Preferred Exchange Offer This is an investment idea for three Citigroup non-cum preferred stock that remain outstanding after the exchange offer to common stock completed earlier this year. Citigroup announced on February 27 it will issue common stock in exchange for preferred securities in an effort to raise capital. The company also announced that will continue to pay dividend for all trust and enhanced trust preferred but will suspend dividend for all non-cumulative preferred stock that are listed on table 1.
Issue Par Ticker Coupon Exchange Ratio
Citi Non-Cum Pfd $25 CprP 8.125% 7.30769
Citi Non-Cum Pfd $25 CprM 8.5& 7.30769
Citi Non-Cum Convertible Pfd $50 CprI 6.5% 13.0769

Table 1

A series of amendments were also part of the offering and were designed to eliminate the legal obligations of the issuer to pay dividends on the non-cum preferred stock even if some of the investors did not agree to the exchange and such securities remained outstanding after completion of the exchange.

Proxy Voting June 16, 2009 was the record date for holders of preferred securities to be eligible vote on the Common and Public Preferred Stock Proxy for a series of amendments.

Common Stock Proxy Non-cum preferred and trust preferred holders voted and it was passed. It authorized the increase of common shares from 15 billion to 60 billion, a reverse stock split and the elimination of rights solely related to preferred holders.

Preferred Proxy Statement Non-cum preferred holders voted and it wasn’t passed. It was supposed to authorize the elimination of the dividend blocker, waive the right to appoint two directors to Citigroup’s board under some circumstances and increase the authorized preferred shares.

Dividend Blocker It prevents the issuer from paying dividends on securities ranked equal or junior in the capital structure to preferred shares. Citigroup has to pay a dividend on the non-cum preferred remaining outstanding after the offer before the common dividend can be paid.

Director Amendment It allows holders of the non-exchanged non-cum preferred shares to vote for the election of two directors to the board of directors of Citigroup after the company defers the dividend on these outstanding shares for six quarters. This is important because these shareholders can exercise a level of influence over the management and governance of the company that is disproportional to the remaining economic interest.

Possible Scenarios The failure to pass of the preferred stock amendments is significant. There are still over 7mm shares of non-cumulative preferred stock outstanding after the completion of the exchange and some investors are speculating in a rise in price or clean-up offer. It is unclear when Citigroup will resume its common dividend but we assume that it will happen at the end of the 3rd Q of 2011. Results of the exchange offer are available here.

Scenario 1 The shares are called at par right before a common dividend is paid or announced (3Q 2011). This scenario provides attractive returns but it is not likely to happen because even if the company reduces expenses by eliminating a dividend on the non-cum preferred shares, failure to do such for six straight months can incur in a loss of control per the director amendment. However it’s a possible case and should not be excluded.

Issue Price 10/16 Annualized Return
CprP 16.00 17.82%
CprM 15.92 18.00%
CprI 27.55 23.09%

Scenario 2 The dividend on the outstanding non-cum preferred shares is resumed after six quarters of deferred payments and the shares are called at par right before a common dividend is paid or announced (3Q 2011). This scenario is the most expensive for the company and therefore the highest payout to investors, however it might be an appropriate course of action for Citigroup to prevent loss of control.

Issue Price 10/16 Annualized Return Annualized Income Total Return
CprP 16.00 17.82% 1.77% 19.59%
CprM 15.92 18.00% 1.89% 19.89%
CprI 27.55 23.09% 0.71% 23.80%

Scenario 3 An involuntary exchange offer into common stock for all non-cum preferred shares outstanding is announced before the company defers the dividend on these shares for six straight quarters. This represents the best option for the company because it represents a an non-cash expense with minimal dilution but it would be subject to SEC scrutiny which might not approve the deal. Assuming the company offers 85% liquidation value for the outstanding preferred (it was 95% on the original offer announced in February) and that at the time of the announcement Citigroup common is trading at $5.00 per share, preferred holders of par $25 will receive 4.25 shares (4 shares plus cash) and holders of per $50 will receive 8.5 shares (8 shares plus cash).

Issue 85% Par Liquidation Value Number of Shares
CprP 21.25 21.25/5=4.25
CprI 21.25 21.25/5=4.25
CprM 42.5 42.5/5=8.5

It’s hard to speculate how much return preferred shareholders can get as it depends on what price the common stock will be trading after the announcement.

Conclusions Purchasing any of the outstanding preferred shares could score a significant profit as the prices can rise in speculation of a potential reorganization or exchange offer similar to one of the scenarios illustrated. It is a risky investment because there are a lot of uncertainties and variables involved. Liquidity can be an issue as the number of shares outstanding is limited and an investor could be stuck with an illiquid position for quite some time. 

Formulas

Annualized return formula= [1+ln (Par/Price)] ^1/ (Quarters/360)

Ln= Natural Log of return. Continuous time frame.

Quarters= Number of Quarters and 1Qis 90 Days.

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