Description

CIT Group is a diversified and predominantly commercial finance company comprising a large number of lending businesses across the full spectrum of the economy. These include the following:
· Equipment finance: equipment lending and leasing - primarily construction equipment, machine tools, business aircraft, and office equipment - to middle market businesses
· Capital finance: customized secured financing (mainly operating leases) for commercial aircraft (to airlines) and railcars (to rail operators and shipping companies).
· Vendor finance: sales financing for equipment vendors (e.g., Dell Computer) to middle market businesses
· Structured finance: merchant banking & advisory, syndicated lending, and project finance.
· Commercial services: #1 U.S. factoring business.
· Business credit: Asset-backed lending to small and middle market businesses of lower credit quality (e.g., workouts and restructurings).
· Consumer finance: Home equity loans plus sales financing for recreational vehicles and manufactured housing.

The investment case for CIT can be summarized in the following four points:

1. The stock is extraordinarily under-priced. CIT has a tangible book value of $14.80 and I estimate normal earnings power of $3.55. Thus at its 2000 low the stock traded at an incredibly low 3.8x normal, and at its present price just over $20 it still trades at a mere 5.7x normal.
2. The stock price is not sustainable at the current low levels because of the potential for a takeout. The high discount of CIT relative to bank valuations makes the company an obvious target for an acquirer. An example of such a transaction has already occurred in Nov of 2000 with Citigroup's acquisition of Associates for .7334 shares. Given the very large value opportunity in CIT, the investment case thus boils down to assessing the major risks.
3. The company's exposure to technology-boom lending is minimal, far less than what some investors still fear. The company's only exposure to the well-publicized problem area of telecommunications debt is via a part of its structured finance unit. All rumors to the contrary, the vendor technology business is a somewhat mundane equipment leasing business, not a captive finance outlet for questionable buyers of high technology equipment.
4. The risk of higher credit losses in a slowing economy is real, but the company's long history of managing credit risk is a stellar one. CIT has always been successful in maintaining good returns via diversification and increased interest spreads (i.e., pricing). If the North American economy enters a prolonged downturn, CIT will, along with the whole lending sector, miss earnings, but the magnitude of the miss will be far less than the stock price suggests investors fear.


Background

CIT was sold out of the Manufacturers Hanover and Chemical bank corporations over a period from the late 1980's to the mid 1990's. The company continues to operate in a number of bank-like businesses but without a deposit base and with a lower degree of financial leverage than banks employ. To earn an acceptable return on equity under these circumstances, CIT focuses in areas where they can earn above-average profits either via scale advantages (equipment financing, vendor financing, factoring) or via specialized underwriting expertise (capital finance, structured finance, business credit). The company in its present shape was formed via the merger with Newcourt Credit in 1999. This acquisition led to the value opportunity in the stock price, as investors reacted highly negatively to the transaction, particularly after Newcourt reported weak results in the second quarter of that year. In addition to dissatisfaction with the price paid, investors reacted negatively based on a fear - erroneous, as I discuss below - surrounding vendor finance's exposure to technology equipment. Finally, interest rate movements during 1999 and 2000 significantly narrowed net interest margins for all lenders, including CIT. The combination of these factors resulted in a stock price which hovered only a little above tangible book value ($15 per share) for a good part of 2000, a steep and highly unusual discount for a financial company not undergoing significant financial distress.

Risk and Reward

By any measure, CIT's stock price represents an extraordinary value. CIT trades at an extraordinary discount to its peers, the only exception being the financially distressed Finova Corporation. Also relevant is the comparison to the valuations of several money center banks. Although not as directly comparable to CIT, these companies make a related point: CIT's low valuation makes it financially attractive as an acquisition target. For example, before taking account of any synergies at all, Citigroup - which acquired Associates at the end of 2000 - could pay a price of $30 per share - a 50% premium to the current stock price - and still achieve EPS $0.04 (more than 1%) in immediate EPS accretion. In actuality, of course, the potential synergies in such a transaction would be substantial, enabling a higher premium at the same level of accretion.

CIT's very low stock price makes the potential reward to an investor - well over a double within my investment horizon - very attractive. The task of assessing the risks remains. I believe that two of these - one real, one exaggerated - figure prominently in the thinking of the investment community. The exaggerated risk centers on the company's exposure to at-risk debt in the telecom equipment sector. CIT's principal exposure in this area comes from its syndicated lending operations in the structured finance unit, primarily senior loans to competitive local exchange carriers (CLECs). I estimate CIT's total exposure in this area to be around $350 million in managed assets, a tiny fraction of the company's total of $56 billion. Under a draconian assumption of 50% loss rates on these assets, the total hit to the company's equity would be about $0.44 per share, or 3% of the current tangible book value. Incidentally, the company's current experience on these assets is perfectly healthy.

The real risk - in the near term - to the CIT investment case is the potentially negative impact of an economic downturn on earnings per share. But here I would argue that the risk is far less severe than investors appear to be fearing. From 1990 to 2000, CIT's cash return on opening tangible equity had its minimum at a respectable 12.4%, achieved in the 1991 recession. Since then, the number has risen steadily to levels around 19%, mirroring trends in the broader industry. During the same period, returns on average earning assets have remained within a fairly narrow range of 135 to 150 basis points. The reason for this consistency is not mysterious - the company has historically compensated for higher credit losses with higher interest spreads, and these spreads narrow in better times. If 2001 turns out to be a recession year, the likely result will be a tighter credit environment, a reduction in competitive intensity in CIT's segments, and wider interest spreads, partly offsetting higher credit losses. This analysis suggests that the macroeconomic risks for CIT are far lower than those reflected in the stock price, even given the company's greater exposure - via Newcourt - to capital markets fee businesses in the structured finance segment. My own work suggests downside-scenario cash earnings of around $1.60, implying a downside of perhaps $15-16 versus a potential upside to $40+, a risk/reward tradeoff which is clearly favorable and which makes CIT a still-compelling value even after its recent price appreciation.

Catalyst