Citigroup (NYSE:C) shareholders were left standing outside in the cold on Wednesday, while the shareholders of America's largest banks (even Bank of America, for heaven's sake) received a federal blessing to raise dividend payouts. The price of Citigroup stock, as you might have guessed, has fallen in response to the news to settle at a price under $48 per share.
The take-home lesson for investors seems to be this: Citigroup has the current capacity to pay a meaningful dividend. However, the government was not satisfied with Citigroup's internal controls if stocks hypothetically fell by 50% and the bank's capital ratio plummeted, so Citigroup was rejected by the Fed.
As ABC News reported:
The Federal Reserve on Wednesday barred Citigroup from raising its dividend or boosting its stock buybacks, saying it's too hard to predict how some parts of the bank's global operation would fare in a sharp economic downturn.
Citi had asked the Fed's permission to buy back $6.4 billion in shares through the first quarter of next year, and to raise its dividend to 5 cents each quarter, up from a penny per quarter now.
New York-based Citigroup was blocked from raising its dividend in 2012, too, after failing its stress test. Later that year it brought in a new CEO, Mike Corbat, with a mandate to speed up its turnaround.
Corbat said Wednesday that the company is "deeply disappointed" by the Fed decision. The dividend and buyback would have been a "modest level of capital" for shareholders, and Citi still would have exceeded requirements for its financial health, he said in a written statement.
It's very telling that the Federal Reserve found trouble with Citigroup's internal controls, rather than its current profit engine. Citigroup just made $13.9 billion in profits last year, and the analyst expectation is that Citigroup will make $15.2 billion in net profits this year. The company's book value is at $65 per share.
We're starting to enter Walter Schloss territory on this one; Schloss was known for buying companies with profit engines that were much more substantial than the trading price of the stock. A lot of times, the price of the stock was low due to reputational risk. The higher the profits and the worse the reputation, the greater the value investment.
If you look at Citigroup's recent business performance and compare it to the current price of the stock, there is a lot for value investors to like. In 2013, the bank made $650 billion in loans. The return on shareholder equity improved from 4.0% to 6.8%. Total deposits increased from $930 billion to $968 billion. Per share profit increased from $3.86 in 2012 to $4.39 in 2013. Revenues increased 8.8%, from $70.1 billion to $76.3 billion. In other words, Citigroup's banking performance is back on track and delivering pleasant growth, even though the company did not receive clearance to raise the dividend.
This is where adopting a long-term, or at the very least, a medium-term perspective becomes useful. By traditional measures of book value, Citigroup looks quite cheap. The current price of $47.50 in relation to book value of $65 per share indicates that the shares trade at a 36.8% discount, conservatively calculated.
Most interestingly, Citigroup's long-term dividend potential is astounding, even though the recency bias of the Federal Reserve's dividend rejection might make it hard to see. The big banks that received clearance are paying out roughly 40% of profits to shareholders as dividends this year. If Citigroup did that, it would be paying out a dividend of $1.75 per share.
Yesterday, Citigroup dropped over $2 per share, falling a little over 5%. That's because people are thinking short term; they can't get the dividend now, so they're trashing the stock. But you have the opportunity to think like a medium-term business owner with this company. Not only is the stock trading at a substantial discount to book value ($47.50 stock price relative to $65 book value), but the company's capital ratio is fine. It's over 10%, and it passed the Federal Reserve's stress test (under stressful conditions, the Fed calculated that Citigroup's Tier 1 capital ratio would be 6.5%, while the Fed minimum is 5%). Interestingly enough, the Fed's rejection will allow Citigroup to tuck away $15 billion in net profits this year to its balance sheet, enabling the bank's balance sheet to get stronger as it builds up capital.
This is roughly analogous to the Bank of America (NYSE:BAC) shareholders that got to buy the stock at $11 per share a year ago, and they had to wait 15 months to get their $0.05 dividend. People that buy Citigroup today will likely be rewarded with a nice dividend hike a year from now. The company's Tier 1 Capital ratio is already above 10%, the company is plowing an additional $15 billion in profits to its balance sheet over the next twelve months, and earnings per share have increased every year since 2009. For the income and value investor that is able to think in terms of earnings power and dividend capacity, they will be justly rewarded for taking advantage of the current folly in the stock price caused by this week's dividend disappointment.
Disclosure: I am long BAC. 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.