Citigroup Stock Sheds Its Tether After Conversion

(Includes closing stock prices.)

NEW YORK ( TheStreet) -- Anyone searching for an explanation to the dips and peaks of Citigroup's ( C) share price recently needs to look beyond the fundamentals.

Citi shares wilted Monday morning, the first day of trading after the bank completed a mammoth conversion of preferred stock into common. Its stock was down more than 5% at times in early trading, closing down 4 cents, or 1.5%, to $2.69.

The sluggish pricing reflected a few practical factors, despite bullish sentiment expressed by those analyzing Citigroup's fundamental ability to earn money.

First is the basic issue of supply and demand, with a tidal wave of new stock pushing down the price. The exchange offer is expected to bring Citi's total shares outstanding to 23 billion, vs. 5.5 billion at June 30.

Another factor at play is the arbitrageurs who were only holding preferred to reap the benefits of a pricing differential, but really had no interest in owning Citigroup.

In The Money
In The Money Chart
Source: Bloomberg

Once the stock conversion was announced on Feb. 27, investors flocked to get a piece of Citi's preferred stock that was eligible for the exchange. Its Series AA preferred security, eligible to be converted into 7.307 shares of common, soared $2.57, or 47%, on the day of the announcement, to close at $8.05.

The preferred series has traded in a wide, but profitable, range ever since the announcement, representing a premium of 55 cents to $12.50 over the closing price of common stock.

Some investors have also attempted to boost the profitability of the trade by shorting Citi common shares as well, though the availability of shares for lending has been too limited or too costly at times to make the trade work. Nonetheless, short interest in Citigroup surged from 0.4% on Feb. 27 to 1.5% just two weeks later. It has climbed pretty steadily since then, reaching a peak of 6.6% in July.

All these back-door maneuvers have helped restrict Citi's stock from sustaining momentum above the $4 mark. But now that the Citi arb-play is played out, investors may be able to make a traditional investment in the company again -- as long as they're prepared to wait awhile to see sustained, healthy returns.

The Citigroup Smackdown!

Citi is still in the process of dismantling its operations and selling off all the components piled into its so-called bad bank, Citi Holdings, which have been deemed no longer necessary to the core banking franchise. The company has made headway with the sale of a majority stake in Smith Barney to Morgan Stanley ( MS) and its Japanese brokerage Nikko Cordial to Sumitomo Mitsui Financial. Citi also has shuttered smaller operations, but it still has a long way to go.

The bank is also constrained by the huge swath of bad loans on its books, which got Citi in to trouble in the first place. Its provision for loan losses last quarter was 7.63% of its portfolio, while reserves are 5.60% of loans and only 69.7% of non‐performing assets. Rochdale Securities analyst Richard Bove notes that those are figures "generally associated with banks that are unable to survive."

Of course Citi likely will survive, but only because the government is keeping it on life support. The federal government will now have a 34% stake in Citi, since half of the preferred shares converted to common stock was owned by the Treasury Department. All told, Uncle Sam has committed $50 billion to Citigroup through capital infusions and backstops on bad debt.

While the moves give Citi $100 billion of tangible common equity and a 9% Tier 1 common ratio, they also put Citi on a much longer road to escape government ownership and strict oversight than its competitors.

JPMorgan Chase ( JPM), Goldman Sachs ( GS) and Morgan Stanley have already thrown off the TARP shackles, or begun to, and others like Bank of America ( BAC) and Wells Fargo ( WFC) are forging ahead with strategies to do the same.

Citi, on the other hand, just finished the process to give the government a huge stake.

Some say the benefits outweigh the costs. After all, the government has made it clear that Citi will not fail, and will be well-capitalized as it goes through a transition from financial supermarket to financial minimarket. Bove holds a buy rating on Citi shares, saying that "a concerted effort is being made to dissolve the old company and replace it with a new, better capitalized, better managed entity."

On the other hand, it could also work to hamstring Citi's competitive edge. There has been an enormous amount of public outrage and political posturing over lucrative compensation packages at companies heavily supported by taxpayers, the prime examples being American International Group ( AIG) and Bank of America's Merrill Lynch. But managers and employees at those companies have argued that without competitive pay, top talent will go to competing companies or hedge funds that offer more dollars and less scrutiny.

A recent article in the Wall Street Journal about a $100 million salary expected for the leader of Citi's energy trading division highlights the problem. The Obama administration's so-called "pay czar" Kenneth Feinberg is sure to crack down on such highly publicized pay packages as tensions persist.

For the patient investor, Citi may be worth the wait. Bove estimates that Citi's normalized earnings are about $1.23 per share. But while he forecasts that most banks he researches will achieve normalized earnings within three years, Citi will take about five.

An article in the most recent edition of Barron's also garnered attention on Monday, as it predicted Citi shares could double by 2012. The magazine based that forecast on the bank's share price, which trades at 65% of tangible book value.

"No, Citi isn't Goldman Sachs or JPMorgan," Barron's said. "Yet this tarnished but still attractive global franchise holds the potential to generate nice profits and decent stock gains as the economy turns."

But with the overhang of government influence -- which is guided not by economics, but by political will -- and Citi's mammoth dismantling project under way, there is still a good deal of uncertainty about what, exactly, Citi's normalized earnings are. Analyst estimates for 2009 range from a loss of $1.20 per share to a profit of 20 cents per share, according to Thomson Reuters. Estimates for next year range from a loss of 55 cents to a profit of 40 cents.

And while the Barron's article got attention for predicting that Citi shares will reach $4 within a year and $6.50 by 2012, it also placed a cap on potential growth. The magazine said Citi will be "hard-pressed" to breach the $10 level in coming years and that its tangible book value is comparable to that of AIG, another financial giant that nearly came to ruins. Perhaps there is a reason why.

--Reported by Lauren Tara LaCapra in New York.

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