Citigroup Just Hit A Home Run

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 |  About: Citigroup Inc. (C)
by: Josh Arnold

Summary

Citi's quarter was a blowout positive and the stock moved up 4.4%.

Implications for shareholders are great as margins and loan losses improved.

Citi Holdings is no longer the drag on earnings it used to be as it moves ever closer to breaking even.

Management is dealing with its fraud risk issues, and once those are remedied, the stock should move materially higher.

Well that was fun. Citigroup (NYSE:C) reported blowout earnings yesterday, much to the joy of shareholders. Shares traded up 4.4% on the news, a huge move for a stock the size of Citi, amid a broadly green day in the markets. But there was much more to this move than simply trading up with the market; Citigroup had a terrific quarter. Amid what has been relentless negative sentiment on the global banks in the past few weeks, earnings expectations had been beaten down. Citi showed us yesterday that execution still rules the day and that the sky isn't falling. I believe even more strongly in my long position today than I did before the report because there was so much good news.

To make this point I'll go over a few of my favorite things that came out of the earnings report and those that I believe will have the greatest impact to shareholders in the coming quarters. First, margins are higher. Citi reported a 2% decline in earnings but a 4% increase in net income. This means that Citi doesn't even need revenue growth in the future in order to continue to increase earnings as it is making more on each dollar of revenue. This is hugely positive for the stock and I believe may have been overlooked yesterday.

Second, loan loss allowances plummeted $4.8 billion from the year-ago quarter, to only 2.87% of loans from 3.7%. This means that Citi is doing a much better job of assessing credit risk when extending loans to its customers and this, in turn, is helping margins expand due to decreased credit losses. The bigger picture here is that it means Citi's management is tightening its risk controls and given the Banamex incident, that is something all shareholders will applaud. Citi is extending credit when prudent and not just when the opportunity arises, a distinction that couldn't have been made in the crisis years.

Citi Holdings, Citi's "bad bank" where its unwanted junk is stored for safe keeping, produced a net loss of only $284 million during the quarter, an enormous improvement over last year's $804 million first quarter loss. This has tremendous implications for shareholders as Citi Holdings has been destroying value for years and it looks like we may be pretty close to that story changing tunes. If Citi Holdings can just break even, that will remove a tremendous drag on earnings that has been hurting results since the crisis. The days of Citi Holdings losing billions of dollars are over and that means there is potentially material upside to earnings estimates, in my view.

Finally, the big news was Citi's traditional and tangible book values reported for the end of the quarter. Those numbers, respectively, were $66.25 and $56.40. This means Citi's discount to its traditional and tangible book values now sit at 39% and 18%, respectively. These discounts were large going into the quarter, but now they are downright wacky. Tangible book value was up 8% in the quarter and given the underlying strength in Citi's businesses, I think there is upside surprise potential to my $62 price target. Forget trading at a tangible book value premium; Citi is still a long way from even reaching that number. This means the downside risk is very minimal indeed and that there is even more significant upside than I previously thought. It turns out I was too conservative on Citi's potential despite my bullishness.

Citi is not without its risks, however. As we've seen with the Banamex fraud discovery mentioned above, Citi still has some internal risk control issues it is working through. And just yesterday, we were apprised of another fraud that may be related to the first incident. This one, however, appears to be only a fraction of the size of the first one at less than $30 million. Still, this is real money and Citi has clearly got to get better at controlling fraud risk. This is the one area where Citi is failing right now but I believe in Citi's management team, something I've never said before, and I believe they will fix any issues that crop up and prevent them from occurring again. If it weren't for these fraud issues, Citi would likely be several dollars higher than it is right now. In addition, I think investors are waiting to see what else comes through in terms of fraud risk because right now, we don't have any clarity. Once it is clear the fraud issues have been dealt with, we should see some impressive multiple expansion.

Citi's embarrassing CCAR rejection means it's got some work to do on impressing its regulators in 2014 regarding the qualitative factors involved in stress testing. However, management will not allow this to happen again and with Citi's equity position increasing on a steady basis, I have no doubt Citi will be able to return an enormous amount of capital to investors next year and beyond. The company's fraud issues are a black eye but once remedied, will only be a distant memory for shareholders. I believe the company's results this quarter provide solid evidence that Citi deserves to trade at a peer group multiple of book value and earnings, both of which would put Citi near $60, or roughly 25% higher than it is today. In short, Citi hit a home run and once investors catch on, the stock will move much higher.

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.