Trust Sandy to try and upstage the U.N. summit.
As scores of world leaders descended on New York Wednesday, Sandy Weill's
announced its intention to buy consumer lender
( AFS) in a $31.1 billion deal that will substantially extend its retail operations around the world and boost Citi's size to the point where it may just need its own seat on the Security Council.
The deal, which had been rumored on and off since last year, is the biggest struck by Citigroup CEO Weill since
merged in 1998. In acquiring Associates, Citi will be well on the way to becoming a trillion-dollar institution. Adding the Dallas-based consumer finance firm's $100 billion of assets would give Citi nearly $900 billion in assets.
Though Citi paid a steep 50% premium to Associates' closing Tuesday share price of $28, analysts and investors are generally supportive of the deal, predicting that Citi will have little trouble integrating Associates and making its operations more efficient through cost cutting and better management. One area of concern exists, however. Could Associates be suffering from an as-yet-undisclosed jump in bad loans? Despite being pressed on the credit-quality issue during a conference call Wednesday, Weill repeatedly refused to say how much, if any, of a proposed $700 million merger charge is being used to cover problem loans at Associates.
As a consumer finance firm, Associates doesn't take deposits like a bank. Instead, it borrows in the market the money it lends to customers. It then bundles those loans as bonds and sells them to investors. At the end of the second quarter it had loan receivables totaling $85 billion, with most of these concentrated in its three largest business lines: home equity loans, personal loans and credit cards. About a quarter of its loans are to corporations.
But investors have recently been cautious of consumer finance firms, since they are vulnerable to spikes in borrowing costs and many have had extensive exposure to high-risk borrowers. Though as of Tuesday it had risen nearly 80% from its 52-week low, Associates' stock, even at Citi's buyout price of $42.50, remains well below its all-time high of $48.88, posted in 1999.
While investors aren't too keen on Associates and others as a stand-alone companies, they don't seem to mind Citi doing the consumer finance thing through its
division. That may be because Weill and Bob Lipp, Citi's head of consumer operations, are experienced operators of consumer finance operations, as evidenced by their turnaround in the late 1980s of
, out of which CitiFinancial was formed.
It's hard to overestimate the impact that this purchase will have on Citi, which aims to close the transaction around year-end. It will make consumer operations a larger part of Citi's overall business. It should also reduce Citi's reliance on its more volatile businesses, like its large investment bank,
Salomon Smith Barney
, which has recently been the bank's biggest engine of profits growth.
In the second quarter, Citi's consumer-based revenue of $7.5 billion accounted for 46% of the $16.4 billion total at the bank. Assuming that Associates' consumer businesses contributed three-fourths of its $3.6 billion of second-quarter revenue, a combined Citigroup-Associates entity would have gotten over half its revenue from consumer sources. For sure, consumer-finance revenues aren't immune to swings; bad loans would be legion in a recession, for example.
In the first year after the closing of the proposed merger, Citi expects Associates' operations to add at least 10 cents to per-share earnings, equivalent to around 3% of the $2.98 per share that the bank should make in 2001, according to analysts surveyed by
First Call/Thomson Financial
. The 10-cent accretion would depend on cost savings of around $400 million in the first year, according to Citi, which expects to make savings of at least $600 million over two years.
However, many think Citi's profitability projections are conservative. Cost savings could easily be higher and Citi should be able to cross-sell other financial products to Associates' customers. In addition, Citi managers could prove to be better at running Associates operations. CitiFinancial's profits soared by 50% in the second quarter, compared with the year-earlier period. Associates' profits were up 14%, by contrast. CitiFinancial returned 2.48% on assets in the second quarter, against Associates' 1.87%.
As Citi execs made clear many times on the conference call, one of the main reasons they want Associates is its large international presence, particularly in Japan, where it's the fifth-largest consumer-finance company, with more than 700,000 customers and 675 branches.
"If they can leverage Associates in Japan, this deal will be huge for Citi," says Adam Levy, an analyst for the
Invesco Financial Services fund, which owns shares in Citi and Associates.
While the deal has been given a positive reception, there are two areas of concern. Japan has recently introduced a so-called usury law that limits the interest rate on loans to just over 29%. This will almost certainly have an impact on Associates. "The prospective growth rates in Japan could be slower than in the past as a result of the usury ceiling," says Moshe Orenbuch, analyst at
Donaldson Lufkin & Jenrette
, which rates Associates a buy and has done recent underwriting for Associates.
Then there's the issue of credit quality at Associates. The firm reported higher losses in home equity loans at the end of last year. Then earlier this year it said it was discontinuing its mobile-home loan portfolio, taking a $112 million pretax charge in the process to partly cover higher losses and lower-valued repossessed homes. Now, its truck-loan division is showing sharply higher losses, though credit quality is improving in its consumer lines. If Associates' credit quality is taking a turn for the worse, Citi may have used it as an opportunity to get Associates sooner and cheaper than otherwise might have been possible.
However, a higher level of bad loans, provided there's no huge spike waiting in the wings, shouldn't unnerve investors too much. After all, Commercial Credit was hardly in great shape when Weill joined.