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Summary

  • Shares of Citi have been held down by sentiment and disbelief that the company can execute.
  • Earnings estimates are too low, offering tremendous upside potential.
  • Shares will trade over book value after interest rates begin to rise and fundamentals further improve.

Shares of beleaguered mega bank Citi (NYSE:C) have seen rapid gains and declines amid high volatility for the past few years since the crisis. Earnings estimates are all over the place for Citi, and with the uncertainty of the company's ability to return capital to its shareholders subject to the whims of the Fed's CCAR program, investors may be left wondering what to do. I happen to think Citi is still very cheap, and in this article, we'll take a look at why I believe that is the case and why I'm still long.

(click to enlarge)

To do this, I'll use a DCF-type model you can read more about here. It uses inputs such as earnings estimates, which I've sourced from Yahoo, dividends, which I've set at 20 cents of growth annually, and a discount rate, which I've chosen as the 10-year Treasury rate plus a risk premium of 6.5%, reflecting the relative stability of C's business and my outlook for it. As a side note, the dividend for Citi is impossible to forecast because of the CCAR uncertainty; I've simply made what I believe to be a realistic estimate, but it could turn out much differently.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior-year earnings per share

$4.39

$3.64

$5.37

$5.97

$6.64

$7.38

x(1+Forecasted earnings growth)

-17.10%

47.50%

11.19%

11.19%

11.19%

11.19%

=Forecasted earnings per share

$3.64

$5.37

$5.97

$6.64

$7.38

$8.20

Equity Book Value Forecasts

Equity book value at beginning of year

$66.76

$70.36

$75.53

$81.10

$87.13

$93.71

Earnings per share

$3.64

$5.37

$5.97

$6.64

$7.38

$8.20

-Dividends per share

$0.04

$0.20

$0.40

$0.60

$0.80

$1.00

=Equity book value at EOY

$66.76

$70.36

$75.53

$81.10

$87.13

$93.71

$100.92

Abnormal earnings

Equity book value at beginning of year

$66.76

$70.36

$75.53

$81.10

$87.13

$93.71

x Equity cost of capital

8.90%

8.90%

8.90%

8.90%

8.90%

8.90%

8.90%

=Normal earnings

$5.94

$6.26

$6.72

$7.22

$7.75

$8.34

Forecasted EPS

$3.64

$5.37

$5.97

$6.64

$7.38

$8.20

-Normal earnings

$5.94

$6.26

$6.72

$7.22

$7.75

$8.34

=Abnormal earnings

-$2.30

-$0.89

-$0.75

-$0.58

-$0.38

-$0.14

Valuation

Future abnormal earnings

-$2.30

-$0.89

-$0.75

-$0.58

-$0.38

-$0.14

x discount factor(0.089)

0.918

0.843

0.774

0.711

0.653

0.600

=Abnormal earnings disc. to present

-$2.11

-$0.75

-$0.58

-$0.41

-$0.25

-$0.08

Abnormal earnings in year +6

-$0.14

Assumed long-term growth rate

3.00%

Value of terminal year

-$2.30

Estimated share price

Sum of discounted AE over horizon

-$4.11

+PV of terminal-year AE

-$1.38

=PV of all AE

-$5.49

+Current equity book value

$66.76

=Estimated current share price

$61.27

As we can see, the model produced a fair value of about $61 for Citi, in contrast to the current price of about $52 as I write this. This is a large discrepancy, but in a good way for longs, so we'll investigate why I think the deficit between the current price and the fair value exists.

First, the fair value is not a price target; a price target is an EPS estimate projected out into the future times an earnings multiple. The fair value computed is the price at which Citi is a good buy today. In other words, the present value of Citi's future earnings stream, adjusted for any dividends, is around $9 higher today than the current share price, according to my inputs. This is a large margin of safety, so a long position still looks good so far.

Is Citi's business able to back this up? After all, there must be some reason shares are still trading below even tangible book value. I think a lot of it is continued negative sentiment left over from Citi's past sins. On a split-adjusted basis, shares of Citi are still down around 90% since their peak before the financial crisis. Of course, on a market cap basis, it's much lower than that due to significant dilution since that time, but still, the fact remains that many investors remain hopelessly under water on their Citi shares, and will never get their money back. I suspect this fact is helping keep shares down, despite rapidly improving fundamentals.

And speaking of fundamentals, Citi has spent the last few years shedding toxic businesses and assets in an effort to right-size for the future. Citi management has done a terrific job of focusing on what Citi's core businesses will be going forward, and in this case, I really applaud the efforts of CEO Corbat. I think he's done a remarkable job since taking over the CEO post, and in a relatively short amount of time, steered Citi in the right direction. Consider the mess Corbat took over and then consider the results since; he's done a great job, and I'm happy he's running Citi.

With the modest earnings growth expectations highlighted above, I think Citi is very cheap. In fact, shares are still trading for less than 10 times next year's earnings consensus, a ridiculous number that should be much higher. And Citi is still trading below both its traditional and tangible book values as though the financial crisis is still going on. I truly cannot understand this, but at some point, shares will overtake both of those values; it's just a matter of how much time will transpire between now and then. And also keep in mind that book value increases with virtually every quarter that passes, so that is a tailwind for the stock as well.

Also remember that all banks will benefit from rising interest rates. Of course, no one knows when that will happen, but I have a strong feeling that interest rates cannot be held down at less than 2.5% on the 10-year Treasury for long without Fed intervention. Once the Fed ceases its quantitative easing operations, I suspect it won't be long before interest rates begin to creep up. As this begins to happen, we should see net interest margin spreads for banks increase appreciably, and with it, earnings. I think Citi has been positioning itself well for this eventuality, getting back to simply operating like a bank, and that there is upside risk to the earnings estimates above.

Overall, the outlook for Citi is way too bright to avoid a long position. The company settled over MBS practices during the crisis, getting the biggest hurdle out of the way for future earnings, although the price tag was unbelievably high. Couple the increased certainty with the earnings power of this company and the fact that it is being valued like earnings are shrinking, and you've got a case for a strong buy. I love Citi at these valuations, and I just hope I get a chance to buy more in the low $50s before shares take off.

Source: Citigroup Offering Potential Gains For The Bold