by David Sterman
Uncle Sam's decision to unload its remaining block of 2.4 billion common shares of Citigroup (NYSE: C) -- one quarter ahead of time -- has caused many to take a fresh look at the banking titan. A quick survey of analysts' opinions reveals a stock with +15% or +20% upside from here. Yet as you dig deeper, you'll see why Citigroup can actually spike well higher -- perhaps rising +50% or more in the next two years.
A continuing clean-up
Make no mistake, Citigroup is still hurting. The damage from the 2008 crisis was so deep that management will be spending another year -- or more -- cleaning up the mess. They've started the process by creating "Good Citi" and "Bad Citi," otherwise known as Citicorp and Citi Holdings. Citicorp holds all the assets that we'll be talking about a few years from now. Citi Holdings contains a hodge-podge of assets that management hopes to eventually sell, including retail partner credit cards, CitiMortgage, private student lending, brokerage and a group of pooled assets.
There are two items to note about these unwanted assets. First, Citigroup is carrying them on its books at levels likely below fair market value. So the bank's tangible book value of $4.44 is understated. Second, as the economy improves, so will the likely value of these assets. Management is in no hurry to simply hold a fire sale, so it may be several years before the process is complete.
The road ahead
The remaining assets (Good Citi) are what investors will be focusing on. And there's a lot to love. Citigroup aims to get back to the old-fashioned business of banking, providing advice, facilitating global transactions and generally playing it safe. The days of throwing money after the latest financial gimmicks are over. CEO Vikram Pandit, who seemed to be a poster child of financial recklessness a few years ago, now appears to be the most sober-minded executive in the business.
Pandit is staking his claim on Citigroup returning to its historical role of consumer banking and advice. And we're again reminded that banking is a nice business. Citigroup lost $7.8 billion in 2009 as many assets were written down, but it is likely to generate more than $14 billion in operating profit this year. Pandit's goal is to boost that figure well higher in coming years. To get there, he's making a big push into Asia, Latin America and Africa.
Judging by recent results, Citigroup is making major inroads in some of the most dynamic regions and countries in the world. In the most recent quarter, Latin America-derived revenue rose +8%, while Asia-derived revenue rose +17%. Right now, North America and Europe constitute about two-thirds of revenue. But emerging markets are expected to grow at a faster pace than Europe and North America in coming years, so that revenue mix may move closer to 50/50.
The emerging market focus isn't on the rising middle class in these countries. Instead, it is on those in upper income segments, as well as corporations. So much wealth is being created in places like Brazil and China right now that the ranks of millionaires is likely to keep swelling. And that's Citigroup's bread and butter. From private banking to corporate advisory services, Pandit is focusing Citigroup on the highest margin businesses.
By the numbers
Shares of Citigroup have traded between $3 and $5 in the past year. And after a recent spike, they currently hover around $4.60. But I see a move up to $7 by early 2012. Here's how we get there…
First, Citigroup needs to keep shedding the divisions housed in Citi Holdings (Bad Citi). That could take anywhere from 12 to 36 months to complete. As noted, a patient disposition of those assets should yield sale prices above the level they are being carried on Citi's books.
Second, with increased financial flexibility, look for deals that expand the company's footprint in emerging markets. (That financial flexibility is noted by a 10.3% Tier One Capital ratio, the highest among any major bank, and well above regulatory minimums). Third, look for the U.S. and European economies to start to perk back to life in the next six to 18 months. As signs of life emerge in these two large economic regions, investors are likely to reward bank stocks with higher price-to-book multiples.
Right now, shares of Citigroup trade right around book value, which is $4.44. The bank is generating impressive 20%-plus returns on its equity base, and book value could exceed $5.50 by the middle of 2012. By then, a more bullish take on bank stocks could lead to target price-to-book multiples to rise up to 1.5. That would push shares of Citigroup past $8.
By 2012, Citigroup will also likely be buying back stock, boosting its dividend, or both. Based on 2011 profit forecasts, Citigroup can afford to pay out $0.35 to $0.45 in dividends. Assume it's the lower end of that range, and assume that investors own the stock for a 5% yield. That translates into a $7 stock.
It's been a brutal slog for Citigroup, and the struggle isn't over just yet. The U.S. economy remains weak, and the company needs to keep working to clean up its balance sheet by unloading those unwanted assets.
If the economy stays weak for an extended period and Citigroup can't find any takers for those assets, then shares are likely dead money for the next few years. But if the stars align, then investors are looking at +50% or even +70% upside. That will take several years to accomplish, so this is a "buy-and-hold" stock and not a quick trade. But one thing's for sure, it's safe again to be a buyer of Citigroup.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.