The tussle between Citigroup Inc. (C) and Morgan Stanley (MS), over the valuation of their brokerage joint venture (JV), Morgan Stanley Smith Barney, has been prolonged due to an extension of the appraisal period for the JV.
Instead of this week, the fair market value determination will now be made on September 10. Therefore, the sale of the stake will also be delayed, which was previously scheduled to be accomplished by September 7. Also, this will postpone the estimation of the impact of this asset sale on Citi’s financial results in the third quarter of 2012.
If the third party valuation lies close to either of the company’s estimated valuation, then it would have an extensive effect on the other company: either Morgan Stanley will have to shell out extra or Citi would incur substantial non-cash charges for its stake.
Notably, Morgan Stanley, which already holds a 51% stake in the JV, is making efforts to acquire an additional 14% stake from Citi. While framing such deals, Citi valued its 49% stake in the JV at about $11 billion. However, quite surprisingly, Morgan Stanley has valued the full brokerage firm at around 40% of Citi’s valuation for the JV. This wide variation in the valuation of the brokerage JV by Citi and Morgan Stanley has called for a third party appraisal process.
As a matter of fact, in a filing made by Citi in July with the Securities and Exchange Commission, the company announced that owing to the low valuation made by Morgan Stanley for the JV, Citi might end up incurring a substantial non-cash GAAP charge to its net income in the third quarter of 2012. This would represent other-than-temporary impairment of the carrying value of its 49% stake in the JV. Such impairment charges would adversely affect Citi’s reported tangible book value, equity and its Basel 1 regulatory capital ratios.
The Back Story
In 2009 Citi sold off its 51% stake in Smith Barney brokerage unit to Morgan Stanley after suffering substantial losses during the financial crisis. Citi termed several businesses as non-core and is continuously winding down these units so as to streamline its business and generate adequate capital to run and expand its core franchisee as well as satisfy regulatory norms. Notably, Morgan Stanley, which currently holds a 51% stake in the JV, has the right to acquire the full brokerage unit.
Our Viewpoint
We believe that the stake sale is a strategic fit for Citi. While this wider gap in the valuation of the JV by Citi and Morgan Stanley has led to the involvement of the third party appraisal process and could result in Citi shelling out non-cash charges in the third quarter, the sale would ultimately help Citi in roping payments which would boost its Tier 1 Common regulatory capital ratio for Basel III purposes.
However, as Citi’s stake in the brokerage joint venture is not included for Basel III regulatory capital purposes, its impairment related to that asset would not impact its estimated Basel III capital position. As a matter of fact, the capital rules proposed under the Basel III norms are aimed at helping the financial industry at large and the banks in particular, to overcome any stressful situation by holding adequate buffer capital.
Also, sale of non-core assets at Citi is on track and at the end of the second quarter of 2012, Citi Holdings, the non-core asset portfolio, represented approximately 10% of total Citigroup assets. These runoffs ultimately reduce the company’s risk profile and free up capital that the company continues to invest in its core businesses. Such measures serve as a long-term catalyst for the stock.
Currently, Citi shares retain a Zacks #3 Rank, which translates into a short-term Hold recommendation. Considering the fundamentals, we have a long-term Neutral recommendation on the stock.
CITIGROUP INC (C): Free Stock Analysis Report
MORGAN STANLEY (MS): Free Stock Analysis Report
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