CIT common stock offers a compelling margin of safety
1. Conventionally cheap
Using conventional valuation short cuts, CIT looks cheap. A price of $43-44 is below 0.9x the tangible book per share of $50.03 at Sep 30, 2018. And given recent ROEs of 7-9%, the P/E is +/- 10x, depending on the calculation and the period. A 9% to 11% earnings yield is fine, but I see multiple paths to a higher return. First, nothing structural prevents the company from achieving management's ROE target of 11-12% in the medium-term, and even higher in the long-term. Further upside exists, in my view, should CIT sell to a strategic buyer. I estimate that a buyer could pay 1.6x tangible book and still earn a 10% ROI. Thus there is a relatively short term path to significant capital appreciation of 80% even while expecting a 5%+ earnings return during the holding period.
The median and average for a peer group of 30 banks is 1.65x and 1.7x P/TBV.
2. Long history of profitability
CIT Group was established in 1908 and the company listed stock on the NYSE in 1924. Based on my investigation, CIT reported 99 years of uninterrupted profitability until 2007. In most years, the returns were above the cost of capital. The lows were 1987, and 2002. In 1987, the company started with $1.2 billion in equity and earned $40 million, about a 3% ROE. The lower return in 1987 was caused by losses on a manufactured housing portfolio in Oklahoma and Texas hurt by lower oil prices, and losses on loans in Mexico owing to the lower peso exchange rate. The year 2002 is obscured a bit because CIT was held and then sold by Tyco. Tyco recorded an enormous goodwill impairment, which had more to do with the price Tyco paid for CIT than with the business performance. Excluding the $6.5 billion pretax goodwill impairment, CIT's pre-tax profit was a bit over $100 million. The lower return in 2002 was caused by losses on telecom (notably CLEC exposures) loans and losses related to the devaluation of the Argentine peso. After 2002, the company's returns on equity recovered the 10%+ level until catastrophic failure materialized in 2007-2009.
So in nearly 100 years, CIT experienced no losses and paid uninterrupted cash dividends. Returns exceeded the cost of equity in at least eight out of every 10 years. (The 1957 annual report has a financial summary back to 1908.)
Then the investment bankers arrived!
CIT hired an outsider as CEO in 2004, Jeff Peek, who had been passed over for the role at his prior employer, Merrill. Peek led CIT away from its roots as a commercial lender. The C in CIT stands for commercial. Under Peek, CIT expanded in subprime mortgage lending, student lending, international lending, and leveraged lending. Consumer credit exposure increased by more than 200% in only four years, and rose from near 10% of total to near 25% of total earning assets. This strategy turned out poorly.
CIT hired another outsider as CEO in 2010. This time, CIT's board got a full fledged Merrill CEO when John Thain replaced Jeff Peek. Recovery under Thain seemed slow, and CIT remained under heightened regulatory scrutiny.
3) New management is repairing both sides of the balance sheet
Recovery gained momentum nearly three years ago when a commercial banker named Ellen Alemany replaced Thain. Her strategy is to simplify and fortify CIT, and to return it to its commercial roots. It matters little that Alemany's strategy seems intelligent to me. More importantly, the bank's regulators appear satisfied. In 2016, CIT gained regulatory approval to return up to $3.3 billion of capital to shareholders. In 2018, CIT gained regulatory approval to return more capital in 2018 than the regulators had originally approved -- $800 million more than the original $355 million approved.
If regulators were pleased, it might be with CIT's move to operate more like a traditional bank. The company exited aircraft leasing, which regulators have prevented from being funded by bank deposits. In addition, CIT exited nearly all its non-US operations, its reverse mortgage business, and CIT shrunk its leveraged lending exposure after regulators increased scrutiny of the asset class. Alemany has also shrunk the size of the company's investments. CIT's assets are down nearly 50% from over $90 billion to under $50 billion. This is an unusual course for a CEO to follow, and it indicates that Alemany is prioritizing the welfare of CIT above her own personal interest. In my judgement, CIT's assets have been fully rehabilitated and pose no outsized risk.
CIT has improved its funding too, though liabilities remain CIT's weak point. Bank deposits now exceed $31 billion and fund 70% of earning assets, which is a substantial improvement from under $3 billion in 2007, which funded less than 4% of earning assets. Management has turned the organization's focus from raising deposits to improving the durability and cost of deposits. One tactic is to replace brokered deposits with savings accounts.
4) Long history of profitability plus new management and industry norms suggest ROE of 12%+ is possible
CIT's ROE average during the ~70 years before 2007 was 12%.
The FDIC system average during the past 25 and 50 years was 14% and 13%.
CIT's ROE has been 8-9% recently.
Increasing financial leverage from CIT's CET1 ratio of 12.4% to the peer group's 10-11% would boost CIT's ROEs by 100-200bps.
Reducing interest costs by gathering deposits to replace maturing unsecured debt can also boost ROEs by around 100bps. CIT still funds several billion dollars of rail car leases with unsecured debt that costs around 5%. When these rail cars are replaced, CIT can finance them with deposits that today would cost less than 2%.
The CEO's compensation is tied directly to ROE.
5) Strategic buyers have acquired CIT four times
An investment in CIT makes sense without speculating on prospects for a takeover proposal. The fact that strategic buyers have paid control premiums on four occasions since 1980 indicates that CIT has distinctive capabilities that are cheaper to buy than build.
In 1980, RCA purchased CIT for 1.4x book value. This may not seem like a large premium, but the P/E on the S&P at the time was less than 10x.
In 1984, Manufacturers Hanover Trust purchased CIT for 1.5x book. The P/E on the S&P 500 was less than 12x.
In 1989, Dai-Ichi Kangyo bank purchased CIT for 1.6x book. The P/E on the S&P 500 was less than 13x.
In 2000, Tyco purchased CIT for 2.3x book.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise do not hold a material investment in the issuer's securities.