As this historic bull market continues to age, it is rather remarkable that an investor can still buy some of the most attractive financial franchises in the world at a discount to tangible book value, despite improving profitability and the strongest balance sheets in a generation. Citigroup (C) under the leadership of Michael Corbat and Michael O'Neill, is an extremely well-capitalized bank that should see above-average earnings growth from its core franchises, as the legacy Citi Holdings business continues to wind down. Despite positive developments in the leadership changes that have occurred, an improving housing market and a reduced cost structure, the bank is still punished by market participants for the perceptions that the sins of the past will be repeated. At T&T Capital Management (TTCM), we have continued to use pullbacks in the stock to add to our long-term holdings, which were bought at much cheaper prices because we continue to be impressed by the changes that management has made and we are confident that the intrinsic value will continue to increase at a double-digit rate of return, excluding dividends paid. Short-term concerns over businesses such as FICC and mortgage originations may dissuade analysts concerned with quarterly projections, but long-term investors should take advantage of the opportunity to buy this growing global franchise at a discount to tangible book value.
There is little doubt that Citigroup has one of the elite geographic footprints of the large global banking franchises. This is beneficial in that it can potentially lead to faster revenue growth but it also exposes the company to a broader range of economic crises. For example, a poor regulatory environment in Korea has had a significantly negative impact on Citigroup's Asian business, and a decelerating Latin American economy has also been a marginal headwind. Prior to Michael Corbat becoming CEO, a huge concern of investors in the company was that costs were way too high, making for poor efficiency across the franchise. Since the change in leadership, Citigroup has presented tangible proof of improving operating leverage, which should allow the company to reap the benefits of that global reach through improving profitability and returns on equity.
While Citigroup struggled through the Financial Crisis with one of the worst banking balance sheets ever created, the emerging company has a much better capital structure and business mix. One fortunate aspect of the company being so weak 5 years ago was that it didn't get caught up as many of the punitive legal cases being brought against the large banks; as a result of improprieties made by the acquired banks. That occurred before the likes of Countrywide, Washington Mutual and Bear Stearns were acquired by Bank of America (BAC) and JPMorgan (JPM). This was beneficial in the sense that Citigroup has a lot less exposure to the repurchases, warranties and litigation that have proven to be an ongoing plague to its major competitors. In addition, thanks to the dramatic improvement in the housing market as exemplified by the Case-Schiller pricing index, Citigroup seems to have more upside from its still large credit loss reserves, than other banks do. I believe the stage is set for many years of improving fundamentals and profitability, which should lead to excellent performance for Citigroup's stock from its currently low valuation.
On October 15th, Citigroup reported 3rd quarter earnings that were expectedly a bit soft. It is more constructive to look at the results on an adjusted basis excluding the non-economic CVA/DVA charges, the tax benefit and also to strip away last year's impact from the Morgan Stanley Smith Barney venture, which was sold earlier in the year. Revenues of $18.216 billion were down YoY from $19.163 billion, while earnings before taxes of $4.602 billion were up YoY from $4.451 billion. Net income of $3.259 billion was down from $3.268 billion in the year-ago period, while diluted EPS of $1.02 was down from $1.06. Operating expenses of $11.7 billion were 4% lower than the prior-year period. Net credit losses of $2.4 billion declined 38% versus the prior-year period and the company utilized $500MM of deferred tax assets, which is very beneficial as far as the capital metrics go. Thus far in 2013, the company has utilized $1.8 billion of deferred tax assets. Citigroup's allowance for loan losses was $20.6 billion at the end of the 3rd quarter, or 3.2% of total loans, compared to $25.9 billion, or 4% of total loans at the same time last year.
Citicorp end of period loans grew 5% versus the prior-year period to $561 billion, led by corporate loan growth of 8%. Citi Holdings assets of $122 billion have declined $49 billion, or 29% from the 3rd quarter of 2012 and now represent only 6% of the company's balance sheet, which should have a material impact on earnings moving forward, as these legacy assets have been a primary source of losses distorting the attractive underlying profitability of Citicorp. Citigroup ended the quarter with an estimated Basel III Tier 1 Common Ratio of 10.4% and the supplementary leverage ratio (SLR) increased to an estimated 5.1%. The company's Basel I Tier 1 Capital Ratio was 13.6% and its Tier 1 Common Ratio was 12.6%, so the company continues to have one of the strongest balance sheets in its history. Book value per share increased to $64.49 and tangible book value per share increased to $54.52 at the end of the 3rd quarter.
Based on 3.033 billion shares outstanding and a recent price of $48.90, Citigroup has a market capitalization of roughly $148.3 billion. The stock trades at a 10% and a 24% discount to tangible book value and book value, respectively, offering plenty of room for upside considering that these metrics should continue to grow over the next several years. Through the first 3 quarters of 2013, the company has posted net income of $11 billion, while the core Citicorp franchise has generated $12.6 billion on its own. Every quarter, Citi Holdings becomes less of an issue, which will remove the headwinds that have been impacting the overall company's profitability. Normalized earnings are easily $16-$20 billion and I believe that the bank has one of the better growth profiles due to its geographic exposure to emerging markets. At less than 10 times normalized earnings, Citigroup is way too cheap and offers the potential for 12-15% per annum appreciation over the next 3-5 years, as the discount to its growing book value converges, and there could be upside beyond if market participants assign a higher multiple to the company.