the low end of its target range (3.00%-4.00%).

• CIT exited bankruptcy with high cost term debt which was highly favorable for the restructured bondholders. This was primarily Series A term debt with a 7.00% coupon, of which $9bn is still outstanding, down from $21bn when they exited bankruptcy. CIT also has $9bn of Series C debt with a 7.00% coupon. This is basically "old" Series A debt that was exchanged into Series C during Q2, with the benefit to CIT of lighter covenants (for example, the Series C becomes unsecured when the Series A are repaid). For modeling purposes, I assume all this 7.00% debt is replaced between now and the end of 2013 as follows:
  • $4bn just from having less funding overall, primarily as a result of shrinking their $10bn cash balance to $6bn.
  • $6bn from growing deposits. CIT currently has brokered CDs, and it is launching a retail internet deposit platform by yearend. These are very expensive "hot money" deposits, but nonetheless they are a lot cheaper than unsecured debt. The main constraint to growing deposits is growing loans within its bank, where CIT currently has 15% of its total loans. Currently the bank has $1bn of "excess" deposits which are sitting in cash. Bank regulations (Rule 23A) prevent CIT from moving existing loans into the bank, so it has to grow organically by originating new loans within the bank. It takes until 2014 for organic loan growth to get the bank, and therefore deposits, up to CIT's targeted size.
  • $7bn of new unsecured debt at a 6% coupon. This is the "riskiest" piece of the funding cost story because it is the only part of the story that depends on the bond market being open. But, I think it is very realistic because CIT has already issued $2bn this year at a weighted average rate of 6%. The bonds are currently at 98 and were at 101 two weeks ago. I think it is likely that over the next two years CIT will be able to opportunistically issue debt at this rate or below because CIT becomes a "safer" credit as a result of mix shifting to deposit funding, and as a result of paying down the Series A debt, which un-encumbers assets.
  • Here is how I see the liability side and cost of funds improving over time:

Issues

• One common fear is that CEO John Thain wants to acquire a bank, which makes sense because it would immediately reduce funding costs, but its creates risk of overpaying. However, at a recent conference, Thain essentially said he is not interested in acquiring a bank, noting it is cheaper to raise deposits today on the Internet. He did say that he would like to acquire "3-4" branches "in the middle of nowhere" from the FDIC in order to have some modest deposit diversification, which regulators like to see.

• Another fear is that Thain would not sell CIT if the opportunity presented itself. CIT would be extremely valuable to a large bank given the funding cost synergies, and the difficulty for banks to originate new loans in a de-leveraging economy. However, Thain is explicitly saying all the right things, namely that he understands the synergies of combining with a big bank, and that he would do the right thing for shareholders if the opportunity arose. Time will tell. I think the M&A environment will be muted for a while, but optionality for a take-out improves over a 2-3 year time frame.

• Poor quality of business. Historically as a non-bank lender focused on specialized loan categories, CIT has had more funding risk and more credit risk than a typical bank, thus its bankruptcy. These are valid issues with which I agree. I would argue that CIT will be slightly better going forward because it will have the benefit of more diversified funding with deposits, however I am still only assuming the "core" business is worth 0.8x BV.

• Credit risk. CIT is at risk for higher credit losses in a double dip scenario. Like many lenders, CIT's loan losses have declined closer to "normal" levels since peaking in 2009. CIT targets 1.00% of annualized losses, and in Q2 it was actually slightly better than the target. Losses peaked at 4% in 2009. In a double dip scenario, I think losses of 3.00% would be fairly severe given that most of CIT's riskiest loans "burned off" during 2009, and underwriting has subsequently been more stringent. This would translate into an incremental $1.50 per share hit to book value which is easily absorbable.

• Macro Risk/Timing: The timeline for returning to normal profitability levels depends on the economy (for credit quality and loan growth), and the capital markets (for refinancing into lower cost debt). But regardless, there is still potential for significant improvement apart from the macro situation as a result of using excess liquidity to repay high cost debt, raising deposits, and putting excess capital to work.

• Potential to squander the excess capital war-chest. Management has guided that it wants to put excess capital to work overtime through a combination of acquisitions of loan portfolios and buybacks, and the mix will depend on the opportunity set. This ultimately requires trust in management's judgment. The CEO has said he would love to be buying back stock below tangible book value if he were able, and I take him at face value. While my bias is for all excess capital to be returned to shareholders, I think it is likely that CIT can also create value by opportunistically acquiring loan portfolios at reasonable prices. For example, CIT has said it will look at buying portfolios from European banks in areas where there is overlap, and from technology equipment companies looking to jettison their captive vendor finance portfolios. In addition, CIT's expense base is significantly under-utilized relative to the size of its loan portfolio, so loan acquisitions would enhance operating leverage.

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

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