A Citi Thesis

I want to propose some discussion points on Citibank.

1. C currently has a massive amount of short interest (more than 1.4 billion shares). With a total number of shares outstanding of only 5 billion, this means that 30% of the total share base is currently sold short. On a relative basis, this is absolutely gigantic. A short interest of this magnitude can imply two totally different things. On one hand, it could be a sign that institutional investors strongly believe the stock will drop in price in the future and have thus heavily shorted the stock to profit from a future price drop. OR, it could mean that the short trade is enormously “crowded,” and once everybody starts leaning one way on a particular stock, it has a strong probability of moving the other way. Basically, these 1.4 billion shares short represent shares that ultimately need to be bought back. This represents “hidden buying power” to traditional buyers (such as mutual funds) who will buy the stock long simply because they believe it is undervalued. I would imagine that if the fundamentals of C continue to improve, these 1.4 Billion shares will be bought back in short order.

2. Large institutional asset managers are legally restricted by their byrules from either HOLDING or BUYING stocks priced under $5 per share. This is to prevent funds from dabbling in “penny stocks,” which large investors typically avoid given how difficult it is for them to buy penny stocks without ramping up the stock price. Here’s a brief and important analysis to look at. Under Yahoo Finance for C, look at the section called “Historical Prices” where you can see the daily price/volume for Citibank in 4Q08 and 1Q09. Exactly as Citibank approached the $5 level on the way down, every large investor hit a trigger where they NEEDED TO SELL (regardless of what they thought of the fundamentals) because of their fund bylaws. The stock literally went from $5 to $1 almost “overnight,” on record-setting volume (up to 10x normal), while at the same time no significant news came out, nor did other similar large financial institutions see their prices fall during this same period of time. Now that Citi is approaching the $5 level on the way up, you will find the same firms who sold BILLIONS of shares of Citi once it went below $5 buying right back - which should have a “whipsaw effect” once the stock stabilizes back above $5 and stays there. We’re talking about a cumulative effect of billions of shares, so the impact will be significant.

3. Right now, mutual funds are still considerably UNDERWEIGHT financials relative to their index benchmark. As C starts to ramp up back above $5 - and it starts to represent a more meaningful % of the S&P 500, S&P 100, Dow Jones, etc., all of these index ETFs (such as SPY, which tracks the S&P500) will NEED to buy more and more shares of C in order to match the weight in the index. This effect is relatively smaller but nonetheless estimated at hundreds of millions of shares that will need to be bought as C moves upward as the tens of billions of dollars invested in the S&P 500, the Dow Jones and so forth dictate by their fund bylaws that they need to match the weight of each stock in its respective index.

4. The last point here is fundamental in nature and worth understanding to really “get” my investment thesis. The last major issue hanging over Citi is the outstanding situation regarding the capital the firm needs to raise as dictated by the government’s recent “Stress Test.” This Test looked at the 19 major banks in the U.S., did some risk calculations, and then dictated to each bank exactly how much capital they needed to raise by early 2010 to meet regulatory capital requirements.

The way that most of these banks (Wells Fargo, Morgan Stanley, Bank of America, etc.) did so was to issue new shares of stock. This is very simple: the corporation simply creates new shares of stock and sells them directly to institutional investors at a price slightly below the current market price in order to raise cash to satisfy the government. BofA sold over $13B in new stock to investors during May 2009 to meet the Stress Test capital requirements.

Now, Citi needs to raise capital as well, and everybody in the market knows they need to sell stock. This is bad, of course, because the more shares outstanding, the lower the Earnings Per Share (EPS).

However, it is worth looking at BofA’s case, which is similar to Citibank. BofA traded all the way down to less than $3 per share as investors realized they needed to sell a large amount of stock to raise capital. With the stock at only $3 per share, they would need to sell a TON of shares to raise the $13B they needed. However, BofF was prudent in their timing for when they sold their shares; rather than dumping billions of shares on the market when the stock was at $3, they waited and let the market improve and were helped by positive earnings reports and positive discussions with analysts. Thus, the stock went up by itself to $13-$14 before they decided to sell stock; because the stock went up all the way to $13 (rather than $3 where it started), they only needed to sell 25% as many shares as they originally planned and hence the dilution effect on their EPS was tiny relative to what everybody had expected.

I believe the same thing can happen with Citi. The technical factors (outlined above) should help drive the stock higher as large investors get back on board. As the stock price moves upward, investors will realize that the number of shares C needs to issue to raise capital will be less than they had originally planned, which will cause them to buy the stock even more, which will reduce even further the number of shares they need to issue and sell. Basically, it is a self-reinforcing virtuous cycle where an increase in the stock price lowers the number of shares Citi needs to sell, which investors react to positively and drive the price up even further. Then, once the stock gets high enough, Citi will sell ALL of the shares they need to raise capital (thus permanently ending any risk whatsoever of Citi not having enough capital, going out of business, being nationalized by the Obama administration, and so forth), which ultimately provides the background and catalyst to get the stock closer to the considerably higher range ($20s to $50s) it traded in for five years from 2003-2008.

Bottom line is that the reason Citi has mentioned NOTHING about raising capital and/or their capital raising plans - while Morgan, BofA, Wells, Goldman, etc. have raised tens of billions of dollars of capital/cash and issued press releases - is because Citi is waiting for its stock price to improve so the dilution impact is smaller. They want another positive earnings report for 2Q09 to help drive the stock up, hopefully capturing the positive force from points #1 and #2, and then once the stock gets there, BOOM!, they sell the entire block needed to raise their capital and the issue is done with permanently.

Remember, the size of Citi’s business in terms of revenue, etc. is basically the same as it was from 2003-2008. Today, however, the # of competitors is much smaller than the 2003-2008 timeframe - another positive impact on Citi’s revenue and EPS. If C can successfully complete their capital offering, the risk profile of the company will recede even further and investors will start to focus on the positive things going on right now. Right now, Citi is making a killing on their basic lending businesses given they can borrow from the Fed at 0% and lend out at 5% (the positive slope to the yield curve right now is paradise for banks and lenders), corporate bond spreads are coming down in both investment grade and high yield, liquidity is getting better by the day, and (most importantly, perhaps) the IPO and Debt Issuance markets are finally coming back to life after being totally dead for almost 18 months. The amount of companies with pent-up demand to go public or issue/refinance debt is at all-time record levels with a gigantic pipeline of deals waiting to be done. And with the stock market getting healthier and bond rates for companies much better as well, the quantity of business to be done in these principal lines for the investment bank part of Citi cannot be underemphasized.

My sense is that investors aren’t seeing that far down the road yet, however. They are still focused 99% on the capital raising/dilution concerns which is why Citi has been stuck around $3.50 to $4.00. However, if/when the capital raising is successfully resolved, investors WILL start focusing on these positive points and the impact on EPS could easily push EPS BEYOND the peak levels of 2003-2008, which would obviously mean very good things for share prices.

-William. B

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