| 2008 | 2009 | ||||||
| Price: | 12.00 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 3,825 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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At the current price of $11.79, CIT is trading at a very distressed valuation of 0.45x Q108 tangible book and 0.58x adjusted (for the recent $1.5bn dilutive equity offering) tangible book. This valuation suggests that the market is pricing in a risk of bankruptcy or a fire-sale liquidation of assets, a risk dilution from the need to raise additional equity capital at low prices, or a risk of major losses (from higher credit and funding costs) that will erode tangible book. To put it simply, the market is valuing CIT as if it is likely to be the next Countrywide or Bear Stearns.
I believe that market is wrong on several counts. First, I believe that CIT’s underlying asset quality is high and that the cumulative losses on its loan portfolio will be far less than what they would have to be in order to justify the current P/TB discount. Second, I believe that CIT is in a strong liquidity position that will carry them into 2009 without the need for additional dilutive equity offerings and that there is minimal risk of near term bankruptcy or a distressed sale of the company. Third, I believe CIT’s funding crisis is quite likely to serve as a catalyst for a sale of the company at $15-18/share. I don’t think CIT will be the next Bear Stearns because the company has enough staying power to realize its inherent asset value.
The bull case on CIT is:
1) Underlying asset quality is high and intrinsic value is high enough to warrant a $15-18 stock price
2) CIT has made key steps to get out of the current “crisis of confidence” that has driven funding costs higher and broken the company’s model
3) CIT is likely to realize meaningful gains on near-term sale of $4bn rail leasing portfolio; that should serve as a catalyst for the stock
4) CIT is likely to sell the company; a well capitalized buyer should be willing to pay $15-18 even in this tough environment
5) CIT survived a similar (though probably less severe) period of stress from 2000-2002 and is experienced in managing through crisis.
6) Unlike BSC, CIT has time. CIT has ample liquidity to operate into 2009 which will allow the firm to avoid a distressed sale
7) Large change in control payments to CEO & CFO provide a powerful incentive to sell the company.
The bear case on CIT is:
1) Cumulative loss potential on CIT’s $22.5bn corporate loan warrants a price at or below the current stock price
2) CIT will not find a suitor willing to pay $15-18; if CIT sells, they will be another financial “take under” (like BSC, WM, or NCC).
3) Why did the company just issue $1.5bn of equity capital that was dilutive to tangible book per share? Is this a sign that there are no suitors for the company and this was the next best (albeit expensive) alternative?
4) CIT’s funding crisis has created a “doom loop” that will destroy the firm’s earnings power over time (either by raising funding costs, shrinking the balance sheet, or by issuing equity at dilutive prices)
5) CIT’s business model is a flawed model—it works fine in good times, but is a disaster whenever there is a crisis in the credit markets
6) CIT is not in control of its own destiny. Whether or not one will make money depends on factors that are outside of CIT’s control.
7) Recent insider sales at $15.86 (on March 6th) do not bode well.
8) Departure of Chief Credit Officer in early 2008 is a possible red flag
Discussion
A student of George Soros would recognize CIT as a case study in “reflexivity” (a theory about the interplay of perception and reality). Asset quality and funding costs are the two key issues that surround CIT. I believe that underlying asset quality is high and that cumulative losses on the portfolio will be nowhere where they would have to be to justify the current P/TB discount. However, even if I am right about this, there is no guarantee that CIT will be a good investment because the company is dependent on the capital markets for its funding and CIT’s debt funding costs have ballooned to a rate so high that it has rendered the model uneconomical. In theory, this should never have happened because the funding costs should be rationally linked to asset quality. In practice, the mere perception that there is a problem creates the reality of a problem because the firm is captive to the capital markets. CIT’s lack of a stable deposit base and dependency on the capital markets has always been the firm’s Achilles heel. CIT’s model works fine in good times, but whenever there is a crisis in the credit market, it falls apart. CIT’s model is to borrow at a low rate that reflects a high grade credit rating and lend to lower rated firms at higher rates. If CIT cannot borrow at a low rate, the model becomes broken.
To put some numbers to this, I will note that CIT’s cost of debt (as indicated by its CDS spreads) has spiked by over 400 bps since Oct 07. CIT typically earns a net interest margin of 300-400 bps, so this spike as basically made it uneconomical for CIT to write new business. With $10bn of debt coming due in 2008 and $8bn in 2009, this leaves CIT with the specter of losing it’s typical 350 bps NIM on $18bn of business or $630mm/year. CIT is currently operating at a run-rate of $1.2bn/year in pre-provision, pre-tax profit. As I discuss below in the “Higher Credit Losses” and “Asset Quality is High” sections of the “Detailed Analysis” part of the write-up, I expect CIT’s annual loss rate to peak at $992mm for its commercial loan portfolio. Thus, if CIT didn’t have a funding crisis, the firm would be in pretty good shape to survive the worst of the crisis. Unfortunately for CIT, unless they can solve their funding crisis, the company will also get hit with ~$350mm of lost NIM in 2008 and another $280mm in 2009. The combination of lost NIM and higher credit costs could push CIT into a loss position that would wouldn’t otherwise happen if funding costs stayed in-line. This is why I say perception has become reality for CIT.
CIT will be a good stock is the company can break out of the funding cost “doom loop.” Unfortunately, it is also a risky stock because breakout out depends on factors that are not fully in CIT’s control. There are several ways out: 1) general credit market conditions could improve dramatically, 2) the market could regain confidence in CIT’s company-specific creditworthiness, or 3) the company could sell itself. I am not counting on the first possibility because I am expecting a long U-shaped recovery for the economy and deteriorating credit quality. However, I am optimistic on the second and third possibilities.
CIT’s recent $1.5bn equity issuance should provide a path out of the doom loop. I have to admit that I was a little disappointed when they first announced the offering because it was highly dilutive to tangible book value and I thought the company had less expense ways out of the doom loop. However, the company thought this was the best move they could make and what’s done is done. Looking at CIT on a go-forward basis, the recent offering reduced CIT’s tangible book per share from $26.10 to $20.20 but also increased tangible equity from $4.8bn to $6.3bn and increased the tangible equity to managed asset ratio from 8.3% to 10.8%. These are very healthy metrics and should restore calm and rationality to CIT’s credit spreads and debt funding costs. CIT now has adequate funding and capital to operate into 2009 and can pursue the sale of assets and the possible sale of the company in a manner that will realize maximum value. I believe that CIT’s underlying asset quality is high and are worth much more than the stock’s current price to a well-capitalized buyer. CIT’s current crisis has a good chance of leading CIT down a path that could result in the sale of the company for $15-18, which is a good return from the current stock price. The biggest risk to realizing this value is the fact that right now there is a large supply of distressed assets and few buyers and that has resulted in a number of recent “take unders” such as what we’ve seen with BSC, WM, WB, and NCC. Because CIT has more staying power than these firms did, I believe CIT will fare better.
A couple of catalysts that could improve perception on CIT and drive a big rally in the stock are: 1) realizing a large gain on the $4bn of rail assets that they recently put of for sale, 2) an improvement in CIT’s CDS spreads and the resulting “virtuous cycle” that would ensue, and 3) selling the company.
In summary, CIT is a highly catalyzed situation but the ultimate outcome is fraught with risk and uncertainty and factors that are out of the company’s control. A bet on CIT is a judgement call on how the ability for the company to break out of the reflexivity-driven doom loop. For those of you who can use options, there have been times in the recent past when one can get extraordinary premiums from writting covered calls or writing slightly out-of-the-money puts on CIT. I believe there is also an opportunity to bet on a tightening in creidt spreads for CIT.
Risks
The biggest risks to CIT are 1) the possibility that they will not be able to break out of the funding cost “doom loop”, 2) the possibility that the company cannot sell itself for a good price, and 3) the possibility that underlying asset quality is lower than I think and that cumulative losses on the loan book warrant a much lower stock price (I am most worried about the potential for higher losses in the $22.5bn corporate loan book).
Peak Credit Losses— As I show below, I believe CIT’s commercial credit losses will peak at a 2.1% annual rate. Given $47bn of commercial managed receivables, this translates into a $990mm/year loss rate. CIT is currently running at $1.2bn/year of pre-provision operating income. Thus, CIT should still be profitable at this peak loss level with EBIT of $210mm/year. In fact, the company can absorb a 2.5% overall commercial credit loss rate and still break even.
Estimating peak credit losses is an art. One can look at history to get hard numbers on what happened in the past, but that provides no hard guarantees because every cycle is difference and the company appears to be operating more aggressively today than in the past. Also, the history is limited—the last two recessions were in 1990 and 2001. CIT is a much different company today (it is run more aggressively) than it was in 1990 (when credit performed terrifically well) so I don’t think it’s prudent to look back that far. I think 2001 is relevant, but I am expecting a broader and longer downturn this cycle and believe that CIT will do worse this time. That being said, losses peaked in the 2001-2004 cycle at 1.54%, so peak losses of 2.1% leave a reasonable margin.
CIT’s commercial loan book actually consists of loans in 4 categories: Corporate Finance, Transportation Finance, Trade Finance, and Vendor Finance. Unfortunately, the company only started breaking things out this way in 2005 and it is not possible to get an apple-to-apples comparison for these areas across time. There are enough similarities in the Trade Finance & Vendor finance buckets to track them back to 1999, but it is impossible to track Corporate Finance back beyond 2005. This is a particularly vexing issue because I am particularly concerned about how CIT’s $22.5bn Corporate Finance portfolio will perform in this downturn. CIT doesn’t provide any information to assess the nature of the loans that are in that portfolio, so estimating charge-offs there is a big educated guess. One of my key open questions is to drill into the nature of that portfolio with management and to get comfort that losses won’t be a lot higher in that portfolio. If anybody on this board has insights into this key issue, I would like to get your thoughts.
CIT's historical charge-offs look as follows:
1999 2000 2001 2002 2003 2004 2005 2006 2007
Commercial NCO ex Special 0.25% 0.62% 1.13% 1.33% 1.54% 1.11% 0.52% 0.4%e 0.4%e
Trade Finance NCO (old seg) 0.47% 0.60% 0.66% 1.13% 0.80%
Trade Finance NCO (new seg) 0.54% 0.37% 0.34% 0.55% 0.44%
Vendor Finance NCO (old seg) 0.54% 1.11% 1.26% 1.59% 1.32% 1.08%
Vendor Finance NCO (new seg) 0.66% 0.60% 0.57%
Applying Peak Quarterly NCO rates to current managed receivable levels results in the following:
Category 08 Mgd Rec Peak NCO Rate Annual Losses
Corporate Finance $22,507 3.0% $675.5
Transportation Finance 2,667 1.0% 26.7
Trade Finance 6,980 1.0% 69.8
Vendor Finance 14,700 1.5% 220.5
Total Commercial 46,854 2.1% 992.2
Mortgage 9,268 7.0% 648.8
Other Consumer 12,701 0.5% 63.5
Total Commercial & Consumer 68,823 2.5% 1,704.46
Asset Quality is High— Asset quality and peak charge offs are related issues. The true value of CIT’s assets today (which are held for investment and thus booked at cost net of provision) depends on what future cumulative charge-offs will look like (the provision usually only looks forward 1-year and thus does not estimate lifetime losses). CIT’s lending book has four commercial segments and two consumer ones. The student loan book consists mostly of government guaranteed loans that ensure that cumulative credit losses will be minimal. As I show above in my estimate for peak NCO’s, losses are unlikely to be large enough in Trade Finance, Transportation Finance, or Vendor Finance to create major problems.
CIT’s two problem areas are the subprime mortgage portfolio and the corporate finance portfolio. I believe an adjustment needs to be made for the cumulative losses that are likely for the subprime mortgage portfolio. The portfolio has already been marked down & reserved for by 13%, but a conservative estimate would be to allow for another 10% of losses (CIT's home mortgage portfolio compares much better than the ABX index on % with full documentation and % ARM). This would generate $980 of pre-tax losses or $686mm of after-tax. This would reduce tangible book by $2.13/share on the new share count post the recent share offering. While painful, it leaves the stock at a meaningful discount to adjusted TB of $18/share.
I am very concerned about the credit quality of CIT’s $22.5bn corporate loan portfolio. I expect losses in this area to peak at 3%, but there is certainly a possibility that they could peak at much higher levels. The problem is that we really don’t know what’s in this portfolio. The company doesn’t really disclose any key stats to asses the likely loss content of the portfolio. We can’t even get a good view of historical performance since the company didn’t break this segment out in 2001-2004. Thus, estimating losses here is really one big educated guess. Provided that CIT can break out of the funding cost “doom loop”, the biggest risk to CIT’s fundamental value is that this book is a bad book and will prevent a buyer (who can do due diligence on the book) from paying an attractive acquisition price. One factor that bodes ill for CIT is that the book grew from $18 bn on 12/31/05 to $24bn on 12/31/07. Rapid growth like usually brings the risk of lower credit standards and higher future losses.
One can look at the difference between the current stock price of $11.70 and the adjusted tangible book of $19.40 to calculate the “buffer” for losses. This buffer is $7.70/share or $2.5bn of after-tax losses. Depending on whether or not CIT will be able to realize tax benefits from the losses, this would leave $2.5-$3.5bn of buffer for losses. That’s 11% to 15% of the $22.5bn corporate loan portfolio. I believe this buffer leaves a good margin of safety, but I really need to learn more about the corporate loan book to get comfort and to have more conviction in CIT’s intrinsic value.
Higher Funding Costs— Whether or not it is justified by CIT’s underlying asset quality, CIT has found itself in the middle of a self-fulfilling crisis of confidence that has resulted in extremely high debt costs that has rendered the company’s model broken. I discussed this dynamic in great detail above. The key items that one can look at the quantify the impact of this issue is to look at the “Payments and Collections by Year” table and the “Commitment Expiration by Year” table from the annual report. From this table, you can see that CIT has $10bn of debt coming due in 2008 and $8bn in 2009. A similar amount of loans are coming in over this time, so CIT doesn’t have a net liquidity problem but the company does have the problem of being unable to renew business at profitable levels. This means loosing the 3-4% NIM that they generate on this $18bn of loans.
Can CIT Find A Buyer Willing to Pay a Decent Price?—The bears are right that there are not going to be many buyers for CIT in the current environment (most of the would-be buyers do not have the balance sheet street to pursue such an acquisition right now). However, I believe it only takes two interested parties to create enough competition for CIT to realize at least 75% of adjusted tangible book value. Possible buyers include GE Capital, Wells Fargo, Toronto Dominion & other Canadian banks. Recent moves such as the plan to sell the $4bn rail leasing assets should simplify CIT’s book of business and make the fit with potential buyers more straightforward. I am concerned that while the strategic fit with GE Capital is high, GE’s appetite for such an acquisition is probably low right now.
Insider Sales—CIT’s insider activity has been mixed. On March 8th, there were 8 insider sales by 8 individuals of $18K - $241K (most were around $40K). The CEO did not sell any shares over this period and actually acquired $1.5mm of stock in Aug & Nov 07 at $25-34. Earlier in 2007, a number of members in the management team made large sales in the $30-60 range. With the stock at $15, we can’t read too much into those sales other than to say the stock was overvalued at $30-60.
Management Changes— CIT’s chief lending officer resigned on 2/14/08 (after 34 years with the company) with a view towards retirement and was replaced by Nancy J. Foster who joined CIT in early 07 as Chief Credit Officer. The chief risk/lending officer position is very important to a lending business, so I find this change worth investigating further since I view it as a meaningful red flag.
Change in Control Provisions Provide Incentive to Sell The Company—CEO & CFO will get paid $35mm and $14mm respectively in a change of control. They also own 1.4mm and 750K shares, respectively. This provides an incentive to sell the company.
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