According to a recent report by the Wall Street Journal, Citigroup (NYSE:C) may be staring at a multi-billion dollar write-off linked to its stake in Morgan Stanley’s (NYSE:MS) Smith Barney asset management business.  Citigroup reduced its stake in wholly-owned subsidiary Smith Barney to 49% in January 2009. The deal with Morgan Stanley resulted in an after-tax profit of $6.7 billion for Citigroup then. But come May 2012, Morgan Stanley can exercise its option to buy an additional 14% stake in Smith Barney. And that transaction will come at a heavy price to Citigroup – estimated at a loss of about $2 billion. But we believe this raises a far bigger concern for Citi’s investors – one much more far-reaching than a one-time write-off.
We maintain a $35 price estimate for Citigroup’s stock, which is close to current market price.
At the time of the Smith Barney deal, Morgan Stanley was provided with options to buy-out Citigroup’s stake in the entity in 3 yearly stages beginning May 2012. And given Morgan Stanley’s need to stabilize its largely trading-driven revenues, it most likely will go ahead with the purchases – much to Citigroup’s concern.
Analyst estimates show that Citigroup may end up writing-off an after-tax $1.8 billion amount at the end of the first stage if Morgan Stanley exercises its right. The reason for the write-off is the gaping difference between the value of Smith Barney assets on the books of Morgan Stanley and Citigroup. While the former values Smith Barney at around $15 billion, Citigroup records a figure close to $20 billion. And once Citigroup sells another 14% of its stake later this year, it will have to revalue the remaining 35% stake – essentially using Morgan Stanley’s estimates.
This difference will most likely show up as a one-time loss in Citigroup’s Q2 2012 numbers, under its corporate & other losses head.
But if the report is indeed accurate and Citigroup has been recording an figure inflated by nearly a third for Smith Barney’s business in its account books, then this calls to question the valuation techniques used by the banking group. This also lends support to investor fears about the quality of the bank’s asset base.
If the bank is overstating its assets through accounting maneuvers, then these assets could actually be worth much lower in the open market. This would in turn result in a series of sizable write-offs in subsequent quarters as the bank continues to divest huge chunks of its assets held under Citi Holdings. And the bank would have passed them off as losses linked to the sale, rather than to the actual value of the assets.
We expect investors to start taking a second look at Citi’s balance sheet.Notes: