Citi's new convertible mandatories seen as 'equity alternative,' play on financials: B of A Merrill

By Rebecca Melvin

New York, Dec. 21 - Citigroup Inc.'s new 7.5% mandatory preferreds are being added to Bank of America Merrill Lynch's model portfolio for 2010 as an "equity alternative" and as a play on financials, according to research published by the bank Monday.

Adding the newly issued $3.5 billion Citigroup preferred continues with "our theme of repositioning," Bank of America Merrill Lynch convertibles analyst Tatyana Hube wrote.

"We believe that the Citigroup 7.5% convertible mandatory preferred, with its 78% delta and 7.4% current yield, stands to benefit strongly from the Citi stock upside potential, while providing a downside cushion with its yield advantage over common," Hube wrote.

Although some investors were taken aback by some "new twists" in the mandatory structure, a closer look at the details reveals that it is more or less a different way of repackaging a more straightforward mandatory structure, resulting in the same type of valuation, Hube wrote.

"Versus the $3.30 Citigroup common price, the 7.5% mandatory was recently quoted by our trading desk at 101.75 bid, 102, making it 5.3% cheap at the offer price," Hube wrote.

For a 25% move in the Citi common stock in either direction, "we project a one-year total return for the Citi 7.5% preferred of plus 20.4% to negative 15.5%, a 1.3 times reward/risk ratio, assuming it continues to trade at the same cheapness level; even a one-point richening improves the reward or risk ratio to 1.5. In our valuation, we used a 50% volatility assumption and a conservative 700 basis point spread over Treasuries," she said.

Financials eyed in 2010

Equity strategists have recommended remaining overweight in financials in 2010, Hube said.

"In their 2010 year-ahead report published on Dec. 7, the Bank of America Merrill Lynch equity strategy team commented that financial earnings should rebound strongly as banks stop adding to loan loss reserves in 2010 and net interest margins benefit from prolonged steepness of the yield curve as the Fed keeps short-term rates unchanged owing to subdued growth in U.S. gross domestic product," Hube said.

Significantly higher earnings in 2010 would improve confidence in the long-term earnings potential.

The team expects 2010 normalized financials earnings to be at least 30% higher than the sector's 2010 earnings. On normalized 2010 earnings, the sector is trading at a sub 12 price earnings ratio. As banks raise private capital to repay TARP, earnings per share dilution risk is minimized by the high cost of TARP capital, 5% after-tax dividend rate plus warrants. Overweight financial is also a hedge against Asia faltering and lower commodity prices.

The Bank of America Merrill Lynch team prefers larger banks with higher loss reserves, better quality loan portfolios and more diversified revenue streams from capital markets. With average quality loan portfolios, Citi scores at least two out of three on that list, Hube said.

Although Bank of America Merrill Lynch equity analyst Guy Moszkowski recently cut his price objective on Citi common stock from $5.75 to trough book value of $5.10 to account for the latest dilution, he continues rating it as a buy.

He believes that deferred tax assets and intangibles are safe from impairment, and as earnings clarity improves in the second half of 2010, the market should shift to valuing Citi at book value.

Aspects of structure

Although the Citi 7.5% mandatory preferred, called the T-DECS, still "walks and talks" like a regular convertible mandatory preferred, it does have a fairly novel structure.

Instead of being structured as a plain convertible or an equity unit, a forward purchase contract and a senior note that mandatorily convert into common shares after three years, the Citi mandatory features a prepaid purchase contract bundled with a junior subordinated note.

With a more traditional equity unit, a holder buys a senior note, which is then pledged against the holder's future obligation (a forward contract) to buy the common stock from the issuer, paying for that common stock with the proceeds from the senior note's remarketing to some other investors.

With the Citi T-DECS, or tangible dividend enhanced common stock, a holder buys a prepaid purchase contact (to get the Citi common shares in three years) for $79.716 and a junior subordinated amortizing note maturing in three years worth $20.284 for a full price of $100 per T-DECS.

The interesting part is that this junior subordinated note amortizes down from the principal value of $20.284 to zero in three years, and that amortization of principal is paid to the T-DECS holders as a tax-free return of principal in addition to the 6.15% interest payment on that amortizing down principal to comprise the $1.875 quarterly payment, or 7.5% annually, on the T-DECS.

Two points worth noting, Hube said, are: that since the purchase contract is prepaid, the company gets a full equity credit for that portion from the regulators and creditors, and since the bulk of the 7.5% mandatory's payment comes from a tax-free return of notes' principal, taxable holders should receive a great tax benefit from this structure, subject to the IRS overruling that interpretation by Citigroup.

Conversion settlement

Unless Citi exercises its early mandatory settlement option, the Citigroup 7.5% will mandatorily convert into between 25.3968 and 31.746 Citi common shares on Dec. 15, 2012. If the applicable market value, which is calculated as the average of the daily volume weighted average prices, or VWAPs, of the Citi common stock on the 20 consecutive trading days ending on the third trading day immediately preceding Dec. 15, 2012, is greater than or equal to $3.94, the holder will receive 25.3968 shares of Citi common, which is the minimum ratio.

If the VWAP is less than or equal to $3.15, the holder will receive 31.746 shares of Citi common stock, the maximum ratio, and if it is between $3.15 and $3.94, the holder will receive a number of Citi common shares equal to $100 divided by the applicable market price, which is a number between 25.3968 and 31.746 Citi common shares.

If the holder voluntarily converts the 7.5% T-DECS early, he or she will receive only a minimum conversion ratio of 25.3968 regardless of the Citi common stock trading price and will forego the remaining quarterly payments in the T-DECS.

Citi can settle early

Investors are perhaps most troubled by the fact that the T-DECS can be settled early by Citi at any time with as little as five days notice, Hube wrote.

If at that time, the Citi common stock trades above $5.122, or 130% of the upper strike of $3.94, the holder would receive a minimum ratio of 25.3968 at this early mandatory settlement. Otherwise, the holder would receive a maximum ratio of 31.746.

In addition to receiving Citi common shares, the T-DECS holder would also be able to require Citigroup to repurchase their remaining amortizing notes at whatever principal value they are worth at that time, which is akin to a dividend make-whole commonly accompanying provisional issuer calls.

The one big caveat is that the holder would not be able to require this repurchase to occur if Citigroup has already begun to or given notice that it intends to defer the future scheduled installment payments.

In that case, the holder would not get the dividend make-whole until the deferral ends, unless Citigroup has received any required regulatory approval or consent from the Federal Reserve or any successor primary federal regulator to extend the repurchase right to the holder, if then required.

"We read this to mean that if such approval is not required, then the T-DECS holders would once again have to wait for the deferral period to end," Hube said.

The Citi 7.5% mandatory preferred have built-in dividend protection via a conversion ratio increase for any regular quarterly Citi common divdends above $0 a share. Currently Citi is not paying any dividends on the Citi common stock.

Citi price objective

Looking ahead, the research report said Citigroup's shares will begin again to trade based on actual, not tangible, book value, and the probability of a worst-case outcome is receding at this point. ROE in 2011, as earnings begin to normalize, is forecast at 10% to 11%. However, Bank of America Merrill Lynch expects a slower-than-expected improvement in credit conditions and expects this to weigh on the shares.

Therefore, the bank thinks it is fair to expect that the shares will, in the next 12 months, trade to trough 2010E BVPS of $5.10 to account for dilution.

"We believe DTA [deferred tax assets] and intangibles are safe from impairment, and as earnings clarity improves in 2H:10 market should shift to valuing [Citigroup] at BV. We note our 12E estimate does not account for any reduction of share count via buybacks."

As a downside risk, "Citi remains one of the largest holders of both on- and off-balance sheet illiquid assets that may still require marking. Also, the firm's historical ROE has been enhanced by significant leverage, particularly in the investment bank, where we expect significant de-leveraging," the research noted.

"Finally, consumer credit is becoming increasingly stressed and Citi is very exposed through cards and home equity. Uncertainties surrounding earnings power, possible further dilution, and whether the deferred tax assets embedded in shareholders equity will have value pose further downside risk. Other downside risks are possible dilution from a capital raise to pay back remaining TARP TRUPs and dilution from TARP repayment," the research said.

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