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, MaxKapital (543 clicks)
Long-term horizon, value, growth at reasonable price, capital & stock allocation
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Summary

  • Citigroup was severely wounded by the financial crisis, and was rescued by the U.S. government.
  • Much of the repair to the balance sheet is done, but the task remains incomplete. Risks remain elevated.
  • But there is light at the end of the tunnel. After that, it's a matter of realizing their true earnings potential.
  • The stock is attractively priced at a 17% discount to tangible book value.

Earnings season is upon us. And with reports from Citigroup (NYSE:C) due today, this is an interesting time, because we always see a price response to earnings expectations in the lead-up to earnings, with potential for further volatility when expectations adjust based on new information available. When there is a price response, there is an opportunity to benefit from a price/value arbitrage.

In this post, I express my perception of Citigroup's value, and hopefully leave enough information to allow readers to form their own view on the value, if they are so inclined.

Citigroup was severely wounded by the financial crisis, and those were mortal wounds from which Citigroup would have never survived, but for the U.S. government rescue package. Their turnaround has progressed, but remains incomplete, though at present, I see no risk to their ability to survive. In fact, I see Citigroup as a solid turnaround candidate, where the risk while elevated, is considerably lower than it was a few years ago. Much of the repair to the balance sheet is done: now it's a matter of realizing their true earnings potential, which lies far above current earnings. I am looking for a completion of the turnaround in the coming five years, and expect Citigroup to emerge less influential than its prior years of glory, but perhaps a better bank in the next ten years.

Citigroup returned to profitability in 2010. During 2012, Citigroup was amongst four of nineteen banks which failed the Federal Reserve Board's [FRB] stress tests. The reasons for failure were a high capital return plan, together with international loans viewed as having higher risk compared with domestic loans. It failed the 2014 stress tests too. The FRB failed Citigroup on qualitative concerns left unresolved despite regulatory warnings.

This lack of quality control is highlighted by the recent Oceanografia Citigroup Fraud, which adds risk to the turnaround story: Citigroup did well to detect the fraud, but perhaps their risk management system should be tightened up to help prevention.

The market is expensive, and the risk at Citigroup is perceived as high, does it represent a long-term buy? The stock trades at a substantial discount to tangible book value of $55.31 per share. Is it priced to buy to allocation for an investor seeking a long-term return of 13.70%?

In my view, even a bear with little conviction in Citigroup's ability to return shareholder value would be attracted to the company at a price of $34. This might represent a bear market target.

However, a person who believes that Citigroup will successfully turnaround and be capable of returning 52% of core earnings to shareholders would be happy to buy now in the hope of generating over 6% annualized alpha over the coming five years.

How do different market participants view Citigroup?

A couple of years ago, I had written some code to facilitate stock selection. You can view the model output here. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.

AOM Statistical Scores

The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stock's sector and the stock's industry of operation.

Citigroup scores high on value in comparison to the market as a whole, and in comparison with stocks in its sector and industry of operations. Its scores on growth are mediocre. The score for quality are weak, especially when viewed in the context of the industry, while momentum is ugly.

Source: Alpha Omega Mathematica

AOM Model Recommendation

While the stock carries high value scores, it is clear that even value investors view this stock neutrally, after giving some consideration to quality, growth and momentum indicators. It is much the same story for stock selection style-agnostic investors, growth investors, momentum investors and balanced investors, regardless of whether they allocate capital at a sector or industry level, or at market level free of any sector or industry bias.

Source: Alpha Omega Mathematica

Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 50% and an AOM Hold Recommendation for Citigroup.

The AOM Statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.

I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool which uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.

The Case for Citigroup:

Why look at Citigroup now?

Capital Position

We know that Citigroup failed the FRB stress tests. Yet, from the Raymond James Annual Investors Conference Presentation, we know that their quantitative parameters are strong. Here is an extract from the presentation, where they present the capital position for Citigroup.

(click to enlarge)

Source: Citigroup Raymond James Annual Investors Conference Presentation

These capital and supplementary leverage ratios [SLR] suggest that the bank is well-capitalized and is likely to be able to satisfy Basel III requirements. The SLR is 5.4%, whereas recent proposed SLRs which will be applicable to the largest eight U.S. banks is at 5% for the holding company and 6% for insured subsidiaries. So there will be an impact of Citigroup's intended capital return plans, but perhaps not a huge difference.

But there is risk too. Capital ratios do get destroyed if there is a weakness in qualitative measures and the risk management systems. Here below is an extract of text analyzing the FRB's explanation for their objection to Citigroup's capital plans.

"The Federal Reserve's objection to Citigroup's CCAR 2014 capital plan in part reflects significantly heightened supervisory expectations for the largest and most complex BHCs in all aspects of capital planning. While Citigroup has made considerable progress in improving its general risk-management and control practices over the past several years, its 2014 capital plan reflected a number of deficiencies in its capital planning practices, including in some areas that had been previously identified by supervisors as requiring attention, but for which there was not sufficient improvement. Practices with specific deficiencies included Citigroup's ability to project revenue and losses under a stressful scenario for material parts of the firm's global operations, and its ability to develop scenarios for its internal stress testing that adequately reflect and stress its full range of business activities and exposures. Taken in isolation, each of the deficiencies would not have been deemed critical enough to warrant an objection, but, when viewed together, they raise sufficient concerns regarding the overall reliability of Citigroup's capital planning process to warrant an objection to the capital plan and require a resubmission."

The good news is that Citigroup's capital plan indicated a desire to pay a dividend of $0.20 per share and to return $6.50 billion through a capital repurchase program.

The bad news is that the concerns expressed by the FRB suggest that Citigroup has a way to go before their turnaround can be said to be complete. And of course, we know that these risks are very real. After all on February 28, 2014, Citigroup lowered 2013 net income from $13.9 billion to $13.7 billion, from those reported on January 16, 2014, as a result of a discovered in its subsidiary in Mexico.

Overall, the risk is elevated, but as of now, the balance sheet is strong. When investing in a turnaround, the risks always are elevated. But that is alright provided the risk is priced. The question is whether you can make that leap of faith and believe that Citigroup will successfully turnaround.

Growth

Another reason to like Citigroup is its global reach. Whether we like it or not, growth is available in emerging markets, and Citigroup has a strong presence, with 43% of revenue coming from emerging markets.

Source: Citigroup Raymond James Annual Investors Conference Presentation

Capital Return Intent

We know that Citigroup intends to work towards paying a dividend of $0.20 per year. This would have provided investors a yield of 0.43%. In addition, they wanted to authorize a stock repurchase plan of $6.5 billion: about 4.7% of market capitalization. If nothing else, this would have been a pleasant change from the heavy dilution suffered by shareholders these past five years. After all, over the past five years, average annual diluted shares outstanding have climbed an astounding 151.4% in total.

(click to enlarge)

The intent to approve a $6.5 billion buyback plan suggests that further dilution other than that caused by issuances to employees is less likely. When the company reinvests in growth, one of the key areas of investment is employee incentive and retention. If part of earnings are earmarked for investment in employees, and are provided via share grants and options, then when shares are issued to employees, we will have a dilutive event. And when a buyback program is raised to offset the dilution, it does not constitute a return of shareholder value. It represents the payment of consideration on account of an investment in growth. While the buyback plan does not represent a return of shareholder value, it will limit the impact of dilution as a consequence of employee issuances. More importantly, it signals that further capital issuance to repair the balance sheet is less likely.

Truth be told, in my view, at least $1.5 billion of the intended buyback plan would offset employee and other issuances, leaving a maximum of $5 billion (3.6% of market capitalization) as capital returned to shareholders.

Beta, co-efficient of determination and alpha intercept considerations

Value Line reports a beta of 1.95 for Citigroup. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one.

I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 1.89, and I adjust it to 1.60 on account of the beta's tendency to converge towards one.

When I look at the raw beta based on the three-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500, I arrive at a raw beta of 2.06, and I adjust it to 1.71, on account of beta's tendency to converge towards one. What's more, the coefficient of determination has risen from 44.52% for the five-year regression to 66.35% for the three-year regression. This indicates that risk at Citigroup associated with the market risk is rising.

In the post-Pandit era (after mid-October 2012), the raw beta declines to 1.65, which I adjust to 1.30 for beta's tendency to converge towards zero. There is evidence that beta is contracting in response to the change in perception of management competence and the improvement in capital structure. But the regression period is not of sufficient duration. And so, I will use a beta of 1.60 to evaluate Citigroup. But do keep in mind that there is scope for additional alpha, which might be earned as a result of a contracting beta after the time of investment.

Cyclicality and Citigroup

In my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late-cycle, no discernible pattern is evident for stocks in the financial services sector. In my view, the late-cycle conditions are associated with a flattening of the yield curve, and even an inversion towards the end of the late-cycle. If I am right, this is negative for Citigroup investors, but it is a positive for potential investors in Citigroup, because late in the late-cycle and early in the recession is a time when a buy opportunity often, but not always, arises. And coming on the heels of a recession is the early-cycle: a period when the financial services sector tends to outperform very substantially.

You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance, today I think the U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle, it is more difficult to figure out how the U.S. sectors will behave. For example, if Europe, other developed markets, or emerging markets shift into early-cycle conditions, this is a time when the financial services sector typically outperforms, and U.S. companies in the financial services sector could well outperform too.

Analyst price expectations

Recently, Citigroup traded at $45.68. From Yahoo Finance, we know that twenty-eight analysts expect an average price target of $58.55 (median $58.00), with a high target of $68 and a low target of $51. This is a wide dispersion in expectations, which suggests risks are high. It is early in the year. So far, with the price 10% to 11% below the low price expectation, the bears have it.

Bear Valuation

We might believe that Citigroup is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry, or the coverage universe in the analysis of the perception of different market participants. We also know that Citigroup is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in line with our long-term expectations on a standalone basis and regardless of broad market valuations.

Mathematically, the worth of Citigroup is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].

What is our long-term return expectation for a stock with a beta of 1.60, a long-term risk-free rate of 4.50%, and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk-Free Rate plus Beta Multiplied by Market Return less Risk-Free Rate. Thus, for Citigroup, we should be targeting a long-term return of 13.70%. Is the stock priced to deliver that return?

What are our estimates for earnings? Twenty-seven analysts included on Reuters data estimate average earnings of $4.71 (High: $5.80, Low: 4.10) during the year ended December 14, while twenty-six analysts estimate that it will rise to an average of $5.66 (High: $6.40, Low: 4.88) for the year ending December 15. Four analysts assess long-term growth rates at 9.09% on average, with a high estimate of 15.35% and a low estimate of 3%.

How much value do we expect Citigroup to return to shareholders? In the long term, I expect Citigroup will payout approximately 15% of earnings via a dividend, and 20% via buybacks. Last year, Citigroup reported diluted earnings of $4.37. Their rejected capital plan included a planned dividend of $0.20 per year. This implies a dividend payout ratio of 4.57%. They also recommended a capital repurchase of $6.50 billion, of which I expect $5 billion will constitute a return of shareholder value, with the remaining amount representing an offset to dilutive employee and other issuances. This $5 billion amounts to a payout of 37.68% of diluted earnings. Thus, the total intended adjusted payout ratio is 42.25%. Given the terrible past track record in returning shareholder value, I reduce my expectations of estimated adjusted payout to 35%. Keep in mind that if Citigroup successfully turns around, we can look for the adjusted payout ratio to rise to 50% to 52%.

That will leave 65.00% available for reinvestment in growth. This 65% of retained profit re-invested at a 10% return on tangible equity indicates a long-term potential growth rate of 6.50% (65% * 10% = 6.50%). This return on incremental equity is not unreasonable to expect after considering recent performance.

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Source: Citigroup Raymond James Annual Investors Conference Presentation

But what are sustainable earnings? For the year ended 2013, Citigroup earned $4.37. Citigroup had a tangible book value of $55.31.

I view Citigroup as a high-risk turnaround story. So what I would like to do is value where I see the company five years down the road, and discount that value to the present time.

Assuming that tangible book value per share rises at an annualized rate of 10% over the coming five years, we can expect to see tangible book value at $89.08 by December 2018. By December 2018, I expect Citigroup to have completed a successful turnaround. By that time, I would expect earnings per share of $8.91, which represents a 10% return on tangible equity (10% off estimated tangible book value in 2018 of $89.08). And by then, I expect Citigroup's beta to have contracted to 1.30. A beta of 1.30, assuming a risk-free rate of 4.5% and an equity risk premium of 5.75% will indicate investor return expectations of 11.975%. And since the hard work of growing earnings to the potential earnings target will be complete, I will expect the long-term earnings growth rate to return to 6.5%.

Mathematically, the worth of Citigroup is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. Thus, the value of the share in five years can be expected to be $60.66 (106.50% * $8.91 * 35% /(11.975%-6.50%).

Based on my present estimate of beta, I seek an annualized total return of 13.70%. Over 2014 to 2018, I expect to collect an estimated $3.11 in dividends (including dividend growth as the bank's recovery accelerates). And these dividends have a discounted value of $1.86 today. This chart represents how I expect core earnings, dividends, buybacks will evolve over the coming years.

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Source: My Estimates

This $3.11 has a present value of $1.86, using a discount rate of 13.70%. Based on the recent share price of $45.68, the dividend gives me a total yield to cost of 4.1% ($1.86/$45.68), which represents an annualized return of 0.80%. Thus, I should target a return from price gains of 12.90% (13.70% less 0.80%). I expect the shares to be worth $60.66 in December 2018, approximately 4.72 years from today. Discounting $60.66 to present value using a 12.90% discount rate I get $34.21 ($60.66 * 1/112.90^4.72). At this price, the stock is a buy for a buyer targeting a long-term total return of 13.70% (12.90% via price gains and 0.80% via dividends).

The $34.21 represents my perception of bear value at which the stock would be very attractive to buy.

Normal Valuation

In a period of normalcy, we can hope to put the past behind us and look to the future. The management intent to return of shareholder value signaled in their capital return plan which failed to obtained FRB approval indicates a desire to return at least 42.25% of core earnings to shareholders at this relatively early stage of the turnaround. To expect an adjusted payout ratio of 52% for the long term on completion of a successful turnaround is not unreasonable. Indeed, it is very consistent with industry expectations. Nor is it unreasonable to expect a return on incremental equity invested of 15%. And with a return on incremental equity invested of 15%, the 48% of retained earnings would indicate a 7.2% growth expectation. Such growth levels are achievable given Citigroup's strong presence in emerging markets. With beta contraction to 1.3 by 2018, investors in 2018 would be targeting a return of 11.975%. And using these parameters, I would expect Citigroup to trade at $104 by 31 December, 2018.

Mathematically, the worth of Citigroup is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. Thus, the value of the share in five years can be expected to be $104.01 (107.20% * $8.91 * 52% /(11.975%-7.2%).

With the shares trading at $45.68, a price of $104 by 31 December, 2018 indicates an annualized return of 19.05% over the coming 4.72 years. The return of 19.05%, plus the dividend providing a return of 0.80% gives a total return expectation of 19.85%. My return expectation with the present beta is 13.70%. Thus, by buying now, I can hope to generate an excess return of 6.15% annualized: this is potential alpha, and it comes with high risk.

If you use the above formula, do read this explanatory note.

Source: Citigroup: High-Risk, High-Reward Turnaround