- 1st quarter earnings show Citigroup continues to increase its intrinsic value and clean up its balance sheet.
- The recent Fed decision not to approve Citigroup's stock buyback and dividend increase has little impact on long-term investors.
- Citigroup is undervalued in an overvalued market.
Few companies are as reviled by market participants as the global banking giant Citigroup (NYSE:C). Multiple crises and managerial gaffes have reduced confidence in the company, to the point where Mr. Market is valuing the company at a steep discount to a relatively conservative estimate of its liquidation value. This is despite the fact that the company can generate anywhere between $13-$20 billion of net income on a normalized basis. While I'm not one to argue that Citigroup has the kind of dominant banking franchises that a Wells Fargo (NYSE:WFC) or a J.P. Morgan (NYSE:JPM) has, the reality is that the price makes it the most attractive investment in the banking area, which I also view as one of the most attractive areas of the overall market. One must assume either that the books are cooked (highly unlikely given the amount of regulatory scrutiny), or that Citigroup is likely to begin losing billions of dollars, which I also view as being an extremely low probability event, to validate the current valuation. It is much more likely that Citigroup's return on equity will revert to a mean of between 10-13% sooner than later as Citi Holdings becomes an even smaller part of the financial picture, costs are cut, and assets can be deployed to more productive uses after adjusting for the regulatory environment.
There are no excuses for Citigroup not getting their stock buyback and dividend raise requests approved by the Federal Reserve in the CCAR process. The Fed acknowledged that Citigroup has the capital but they disagreed with how Citigroup conducted its own internal tests. This seems much more likely to be a personal disagreement between individuals at the bank and regulators, in what has continued to be an extremely contentious relationship since the Financial Crisis. Citigroup generated $20 billion in regulatory capital in 2013; the quantitative tests showed that the company exceeded the Fed's requirements with 150 basis points of cushion in the severely stressed scenario, which uses the word stressed mildly. While this result was disappointing, the reality is that it has very little impact on my appraisal of the intrinsic value of the business. It is true that stock buybacks done at deep discounts to tangible book value would have been highly accretive; the retention of earnings will only cause the net asset value of the company to grow, while reducing the overall risk profile by further enhancing Citigroup's financial position to the top in relation to its competition. For short-term traders or income oriented investors, the implications are far more frustrating than they are for long-term investors, which we tend to be at T&T Capital Management. Bank analysts generally focus on clean quarterly projections or shorter-term time horizons, as opposed to focusing on the value of the business versus the price that is being paid. It is precisely this disconnect between intrinsic value and the stock price that created an extraordinary investment opportunity, which is tough to find after 5 years of a bull market.
Another major issue was the $400MM loan fraud that hit Citigroup's key Banamex unit in Mexico. Clearly, management missed some obvious warning signs, but the reality is that mistakes will happen with such a large and truly global bank. The "London Whale" incident was much larger and showed that even the highest profile leadership teams are susceptible to surprises in these large organizations. The reality is that banking involves risk and losses are something that have and always will be a part of the industry. The sell-off in relation to these issues has provided an incredibly enticing risk-reward scenario for the enterprising investor. I see the risks of a permanent loss of capital as being exceptionally low because the of the hugely discounted price that we are paying for the stock, while there is a legitimate opportunity for 50-100% returns over the next 3-5 years as the net asset value grows, and returns on equity improve.
On April 14th, Citigroup reported 1st quarter 2014 earnings per share of $1.23, or $1.30 excluding CVA/DVA and a tax item. Net income was $3.9 billion, or $4.1 billion excluding CVA/DVA and a tax item. Revenues for the quarter were $20.1 billion. These numbers were up from net income of $2.8 billion, or $1.23 per diluted share, on revenues of $20.2 billion for the 1st quarter of 2013. Citigroup's net interest margin increased to 2.9%, while net credit losses of $2.4 billion declined 15% versus the 1st quarter of 2013. The loan loss reserve release was $673MM in the quarter, up slightly versus $650MM in the prior year period. Due to net income earned in the United States, Citigroup was able to reduce its deferred tax assets by approximately $1.1 billion, which was the biggest reduction since the Financial Crisis. This utilization of deferred tax assets is crucial in that it reduces the uncertainty that Citigroup will be able to utilize its substantial DTA assets by generating earnings, and it also bolsters regulatory capital. $4 billion of net income helped to generate $6 billion of regulatory capital during the quarter. In 2013, the bank reduced the DTA by $2.5 billion, so the 1st quarter showed notable improvement on that front that should continue into the future as Citi Holdings becomes less of a drag on North American profitability. The consumer bank grew internationally and generated positive operating leverage, which must continue to be a priority for Citigroup. Treasury, trade solution and equities were some of the stronger businesses in the 1st quarter. Mortgage origination and fixed income were slow in the quarter, similar to the results that have been posted thus far by the other big banks.
Citigroup ended the 1st quarter with a tangible book value per share of $56.40 and a book value of $66.25. These figures grew 6% and 8%, respectively YoY and highlight the fact that despite the difficult operating environment, the intrinsic value of the company continues to grow. The company's estimated Basel III Tier 1 Common Ratio was 10.4%, while the estimated Basel III Supplementary Leverage Ratio was 5.6%. Citigroup's deposits of $966 billion grew 3% YoY, while Citicorp loans of $575 billion grew 7% YoY. Citi Holdings Assets of $114 billion declined 23% from the prior year period and now only represent 6% of total Citigroup assets as of the end of the 1st quarter. The loss of Citi Holdings was $284MM for the quarter, which was down considerably from $804MM in the 1st quarter of 2013. These losses should continue to decline providing a substantial benefit to both the bottom line and the company's utilization of its deferred tax asset.
The annualized return on common equity was only 7.8% for the quarter, highlighting the fact that the company is significantly under-earning based on its potential ROE of 10-13% in a more normalized environment. Operating expenses in the first quarter of 2014 included $945MM of legal and related expenses and $211MM of repositioning charges. These issues won't be going away any time soon, but the normalized numbers will be much lower over the long-term. On a trailing 12-month basis, Citigroup has lowered its operating expenses every quarter for more than two years, taking the efficiency ratio from 67% two years ago to 59% in the 1st quarter. There is much more that can be done.
The bank's allowance for loan losses was $18.9 billion at quarter-end, or 2.87% of total loans, while total non-accrual assets fell to $9 billion. This leads me to believe that Citigroup has more room for loan loss reserve releases than many of its peers do. This is largely a reflection that Citigroup had far more troubled assets than most of its peers coming out of the Financial Crisis, which have benefitted from improving markets, mostly in relation to increased housing prices. These assets have improved but the bank has to be conservative in how it marks them. Ultimately, I expect several more quarters at least of strong loan loss reserve releases and reasonably strong credit quality.
I estimate that by the end of 2014 Citigroup should have a tangible book value just in excess of $60 per share and a book value of $70 per share. In addition, the company will be well on its way towards further improving the relationship with regulators paving the way for a return of capital. Citigroup will be vastly over-capitalized by the end of the year unless loan growth picks up dramatically, which I view as highly unlikely. Citigroup will be a huge beneficiary of higher interest rates once the Federal Reserve eventually allows more flexibility on interest rates. Costs are continuing to decline and with each settlement, the legal liability clouds will continue to clear. At some point, the banking environment will be far better than it is now and perhaps the political and regulatory landscape will change with the understanding that for the U.S. to reach its economic growth potential, banks must play a critical role in providing capital to businesses and individuals. Patience and a careful appraisal of facts, as opposed to headline and media hype, are all that are needed for 50-100% returns on Citigroup over the next 3-5 years.