Citigroup Is Still Obviously Undervalued

| About: Citigroup Inc. (C)

Shortly after reporting 3rd quarter earnings, the Board of Directors at Citigroup (NYSE:C) made the move to oust CEO Vikram Pandit, and decided to replace him with Mike Corbat. Citigroup has the most attractive geographic footprint of any global bank, and with the right leadership the company has an opportunity to eventually earn some of the highest returns in the industry. While the stock performed well in 2012, Citigroup still trades at a very large discount to tangible book value, offering a fabulous long-term investment opportunity. By focusing on the company's core strengths and reducing costs at an accelerated rate, I believe that Mike Corbat could be just what the doctor ordered for Citigroup's long-suffering shareholders.

Citigroup has a very large global presence and is focused on the fastest growing markets and cities. Historically this geographic footprint has been both a blessing and a curse, because while it has opened up significant growth opportunities for the company, it has also caused the company to be hit by just about every financial crisis that has occurred in the last 15 years across the globe. In addition, the company has done a poor job in leveraging its asset portfolio to optimize the overall operating efficiency of the firm. Corbat recently announced a $900 MM annual expense reduction for 2013, which was driven by a bottoms-up review of the firm. I believe that the company will get even more aggressive in cutting costs as the year progresses, which ultimately will improve bother operating efficiency metrics, and returns on equity.

On January 17th, Citigroup reported 4th quarter earnings that missed analysts' expectations. I believe the underlying earnings were actually stronger than the numbers would indicate, and that the perceived miss was primarily due to repositioning charges, and overly aggressive loan loss reserving, ultimately setting the stage for better numbers moving forward. Earnings were $1.2 billion in the quarter and if you exclude DVA and the repositioning charge net income would have been $2.2 billion, or $.69 per share. Legal and related costs of nearly $1.3 billion were up nearly $800MM from the 3rd quarter. Despite improving credit trends, Citigroup actually recorded a net reserve build in the 4th quarter in Citi Holdings, compared to a reserve release of $663MM last year. I believe Corbat and company are being extremely cautious to ensure that the problems of the past don't become nagging issues in future quarters. 4th quarter revenues of $18.7 billion were up 8% from last year and operating expenses were roughly flat, which actually wasn't too bad because higher legal and related costs were offset by about a 3% decline in core operating expenses. There is no doubt that Citigroup needs to focus on improving its operating leverage on a quarterly basis moving forward, and I believe that Pandit's relatively slow progress in doing so likely played a large part in the decision to move forward with Corbat. While most banks had lower credit costs than last year, Citigroup actually showed an 11% increase in the 4th quarter, which tells me that this really was a "kitchen sink" quarter for the company due to the fact that Citigroup has very similar assets to the other large banks, and should have shown similar trends in credit costs.

In the 4th quarter, Citigroup decreased Citi Holdings assets by 9% and for the whole year Citi Holdings assets were down 31%. This is critical as Citi Holdings has accounted for significant losses each quarter, and ties up a tremendous amount of capital that can eventually be redeployed at higher rates of return. Most of the assets in Citi Holdings are comprised of North American mortgages, which with the improvements that have been occurring in the U.S. housing market could potentially result in reserve releases that would boost future earnings. Citicorp had 4th quarter net income of $3.2 billion on $17.6 billion of revenue, and Citigroup's earnings should continue to grow as Citicorp continues to represent a larger portion of overall assets. The company estimates its year end tier 1 common ratio on a Basel III basis to have increased to a very healthy 8.7%. End of period loans grew 1% YoY to $655 billion, as loan growth in Citicorp has been outpacing the rapid wind-down of Citi Holdings. Deposits grew 7% to $931 billion. The large U.S. banks have all been able to greatly increase their deposit bases, which will provide a huge earnings tailwind once interest rates begin increasing.

For the fully year revenues were $77 billion, up slightly from 2011, and only 5% of revenues came from Citi Holdings. Operating expenses were down 2% and credit costs declined as well. Citigroup increased its net income by 18% to $12 billion. For 2012, Citicorp's earnings before taxes and loan loss reserves were $20.2 billion, and have been growing at a rapid rate. Securities & Banking and Global Consumer Banking represent 39% and 50% of PPTO earnings, respectively, while Transaction Services accounts for 25%. Corporate and other lost $2.8 billion in 2012, which I believe to be abnormally high. The North American Consumer Bank has experienced a very strong improvement in operations, with full year net income of $4.876 billion. This unit is important because U.S. profits must be generated to realize the significant tax credits incurred during the Great Recession. International Consumer Banking generated net full year net income of $3.458 billion. Securities and Banking had a stellar year generating net income of $6.08 billion and expenses were down despite the 47% increase in revenue, excluding CVA/DVA. Transaction Services generated net income of $3.539 billion and will be helped when interest rates increase, causing spreads to widen. Citi Holdings lost $3.715 billion in 2012 but I do believe that losses in the unit will be down materially moving forward with the improvements in the housing market, and the decline in assets.

Citigroup's vast international operations have allowed the company to maintain respectable net interest margins, which during the 4th quarter were a relatively solid 2.93%. The company grew its tangible book value per share to $51.19 from $49.74 in the 4th quarter of 2011. A simple 15% return on tangible book value would generate normalized earnings per share of $7.68. At a recent price of $41.66, Citigroup has a normalized earnings yield of 18.4%. Assuming a 50% future dividend payout ratio, the dividend yield would be 9.2%. I certainly don't believe that the Federal Reserve would allow such a high payout ratio in 2013, but in a few years Citigroup will be over-capitalized and I am confident it will only be a matter of time until the dividend is increased considerably. I'd like to see Corbat aggressively look to buy back stock in the CCAR process to take advantage of the Federal Reserve's shift to a common sense of approach of actually allowing for adjustments to the capital return plans pending the Fed's test results. Unfortunately, it does appear that the embarrassment of last year's plan rejection has persuaded Corbat to take a more conservative approach than I would like to see this year with the stock trading where it is. For investors that want to take a more conservative approach at the expense of long-term upside, selling the $45 January 2014 puts for $7.20 might not be a bad call. The breakeven on the stock would be $37.80 and the target profit percentage on maximum risk would be 19%. I believe within 3 years Citigroup will be a $70-$80 stock with a great dividend and a conservative capital structure.

Disclosure: I am long C. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.