http://www.notananalyst.com/2009/10/17/citigroup-preferred-shares/

Background In February 2009, Citigroup announced the suspension of dividends on certain non-cum equity preferred (CprP, CprM and CprI) as the securities were converted into equity in an effort to raise tangible common equity and capital requirements. In theory, preferred shares that don’t pay a dividend are worthless based on the Gordon Growth Model but those preferred continued to trade despite the suspension of the dividend due to a technicality. That’s when the value opportunity became evident.

Technicality As I described in my original post, holders of the non-cum equity preferred shares were required to vote on a series of amendments and the most important among them was the dividend blocker. That amendment was designed to eliminate the legal obligation of the issuer or Citigroup to pay dividends on the non-cum equity preferred even if some investors elected not to exchange their shares. However, the dividend blocker didn’t pass and Citigroup became legally obligated to pay a dividend on the outstanding non-cum equity preferred shares before it could pay a dividend on common shares. As a result, the equity preferreds that were trading ex-dividend continued to rise, on speculation of a possible dividend payment in the future.

IRR In my original post, I proposed a scenario in which Citigroup would defer the dividend for six quarters and resume it afterwards. Now, after only four quarters, Citigroup has announced the reinstatement of the non-cum equity preferred dividend. The trade idea yielded an IRR of about 49.5% for each security, significantly higher that the 20% IRR I expected.  Here is the press release:

NEW YORK – The Board of Directors of Citigroup (NYSE:C) today declared dividends on preferred stock as follows:

6.5% Non-Cumulative Convertible Preferred Stock, Series T, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full convertible preferred share, will be paid $.8125 for each receipt held.

8.125% Non-Cumulative Preferred Stock, Series AA, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.5078125 for each receipt held.

8.40% Fixed Rate / Floating Rate Non-Cumulative Preferred Stock, Series E, payable November 1, 2010, to holders of record on October 20, 2010. Holders of depositary receipts, each representing one-twenty-fifth of a full preferred share, will be paid $42.00 for each receipt held.

8.50% Non-Cumulative Preferred Stock, Series F, payable December 15, 2010, to holders of record on December 3, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.53125 for each receipt held.

On February 27, 2009, at the time of the announcement of its public and private exchange offers, Citi announced the suspension of dividends on its Preferred Stock. Pursuant to the exchange offers, Citi offered to exchange up to $14,923,650,000 of its outstanding publicly-held Preferred Securities for Common Stock at a price per share of $3.25; 98% of the Preferred Stock elected to participate in the exchange offers. Dividends declared today will be paid on the Series AA, T, E and F Preferred Stock that remains outstanding.

Common Dividend The dividend reinstatement on those outstanding non-cum equity preferred is a hint to investors. Citigroup should be in no rush to reinstate the dividend on the non-cum equity preferred unless the Company is getting ready to repay a common dividend.  In my opinion, Citigroup will announce the payment of a $0.05 quarterly common dividend in the 1Q of 2011. Stay tuned.

Capital Structure CIT Group has all the characteristics of a High Yield Issuer. The Company is structured as a holding company, it relies heavily on short-term bank debt (JPM Letter of Credit, most of Senior Unsecured Notes, Senior Unsecured Term Loan and Credit Agreement are bank debt) and debt is borrowed at the parent level (the senior unsecured notes are issued by CIT Group which is the parent) but funds to pay the obligations are generated from operating subsidiaries.  The offering memorandum provides very useful insights however it’s 250 pages!

Only the face amount for holders entitled to vote in the offering are displayed

Restructuring Plan The Company’s principal objectives under the Restructuring Plan are to reduce leverage, return to investment grade rating, transfer business platforms to CIT Bank and recapitalization. Bondholders can elect to participate in the Restructuring Plan through consummation of the Offer or the Plan of reorganization. The Offering is conditioned upon achieving acceptable liquidity and leverage targets and the Plan of Reorganization is accepted if it reaches a certain approval percentage. The Company will file for bankruptcy protection without a prepackaged restructuring plan if the offer is not consummated or the plan of reorganization is not accepted.

Terrible deal Investors holding the Canadian Senior Unsecured Note or Structurally Senior Unsecured debt in the table above (for amount of $2,188 mm) are pushing for greater consideration from the Offering Plan as they are entitled to recover close to 100 cents on the dollar from the pre-packed Plan of Reorganization. Also Subordinated Bondholders (amount to $1,979 mm) are only offered Preferred Stock and are asking for more equity or extra money if the company will perform well. It’s important to note that the “New Preferred Stock” offered is not a preferred stock per se but it’s basically an equity stake in the company. The “New Preferred Stock” will have no stated dividend, no intention to pay a dividend, no maturity, it will not be listed on any exchange, it will not be subject to any sinking fund provision and only redeemable at the Company discretion. Should I go on? This Preferred Stock may very well be worthless if the company seeks Chapter 11 protection a few months after the offering.

Amendments and more On October 19, Carl Ichan offered to underwrite a $6,000 mm loan to rescue the lender after the offering was amended on October 16 to include some minor changes that are “sweetening” the offer. However, the company has major liquidity and operating issues and these actions are just postponing the problem. For the months ending on December 31 2009, there is $1,600 mm in notes maturing, including $800 mm due in the first week of November and for the months ending in August 31 2010, there is $7,600 mm of debt funds needed.

Little Hope Bankruptcy seems inevitable for CIT Group even if an out of court reorganization is implemented. The company’s ability to raise funds is impaired under two fronts: capital markets because the company has credit rating below investment grade and cannot issue short term debt like commercial paper (or it might be able to at high rates) to fund its lending business and bank deposits because the FDIC imposed a restriction called Cease and Desist Order on the CIT Bank ability to grow deposits as the regulator is concerned about the firm’s financial well being.

Covenants Restrictions The new notes are going to be subject to certain covenants that protect bondholders but will impair the ability of the Company to generate income.

• Restriction on the parent and its subsidiaries from incurring additional debt. This is obvious but there should be some tests implemented every quarter to check if capital levels are adequate (maintenance or debt incurrence test).
• Pay dividend. The Company has to retain income, if any.
• Make investments .This is my point, how is the company going to grow?
• Create liens or use assets to secure other transactions. A principal element of he Restructuring Plan is to “negotiate new or amend secured credit facility to provide additional liquidity” but this is not possible under the new notes covenants.
• Sell certain assets or merge. If the company ends up in trouble again, which I deem very possible, the only solution will be Chapter 11
• Transaction with affiliates. Part of the business Post-Restructuring Plan indicates that the “most likely scenario” is to transfer all “bank-like” operations (that takes place in other subsidiaries) to CIT Bank, but this is not possible under the new notes covenants and until the FDIC lift the restriction discussed above.

A breach of any of these covenants could result in a default under the New Notes Indenture.

Conclusion The Restructuring Plan doesn’t seem well drafted as some of the core objectives cannot be implemented due to the restrictive bond covenants of the new notes. The company may end up in court for bankruptcy under Chapter 11 as the Offering doesn’t look appealing to bondholders.

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 3^rd 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.

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.

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).

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.