Why We Think Citigroup Could Outperform This Peer

Aug.11.14 | About: Citigroup Inc. (C)

Summary

We're focusing on the strengths and weaknesses of Citigroup in this article.

Specifically, we're looking at its profitability, growth prospects and its potential to become an attractive income stock.

We also focus on its valuation and find that it appears to offer good value when compared to a sub-industry peer.

In this article, we're focusing on US banking stalwart Citigroup (NYSE:C), and discussing whether it offers good value relative to sector peer Banco Santander (NYSE:SAN). Sure, the two banks are based on different sides of the pond, and while they are both major banks, their market caps are significantly different, with Citigroup having a market cap of $145 billion and Santander having a market cap of $114 billion. However, we're well aware that many investors apportion capital based upon GICS sectors and GICS sub-industries. So, with Citigroup and Santander both sitting in the GICS sector of financials as well as the GICS sub-industry of banks, we feel it could be a useful and worthwhile comparison. It'll also be interesting to see how a major US bank compares to a large European counterpart.

Turnaround Stories

Clearly, it's been an incredibly tough few years for the banking sector. Indeed, banks have had it just about as bad as they possibly could, with the worst recession in living memory hitting profitability and balance sheets very hard. Therefore, when focusing on the profitability of Citigroup, we're keeping this at the forefront of our minds, since the bank is more of a turnaround story than the finished article.

Still, profitability numbers are getting back to normal. For instance, last year, Citigroup was able to post return on equity of 4.73%, and although return on assets was a lot lower at 0.51%, Citigroup is beginning reap the benefits of its efficiency drive, which we feel will continue over the medium term. Interestingly, Banco Santander appears to be further down the road in this respect, since its return on equity last year was 7.19%, although its return on assets figures was 0.5%. This highlights that while Santander is delivering more bang for shareholders' bucks, it isn't making particularly efficient use of its large asset base.

Yield Potential

Citigroup also appears to be somewhat behind Banco Santander when it comes to the dividend payout ratio. That's because while Santander pays out a hugely generous 114% of net profit, Citigroup pays out only 1%. Indeed, the two banks are polar opposites when it comes to dividend payments. We certainly understand why Citigroup is being rather mean when it comes to the proportion of profit that it pays out as a dividend: the bank wants to firm up its balance sheet and further improve its capital ratios through reinvesting profits in the business. However, we feel that there is considerable potential for Citigroup to become a relatively attractive yield play, since (as will be discussed later) profit growth plus an increasing payout ratio could prove to be a potent combination and aid in lifting the forward yield from the current 0.1% level.

As for Santander, while we were initially concerned about a 114% payout ratio, the growth forecasts for the bank (discussed later on) mean that dividends could be adequately covered going forward. Clearly, the current level of payout ratio, although it equates to a forward yield of 6.1%, is unsustainable in the long run.

Growth Prospects

Looking to 2015, Citigroup is forecast to deliver impressive growth numbers. While EPS has experienced a number of ups and downs, 2015 looks set to be a good year for the bank, with the bottom line due to rise by an impressive 47.3%. Similarly, although to a lesser extent, Santander is forecast to increase EPS by 16.6% in the current year and then by 27% next year, which gives us more confidence in its ability to maintain the current level of dividend per share payments.

Indeed, higher earnings could aid Citigroup in strengthening its balance sheet, but may also equate to a higher payout ratio. Clearly, this would be good news for shareholders and could also act as a signal to the market that Citigroup is back to a degree of normality, which may have a positive effect on the share price.

Valuation

Despite its strong growth prospects and improving levels of profitability, Citigroup seems to offer good value at current levels. For instance, it trades on a forward P/E of just 9, which is considerably below the S&P 500's forward P/E of 16.2, and also less than Santander's forward P/E of 12. Furthermore, Citigroup's price-to-book and PEG ratios are also lower than its Spanish peer, with the former's PEG ratio being 1.18 (versus 1.33 for Santander) and its price-to-book ratio being just 0.72 compared to 1.12 for Santander. As a result, we feel that Citigroup offers much better value for money than Santander, and could outperform its sector peer going forward.

Conclusion

Although Citigroup and the wider banking sector continue to underperform in terms of profitability, we're encouraged by growth prospects in 2015. We feel that increases to the bottom line will help to strengthen Citigroup's balance sheet, and could also mean a higher payout ratio (and yield) for investors. In addition, we think that Citigroup's valuation is too low versus Banco Santander. While its Spanish rival is more profitable and has a higher yield, its growth forecasts for 2015 are not as impressive and, as such, we do not feel that Citigroup deserves to trade at a 25% discount when it comes to forward P/E, or at a 36% discount in terms of the price-to-book ratio versus its peer. As a result, we believe that Citigroup could outperform its GICS sub-industry peer going forward as the market reacts to what appears to be a mispricing and bids up the share price of Citigroup going forward.

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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.