“The conference call is still going on but earlier CEO Vikram Pandit said Citi enters 2010 with a strong foundation. Consumer credit remains an issue…”– CNBC’s The Call 1/19/2010

Citigroup (C) lost $7.6 billion in their fiscal fourth quarter which was in-line with estimates of a loss of $.33 per share.  Excluding one-time charges, particularly those related to paying back the TARP loans, Citi would have only lost $1.4 billion or just 6 cents per share.  The quarter ended a three quarter long streak of profitability, and shares opened slightly lower because they missed on top-line estimates with revenue of only $17.9 billion versus projections of $18.43 billion.  As of midmorning shares had turned positive along with the broader market because there are some encouraging signs of improvement from a bank that has earned the dubious title of “Zombie Bank”.

One thing Citi has going for it is the fact that the fourth quarter a year ago was just so awful.  A year ago, Citi reported a record loss of $17.3 billion or $3.40 a share as the company was mired in credit losses and write-downs.  In the past year, it was necessary for Citi to raise capital and streamline operations in a difficult period that Citi’s CEO Pandit described as “enormous progress.”  The tier 1 common ratio rose to 9.6% from just 7.3% a year ago, and tier 1 capital improved to 11.7%.  In regards to consumer credit, the credit card division costs dropped 10% from Q3, the lowest level since second quarter of 2008. Credit losses were down sequentially to $7.13 billion from $7.97 billion a quarter ago.  The slowing rate of credit losses is likely a product of improved economic conditions and the worst quality loans losses already having been realized in the last eighteen months.

Interestingly, with improving condition is its overall credit portfolio Citi only bolstered its loan-loss reserves by $706 million, and it can now cover just 6.1% of total loans.  The total loan loss provision stands at $8.2 billion, down 36% from Q4 last year and 10% lower sequentially.  This seems to fly in the face of the banks stated goals over the last year of trying to nurse the struggling bank back to health rather than aggressively grow earnings.  The lack of replenishment to their reverses for losses is clearly a bet that the economy is on the mend, and Citi may be underestimating the risk of a double dip recession.

We are maintaining our Fairly Valued stance on Citigroup even at this very low price level.  Will the bank be trading higher in three years?  We think there is a pretty good chance that it will, but there is still plenty of risk in these shares.  The first huge risk is the uncertainty of Citi’s earnings power going forward as a restructured company, and Vikram Pandit has been very clear that he would like to dispose of Citi Holdings which dragged down this quarter’s results losing $2.44 billion in the fourth quarter.  However, in the boom times these businesses were the high flyers for Citi, rather than the more stable Citicorp part of the business.  Wall Street is calling for the company to earn only eight cents in profit over the next year, which is pretty uninspiring.  Secondly, and perhaps more immanently, Citi is in the process of paying back TARP and believes they are adequately capitalized heading into 2010, and some of the important capital ratios seem to support that.  However, at the same time its loan loss provision is falling.  If you are among the set of investors that believes a double-dip is coming, than Citi is quite exposed to further balance sheet damaging losses.  In our view, Citigroup remains a risky investment and seems better fit for speculating on continued and robust improvement to the economy.

"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.

On Wednesday we wrote a piece talking about the strange upgrade of Pulte Homes (PHM) by an analyst at Citigroup (C).  At that time (Upgrade Trumps Macro-Economics for Homebuilders), we reiterated our Overvalued stance on Pulte, the largest in the group thanks to its acquisition of Centex, as we have that stance on most homebuilder stocks right now.  In the analysts’ note he said that Pulte is “undeservedly out of favor,” but that seems to ignore the fact that their fundamentals have been decimated over the last two-plus years.  Furthermore, the recovery may come especially slowly to homebuilders in particular, as the supply overhang is just now starting to abate.  On Thursday’s Mad Money, Jim Cramer issued his own warning against the stock and put it in the sell-block.

“…Of the homebuilders, the worst house in a bad neighborhood is Pulte Homes. The largest homebuilder America now with Centex, into the sell block.… Yesterday morning Pulte was upgraded from Citigroup from a Hold to a Buy. Hence triggering why I wanted to do this piece tonight. I think that upgrade is totally nuts and I should know…

These homebuilders are still on very shaky foundations and business.” — CNBC’s Mad Money 11/20/2009

Cramer agrees with Ockham that even with the nascent recovery in the housing market, homebuilder stocks are still in a very tough environment.  He says that Pulte paid too much for its merger with Centex which only harms an already strained balance sheet.  Furthermore, he points out that Pulte’s target market, retirees, are probably the most spend thrift of any demographic right now with their retirement accounts getting whacked during the recession.  The picture only gets worse when you combine these factors with a worse than expected loss and cancellation rates high and only rising.

The day of the Citi upgrade all homebuilder stocks got a boost despite much worse than expected housing starts data.  However, Pulte has already given all of those short lived gains back and then some in just two trading days.  Clearly, this is one stock that both Ockham and Cramer agree cannot be bought at this time, and the upgrade from Citi is odd and lacks any bite.  See the chart to the right for a view of all the residential construction stocks that we cover.  It is clearly not a pretty picture as all of these have seen earnings and revenues fallen off a cliff, and asset values have been written down substantially to the detriment of shareholder’s equity.

This morning the Commerce Department released figures that homebuilding activity in the U.S. had unexpectedly fallen in October.  The reasoning was that increased joblessness in addition to doubts that the homebuyer tax credit would be renewed weighed on homebuilders.  Homebuilders slipped to an annual pace of only 529,000 homes which is 11% lower than last year and the lowest result since April.  Multifamily homes such as condos and townhouses slumped 35 percent, far more than single family homes.  Economists had expected to see a slight rise in homebuilding activity in the month, which only adds to the surprise.  Economists, always ready with an answer, pointed out that the wettest October in century could have been a factor.  Building permits also saw an unexpected drop to only 552,000 annual rate.

Homebuilder stocks were mostly unscathed by the news as investors took solace in the fact that the tax credits were indeed renewed which will hopeful further induce buyers into the market.  Pulte Homes (PHM) was among the most active of homebuilder stocks following an upgrade to Buy at Citigroup (C).  Citi raised their price target to $12 as the recent acquisition of Centex is a positive for the company and they were “undeservedly out of favor.”  The stock is trading 4% higher in afternoon trading on this gutsy call.

At Ockham we are reaffirming our Overvalued stance on Pulte Homes as well as many others in that peer group.  The company has seen new orders improve in the most recent quarter thanks in part to their merger with Centex, but there still remains a lot of risk in all of these homebuilders.  Pulte’s CEO Richard Dugas said that “the housing market is still choppy.”  He also said that he expects operating conditions will continue to be difficult through at least 2010. 

This month may be an aberration in the general trend of improvement in the housing market, and we sincerely hope that is the case.  However, we cannot ignore the fact that homebuilders enjoyed very profitable times as the rode the housing bubble up for better part of the decade.  During that time many parts of the country were overbuilt, and that supply overhang is only beginning to clear itself.  Foreclosures remain extremely elevated only adding to the supply glut.  At this time, we just do not see a compelling reason to invest in homebuilder stocks.

Caller: Hey, I’m interested in buying a stock, Citigroup, and I would like to know would it be a good stock? I’m 28 years old, and I want to know it Citi a good long-term and short-term investment?

Cramer: And what was the stock? Did we get the stock’s name? Citigroup. Your age is right. You know why? Because I’m using a $12 price target in the year 2012 for now, remember, we’ve got to get the government selling its share. They own 34% of it. That’s been a huge overhang. I am a big believer in Vikram he’s spinning off the Primerica. I think ultimately he’s going to bring up value, $5.60 is the book value. I think it should trade to that. Ultimately book value builds. I think you’ve got a great stock to own.

Is it as good as Bank of America if they pick Moynihan. Is it as good as Wells Fargo? That’s another one I own for my Charitable Trust, it’s not as well run. But Citigroup makes sense for any 28-year-old who’s watching this show.” — CNBC’s Mad Money 11/10/2009

On Tuesday’s Mad Money, Cramer fielded this call from a young investor curious about Citigroup (C) stock.  Cramer’s advised that for a long term investor Citi is a justifiable stock, and in particular because young investors normally have the time and ability to take on a little more risk.  While we do not see Citi’s valuation as particularly attractive as of yet, that is largely because our methodology is normally pretty risk averse.  When a company has been through so many write-downs and earnings have been decimated to the extent that Citi’s have, it is unlikely that our methodology will look favorably on the stock.

Cramer sees Citigroup trading up to its book value which he states at $5.60 at this point, but according to the latest data from Morningstar (MORN) the book value per share is somewhere closer to $3.41.  If Cramer believes that the stock should trade at only book value, it does make a big difference in whose data you trust.  This is not to say that he is incorrect in his assertion that book value should continue to build over the next few years assuming economic conditions continue to improve.  Citi has some very valuable and diverse assets that will only gain in their appeal as global growth reemerges.

As we mentioned earlier, we have an Overvalued stance on Citi at the current price, simply because the fundamentals have dropped so rapidly from their levels of just two years ago.  With that in mind, the company has already begun the long road back from the abyss and at least earnings are becoming much less negative in recent quarters and have surprised analysts to the upside the last three quarters.  So, even though this stock is not in our wheelhouse according to our value investing methodology because of the risk factor from the last few years, if you have time and an appropriate appetite for risk there is a reasonable case to be made that this stock doubles in the next few years.