Citigroup Gives The Fed The Finger

Apr. 3.14 | About: Citigroup Inc. (C)

Summary

Citigroup's recently announced preferred redemptions will save over $120 million annually.

The signal to the market is that Citi has already moved on from the capital return plan rejection and is investing in the business.

Citi should retire $12+ billion in securities this year, matching last year's total, reducing funding costs by $700+ million annually.

Citigroup's (NYSE:C) embarrassing and shocking rejection from the Fed regarding its capital plan was a black eye that Citi didn't need. Everyone, including CEO Michael Corbat, whom I have a tremendous amount of respect for, was completely unaware the rejection was coming. Citi's capital levels under the scenarios provided in the CCAR process were better than many banks but Citi's capital plan was rejected outright due to qualitative factors. At this point, all Citi can do is move forward with the circumstances we have today and after the initial 6% fall in the stock price, shares have already recovered about $1. In this article, we'll take a look at Citi's first move since the rejection and what it could mean for shareholders in 2014.

The day after the rejection came down Citi was busy making the best of a bad situation. Citi announced the redemption of $2 billion worth of trust preferred securities, the Citigroup Capital IX, VI and XVII. These issues carry coupons of 6%, 6% and 6.35%, respectively, making them relatively high costs for funding in today's environment. In fact, with Citi not needing the funding in the first place at this point due to decreased leverage, they are very expensive. At any rate, Citi's redemption will save the bank approximately $120 million annually in cost of funding, a princely sum for simply redeeming some trust preferred securities.

This $120 million will add about 4 cents per share of pre-tax earnings annually to Citi shares and while that is great, I think the larger point here is that Citi isn't taking the rejection lying down. We all know Citi is unable to return capital to shareholders until at least the second quarter of 2015 at this point but it has decided to take matters into its own hands right now and improve its business further. Redeeming high cost sources of funding such as trust preferreds means that not only will Citi be saving money every year due to a lower cost of funding, but it will also have an improved leverage situation from which it can return capital to shareholders at some point or re-leverage at a lower cost through a debt issue, for instance, should the need arise.

In other words, Citi will likely be better off in the long term because of the rejection from the Fed. If Citi were allowed to return capital as it had wished, it would have seen its excess capital simply leave via dividends and/or buybacks. This money would have disappeared essentially as capital that is distributed or used to buy back shares cannot be used for something else. But in this way, Citi's excess capital is being used to essentially earn 6%+ every year forever. Citi is saving itself more than $120 million per year simply by redeeming these trust preferred issues and I suspect this is not the last we'll see of this kind of move.

Citi is continuing to improve its fundamentals for the long term and since it was not allowed to return capital to shareholders, it is instead investing back into the business, a move that will likely allow it to return even more capital to shareholders in 2015 and beyond. I like Citi's approach here as some banks would perhaps begin to hoard excess capital in response to an embarrassing episode such as a Fed rejection. However, Citi is taking the reins and choosing its own destiny, returning capital to shareholders via lower funding costs and commensurately higher earnings as a result. This won't give shareholders a cash dividend in 2014 but it will help improve earnings and thus, the share price, over the long term.

Consider that if Citi were to redeem another $12 billion in securities in 2014, as it did in 2013, at an average funding cost of 6%, it would be saving shareholders $720 million per year in dividend/interest payments. We've already seen $2 billion and I think we may even see more this year as Citi knows capital returns are definitively off the table for now. That would amount to at least 24 cents per share in additional pre-tax earnings or given Citi's 30% tax rate in 2013, roughly 17 cents in EPS. At its current forward earnings multiple of 8.5, Citi shares would be worth about $1.40 more than they are today, all else equal, simply by lowering the cost of funding. This example is somewhat conservative as well as Citi has many sources of funding that cost more than 6% annually, so there is plenty to choose from.

Nobody likes that Citi's capital return plan was rejected but I believe management is making the best of it. I see Citi's move, only hours after the Fed rejected its plan, as a signal to its regulator that if it isn't allowed to return capital, it will invest in shareholders in ways it does not need permission for. I love the move not only financially, as it reduces Citi's cost of funding, but symbolically as it shows management has moved on from the rejection and is wasting no time getting to work. This is not the last we'll hear from Citi in terms of investing back into the business with the capital it wasn't allowed to return to shareholders and next year at this time, Citi will be even better positioned to pay a larger dividend and buy back shares. Make no mistake; Citi is returning capital to shareholders, just not via dividends and buybacks.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in C over the next 72 hours. 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.