- Citi has underperformed on emerging market fears, but it is well diversified and hedged.
- U.S. improvements and cost efficiencies will offset overseas weakness.
- Well Capitalized: Tier 1 Common Equity of 10.5%.
- Poised to return $6.25-$6.75 billion this year.
- Should trade to $60 or 90% of book value on $5.10+ in earnings.
Over the past month, volatility in the stock market has increased noticeably as investors worried about problems in emerging markets. Turkey and Latin America faced rapidly depreciating currencies while China stared down the potential default of a wealth management security, which it fortunately bailed out. At the same time, U.S. economic data has been disappointing with measures like the ISM suggesting the weakness does go beyond the weather. Given this backdrop, it is unsurprising that equity markets have taken a bit of a breather after a gargantuan 2014. These pullbacks provide perfect opportunities for investors to generate alpha by buying stocks that have been unfairly beaten up. In particular, Citigroup (NYSE:C) has been crushed during this sell-off, and now is the perfect time to initiate or add to a position.
Of all the U.S. banks, Citigroup is really the only one with a global reach on the commercial side. While JP Morgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), and Wells Fargo (NYSE:WFC) have investment banking operations around the world, their commercial lending activities (deposits and consumer/small business lending) are focused almost entirely in the United States. U.S. banks are very U.S. centric unlike European banks, which tend to operate globally, for instance HSBC (NYSE:HSBC) and Banco Santander (NYSE:SAN). Citigroup is the lone exception with commercial operations in South America, Asia, and the Middle East. In fact, this is the major reason Citi shares have underperformed over the past month.
Fears in the stock market have been driven by concerns about the emerging markets. Citi is the lone U.S. financial with noticeable consumer exposure to these economies, and as a consequence, it has been the first financial sold. In a sense, this is a rational course of action, but if we delve deeper, it becomes clear Citi should be bought on this weakness as its emerging market exposure is over-stated, its U.S. operations are robust, and the stock is exceedingly cheap.
First while emerging markets have had a rough patch no doubt, there is an undeniable trend of poorer nations growing faster than developed economies. Investors need to ask themselves whether the volatility of the past month is a bump in the road or a sign the emerging market boom is over. Frankly, I believe that emerging markets will continue to grow over the long-term. This is a perfect example of when long term investors can profit from short-term anxiety. Nations like China, South Korea, Mexico, and Brazil have growing middle classes, improving education systems, strong natural resources, and burgeoning technology. These trends will power growth as their standard of living slowly catches up with developed economies. Looking out ten to twenty years, investors want to be exposed to the middle class of emerging economies, and that is exactly how Citi is positioned.
At the same time, it is not as if Citi is solely an emerging markets company, which is why this sell-off is over-done. In 2013, North America accounted for 44% of its revenue, Europe, Middle East, and Africa accounted for 16%, Latin America 19%, and Asia 21% (data available here). The United States remains Citi's biggest market by miles, and this unit can provide stability if emerging markets falter. Further, Citi's global exposure is diversified around the globe so it is not overly exposed to any specific foreign market.
For instance, significant concern has been focused on Argentina, which has a major currency problem. The Argentinean economy has major imbalances, and while Citi has an operation Argentina, it isn't that problematic. Citi's equity exposure to Argentina is $750 million, so if it wrote off the entire unit, book value would fall $0.25 pre-tax. That is not exactly a monumental catastrophe for a company with a book value of $65.31. Moreover, Citi maintains a book of currency hedges, which help to offset some of the weakness. Last quarter alone, Citi's hedges earned $0.83 as emerging currencies began to weaken. While Citi has exposure to emerging economies and their currencies, its portfolio is well balanced around the globe with appropriate hedging.
In actuality, Latin America was a bright spot in the most recent quarter with revenue growing 8% on a constant currency basis. Further, Citi continues to make progress in India, China, and Hong Kong, all of which continue to have strong long-term growth prospects. Over the past month, the MSCI emerging market index (NYSEARCA:EEM) has fallen by 5% or half of the decline in Citigroup. This comes even though North America accounts for nearly half of Citi's revenue. If you factor out developed economies in Europe and the rest of the world, Citi's emerging market exposure is less than 45% of revenue yet its stock has fallen twice as hard as emerging markets have. This is a sign of irrational pessimism and an overdone sell-off.
Further, its American operations continue to show signs of improvement. While the most recent quarter wasn't perfect, Citi Holdings (the bad bank that Citi is winding down) is shrinking and is less costly than feared. Citi Holdings assets are down 25% and now account for 6% of total assets. Rising interest rates hurt refinancing, which was at an unsustainable pace, but a steeper yield curve will start to help net interest margins in the back half of the year. Moreover, core loans were up 7% as Citi gains some share in mortgage origination and small business lending. Fixed income trading was down though Citi has made progress in M&A and equities. The company is also revamping its UK investment bank operation to regain share throughout Europe.
While taking these actions, Citigroup has actively cut costs, which were down 13% last quarter. Citi has trimmed the fat from its operations, cut headcount, and reduced redundancies, which will help profit margins going forward. While emerging markets may be sequentially weaker in 2014, improvements in its U.S. operations will help to offset this weakness. While Citi is a global bank, the U.S. remains its major market. With steady improvement in U.S. lending and reduced costs, Citi should have a strong year in 2014.
Moreover, the company remains extremely well capitalized with a Basel III Tier I Common Equity Ratio of 10.5%. Importantly, regulators are focused increasingly on leverage ratios as a way to determine whether a bank is safe. U.S. regulators seem to view 5% as a strong level, and Citi easily surpasses that level at 5.4%. Citi is actually one of the less-levered banks in the U.S., and with capital-intensive Citi Holdings running off at a fast pace, its capital stature will continue to improve. As a consequence, the company is likely to get Fed approval in March for an increase to the token $0.01 dividend and small buyback. Last year, Citi was rejected for being too aggressive, so I expect a conservative plan this year. In all likelihood, investors should expect a quarterly dividend of $0.10-$0.15 and buyback of about $5 billion.
In total, this would represent a capital return of about $6.25-$6.75 billion, though the breakdown between the buyback and dividend could be different. Investors should hope the plan skews heavily towards the buyback as it would be extremely accretive. Even if emerging markets take a step back, decreased costs and improvements in U.S. and Europe should drive earnings growth to at least $5.10, which gives shares a 9.6x multiple. Further, shares are trading at a 25% discount to book value and 11% discount to tangible book value. By buying back stock at a discount to book value, book value per share increases further. Citi is in a position where buying back stock makes a lot of sense.
Citigroup should generate an ROE of 7.8-8.2% this year, so it should trade within 90% of book value or $58-$60. At its current price, Citi is pricing in a global crisis that would impair the operations of all of Citi's overseas units. Citi is exceptionally well capitalized to ride out the near term volatility, and its biggest market remains the United States where it continues to show modest improvement. Citi is not an emerging market bank; it is a global bank. Fears over the emerging markets have sent shares down far too steeply, and now is an extremely attractive entry point.
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.