Financial Stocks—Is it time to jump back in?

September 15, 2009

Citigroup Survived, But Barely

Back in October of 2008, during some of the worst of the credit crisis, I predicted that Citigroup (C) was going to be the next bank to collapse. Well, I almost got it right.

Right before the bank was forced to fold (on November 23, 2008, to be exact) Citi was bailed out as Uncle Sam backed up about $306 billion in loans and securities, and directly invested about $20 billion in Citi. Several months later, at the end of February, the government announced it would convert its $25 billion in TARP bailout funds to common shares—bringing its total ownership stake in the bank to 36%.

This steady government support has kept Citigroup from collapsing. Unfortunately, the same can’t be said for the company’s share price. On June 1, it was announced that Citi would no longer be counted as a component of the Dow Jones Industrial Average. Shares of C closed the day at $3.69—a jaw-dropping loss of about 83% from where shares traded 12 months earlier.

The past year has certainly been ugly for this company. However, there are plenty of bargain hunters out there who think that Citigroup is a steal now that the worst of the credit crisis is over. After all, shares are very cheap right now, and the company posted a surprise quarterly profit in its 2Q earnings report. What’s more, the company has implemented deep cost-cutting measures that include slashing almost 100,000 jobs from peak levels and abandoning its “financial supermarket” business model by selling off parts of the company and streamlining operations.

Many of you—including Luke Y., Wei H., Ken H., Stanley C. and Ray G.— wrote to me to get my take on Citi. So here it is: Don’t be fooled by the recent “improvements” in this company. It is still a dog with fleas!

Let me show you why, using my two key indicators of a stock: current strength and future growth potential.

Strength: While it’s true that Citi managed to beat Wall Street expectations in the second quarter, a closer look at where that money came from indicates the stock isn’t faring very well at all. The company reported net income of $4.3 billion—but these results included a one-time $11 billion gain associated with the sale of a 51% stake in Smith Barney! 2Q numbers also showed that credit costs increased to $12.4 billion, including an addition of $3.9 billion to loan loss reserves, bringing the total allowance for loan losses to 5.6% of total loans. So essentially, even an influx of $11 billion from this one-time sale couldn’t offset the damage of all the bad loans on Citigroup’s books last quarter. Ouch!

Growth: I suppose if Citigroup can grow brokerage houses on trees and sell them off every quarter, it would be in good shape. But absent another massive one-time windfall, things are looking far less rosy for this company. Out of 16 top analysts watching this company, only one estimates Citi will turn a profit—and his estimate is for anemic earnings that total a mere penny a share! The gloomiest estimate, on the other hand, is for a 40 cent loss when the company reports earnings on October 15—not good.

Stocks of the Week
JP Morgan (JPM)	Citigroup (C)
Market Cap: $172.84 billion	Market Cap: $50.55 billion
52-week low: $14.96	52-week low: $0.97
52-week high: $50.63	52-week high: $23.50

JP Morgan Rises From the Ashes

If Citigroup is a case study for “zombie banks” kept out of bankruptcy due to extraordinary governmental intervention, than JP Morgan Chase (JPM) is an example of a company that knows how profit from its competitors’ shortcomings.  In a move that would make the bank’s namesake J.P. Morgan proud, this financial powerhouse snatched up market share for pennies on the dollar as ailing competitors had no choice but to join JPM or fall into ruin.

I think every investor remembers the infamous name of Bear Stearns, one of the first dominos to fall and hasten the stock market’s collapse last year. But many don’t recall that on March 17, 2008, JP Morgan Chase offered to acquire Bear Stearns at a fire-sale price of $2 per share—a paltry $236 million for a company that boasted total assets of $350 billion in 2006 at its peak! Angry shareholders managed to convince JPM to pay a bit more, but the company wound up walking away with Bear for a little more than $1 billion when all was said and done.

In a similar move a few months later, JPMorgan Chase bought most of the banking operations of Washington Mutual from the receivership of the FDIC. This was the largest bank failure in American history, but JPM execs saw it as the opportunity of a lifetime and snatched up the bank's assets and deposits for $1.8 billion. The lowball price was shocking, considering that in June of 2008, WaMu boasted assets of over $300 billion. In fact, WaMu filed a lawsuit against the FDIC because the price seemed unfairly low. But unfortunately, when you’re having a heart attack, it’s pretty hard to quibble over ambulance fees, so Washington Mutual had no choice but to be merged with the much healthier operations of JPM.

Those two shrewd deals are just part of the reason that JPM is emerging as the new leader of the financial sector. But all that was then. How does J.P. Morgan stack up right now? Let’s take a look:

Strength: Unlike Citigroup or other ailing banks, JP Morgan always had sufficient capital under its belt during the credit crisis. It returned to profitability in late 2008 and has grown earnings every quarter of this year—including a stunning 600% earnings surprise in the second quarter on $2.7 billion in profits. What’s more, unlike Citigroup’s one-time sale that improved earnings, JPM’s numbers were actually hurt by a one-time charge of $1.1 billion as it repaid some of the government’s TARP funds! JP Morgan certainly put that bailout money to good use in the past year, climbing over struggling competitors and sucking up weaker rivals with cheap government financing, but the firm is now content to clobber the competition on its own without any help from Uncle Sam.

Growth: The future seems bright for JPM, but not quite as rosy as some think. The company’s latest earnings were bolstered by gains in retail banking, consumer lending and commercial banking divisions—all thanks to the WaMu deal. While it’s true that many banking customers have been finding a new home at JPM branches, gains like that aren’t likely to be duplicated without the purchase of another major competitor. It’s also important to note that JPMorgan’s commercial banking division increased its provision for credit losses to $312 million compared with $47 million the year before. And in retail banking, the bank set aside $361 million for credit losses compared with $62 million a year ago. That means that plenty of bad debt is still on the books and threatening the company’s bottom line. While I’m sure that this won’t sink JPM, it could severely cut into the potential for future gains.

Next up: Avoid Financials—Particularly Citigroup