The market is down and the financial sector is under a lot of pressure. Investors are skittish -- the returns, shittish -- and lenders' shares have been extremely volatile. CIT's are down 65% year-to-date and have swung from a high of $44.50 to a low of $5.80 in the past 52 weeks. They closed Friday at $8.76. They're a steal -- a serious opportunity for a 500% return.
CIT used to make some home loans, including mobile-home financing, which gave investors a reason to sell. That business is toxic, regardless of the extent to which it remains a profitable endeavor. So CIT bailed out of mortgages on July 1, selling the unit for $1.8 billion. Shares rallied on that news. CIT's $62 billion loan portfolio is now mostly business loans.
The subprime mess is hurting banks and other financial companies because of two things. Risk managers, nervous after watching subprime collapse, are loath to approve any loans because they're simply not sure what's going to happen next in this economy.. They're simply too scared to lend, so credit is pretty tight. The second way subprime is hitting financial shares is that lenders have been raiding their earnings for cash with which to shore up reserves for bad loans. For instance, even though CIT's 2007 operating income in 2007 fell by about $400 million, it still earned that cash. It just went to the loss reserve instead of to the bottom line. Earnings fall, investors panic. Rinse and repeat.
CIT has $831 million in cash sitting around to cover bad loans. It may well need every dime of it, and that's fine -- that's why it's there. A bank has to stash money away for bad loans even in a good year, just as an insurer has to save for a hurricane even when the skies are clear. Even Wells Fargo, which is as tight as bark on a tree when it comes to issuing credit, has to sock away a few shekels for bad loans.
Things were great for CIT in 2005. It was trading for $35 and it earned $4.24 a share. But it still had to set aside $217 million in the "Just in Case" fund to cover bad loans.
I pulled aggregate banking data from the FDIC: Banks have a collective $6.5 trillion in outstanding loans, and they keep $102 billion in the vault for charge-offs. That's 1.55% of loans. CIT has enough cash on hand to cover 1.33% of its loan, which is less than average but about the same, in fact, as Wells Fargo.
CIT earned $7 billion in interest income in 2007 and had borrowing costs of $3.8 billion, leaving it with $3.2 billion in net interest income and an even $1 billion in operating income (even with that additional $400 million on the loss provision line).
But get this: The assets that earned CIT all that money? They're still there -- except for the nettlesome home mortgages. (CIT shuttered its subprime unit more than a year ago.) The big losses are behind CIT -- in fact, I think it's possible that earnings will artificially jump in the coming years as CIT benefits from being over-reserved -- and a couple of quarters of solid earnings will do wonders for this stock. Investors are sitting on the sidelines. They're dying for a reason to wade back into the financial sector.
Lenders generally have low earnings multiples, but even a PE of 12 gives CIT a fair value of $57.60 based on 2006 earnings. That was then, this is now, sure, but I still think that's ultimately a low estimate. Why? Because CIT has 13.5% more loans now than it did then. All other things being equal, that should scale out to a stock price of about $65.
Brief tutorial: The "earnings multiple" or "PE ratio" quantifies the relationship between a company's earnings and its stock price. It is computed by dividing the stock price by the per-share earnings. This allows investors to compare companies based on their relative performance. Earnings multiples vary by industry. As a rule, higher growth means higher PEs. Utilities, which grow very slowly, have tiny PEs. Google's earnings multiple is significantly higher, which means investors expect its earnings to rise.
CIT shares are a buy up to $30. I'll sell my shares when they hit $40. That's a nearly 500% gain, and, shucks, I just hate to be a greedy bastard. I'll double down if CIT drops below $7.50.
Hey, incidentally, I saw on the Bloomberg yesterday morning that CIT director James S. McDonald bought another 5,000 shares. Insider buying is always a good sign, as directors and officers know better than anyone else what's really going on. McDonald also sits on the NYSE board and is chairman of its audit committee, so I think it's safe to assume that he can read financial statements. So even if you don't buy my arguments for CIT, then listen to the guy who voted with his wallet.