On Friday, Citigroup (NYSE:C) was forced to adjust its 2013 financial results after disclosing its Mexican unit lent money to a fraudulent firm (press release with revised summary financials available here). Shares did not react much to the news, falling 0.12% in the session. While being defrauded is never a good thing, this news item is no reason to sell Citigroup, as the firm is adequately capitalized to handle frauds ten times the size (if not higher) without facing any issues. Unless this is a sign of systemic risk-taking problems (which there is no evidence of), investors should quickly move on as Citigroup continues to be one of the most attractive bank stocks in the market.
Citi was forced to take an after-tax charge of $235 million ($360 million pre-tax) to reflect this loss. To put this in perspective, the bank earned $13.7 billion in 2013. A Mexican unit "Banamex" lent Oceanografia, an oil services firm, $585 million in short-term credit. This credit was backed by accounts receivable due from Mexico's oil company Pemex. As Pemex is essentially backed by the Mexican government, these receivables should have no credit risk, which is why Banamex had no problem extending this credit.
However, there were not $585 million in account receivables due from Pemex. After comparing the books of Oceanografia and Pemex, it has become clear that Pemex only owes $185 million. Banamex will also claw back $40 million in compensation due to this loss, which is why the pre-tax loss ends up being $360 million. Investors should note the pre-tax loss amounts to $0.08 per share, so in and of itself, this loss is closer to being a rounding error than a catastrophe.
The real concern for Citi shareholders should be whether or not there is lax oversight and compliance standards. Is this a one-time incident or the beginning of a barrage of bad news? Fortunately, CEO Michael Corbat has made clear there is no systemic problem. From the press release: "Specifically, we have been taking the following actions: first, we immediately began a 'rapid review' - throughout Banamex and the rest of Citi - of programs similar to the one at issue here. At this point, we believe this is an isolated incident." Citi has not found any other incident, which suggests that there is no systemic problem, though I expect even tighter risk controls will be added going forward.
Incidents like this also should serve as a reminder that stocks reflect the value of future cash flows not previous ones. Long-term investors should ask: does this fraud hurt future cash flows? The answer is "no." It is a one-time event, and if anything, it could improve risk protocols, making future losses less likely. The $0.08 impact on book value is also negligible when determining valuation. As such, this news should not impact your sentiment on Citigroup. Irrespective of this loss, Citi is an extremely compelling long-term investment.
It has unparalleled geography with leading consumer franchises in the U.S., Asia-Pacific, and Latin America and strong investment banking arms throughout the world. While emerging markets face some near-term headwinds, they will likely outpace the growth in the developed world over the next decade. Citi also is very well capitalized with a Tier 1 common ratio of 12.64%, which will allow it to return more cash to shareholders. With a book value of $65.23, shares are only trading 75% of book value.
In 2014, Citigroup should be able to return $6.25-$6.75 billion to shareholders though an increased dividend and buyback of about $5 billion. I also expect Citi to earn at least $5.10 as net interest margins slowly improve and commercial loan growth continues at a mild pace. Citigroup should generate an ROE of 7.8-8.2% this year, so it should trade within 90% of book value or $58-$60. Citi is exceptionally well capitalized to ride out any near-term volatility. Citi is one of the few truly global banks, and this item does not change that fact. This Mexican fraud is a minor stumble that investors should not dwell on. Instead, they should take advantage of any and all weakness to buy Citi.