Friday, March 28, 2008

Citigroup "upgrades" Lehman

Citigroup Investment Research AM Call:
“Upgrading To Buy; Reality Will Trump Fear”
March 28, 2008
SUMMARY Buy Lehman.

After being on the sidelines for a couple of years, we see the current valuation as an extremely attractive entry point into Lehman shares. Furthermore, the recent profitable quarter in a tough environment, the coordinated actions taken by the Fed & Treasury to provide meaningful liquidity, and Lehman’s management team’s excellent track record of creating value and managing risk all serve as excellent downside protection.

In our view, it’s tough to have a liquidity-driven meltdown when you’re being backed by government entities that have the ability to print money. Lehman has ample liquidity to run its business. With $34b in liquidity at the parent company, the ability to get access to over $200b in liquidity from the Fed’s primary dealer credit facility, and its ability to tap the term auction facility, access to liquidity is a non-issue. Actions speak louder than words and in a post Bear Stearns era, the coordinated Fed & Treasury actions are designed to prevent a crisis of confidence leading to liquidity issues for any of the major investment banks. The liquidity backstop buys the time necessary to restore confidence and quell fears that are not based on fundamentals. It’s worth noting that Lehman has not used the facility other than the initial $2b test run.

Core earnings highlight diversity and excellent risk management. We estimate that writedowns aside, Lehman had its 2nd best fixed income trading quarter ever and generated a 20%+ ROE during 1Q08. We estimate that even in a stress-case scenario on the commercial real estate, residential mortgage, and leveraged loan portfolios, Lehman will generate positive earnings and grow book value per share this year. See our 3/20/08 note for analysis of 1Q08 earnings.

We see 70% upside in Lehman shares. LEH’s valuation is compelling based on virtually any historical metric, leading to an excellent risk/reward opportunity. Using our DCF based valuation model, LEH shares are discounting less than a 10% over-the-cycle ROE and our 15% ROE forecast results in a $65 stock or almost 70% upside. Furthermore, on an absolute P/B, tangible P/B and relative P/B basis, Lehman is trading at some of its lowest levels in more than a decade.

On the 19th, Citigroup was sanguine about Lehman when the stock was at 42, and was "on the sidelines." Today Citigroup is pounding the table with the stock under 39.

Yesterday, Meredith Whitney, from CIBC, on CNBC said, "even the financials that I like, I don't like..." She apparently didn't get the missive from the Fed -"talk up Lehman, and talk down any problems there." So Citigroup slaps a buy recommendation on the stock. Here's the story on the Fed's behind the scene dealings:

One American banker said: "[We heard] from the top, 'Do not encourage calls to Lehman clients. We want to run that up the flagpole. We don't want another run on a bank.' "

As a result, it is believed that bankers were told not to solicit Lehman's clients for business or to give the impression the bank is uncreditworthy.

Lehman's business model is closest to that of Bear Stearns, and there has been considerable speculation surrounding the state of its balance sheet. A spokesman from Lehman Bros declined to comment. The other banks involved in the calls also declined to comment.

A spokesman for the New York Fed said: "We never talk about private discussions between the Federal Reserve and commercial banks."

According to a source close to one of the banks, the Wall Street club remains very supportive of Lehman and is wary of doing something that might harm the bank's financial position.

With Lehman's Level III mortgages, (see post below), and Lehman's $7.5 billion in Variable Interest Entities (VIE's) of which decidedly negative CreditSights said Citigroup's could be worth just .27 cents on the dollar, you are recommending a stock, of which you don't know the quality of the assets on their balance sheet.

Lehman which wrote down the net value of subprime securities by $1.5 billion, guaranteed $6.1 billion of investors' money in VIEs and $1.4 billion of clients' secured financing as of Nov. 30, according to a filing also made on Jan. 29.

``We believe our actual risk to be limited because our obligations are collateralized by the VIE's assets and contain significant constraints,'' Lehman said in the filing...

The securities in the VIEs may be worth as little as 27 cents on the dollar once they're put back on balance sheets, according to David Hendler an analyst at New York-based CreditSights.

But if you had a balance sheet, like Citigroup, stuffed with the same securities Lehman has, and you had the urging of the Fed to return "confidence" in the markets, what would you do?

You would upgrade the stock.