An Investment in Citigroup With Almost No Downside?

| About: Citigroup Inc. (C)

After Citigroup (NYSE:C) reported earnings last month (see conference call transcript here), it became more apparent the company was on the right trajectory, rebuilding itself out of the hole it was in at the nadir of the recession. Though shares appeared relatively cheap at the time, I thought it would be prudent to wait and see how the stock would react to the 1:10 reverse split (which occurred two weeks ago). Since the company effected the reverse split, shares have headed almost straight down, dropping nearly 10% before stabilizing in the past two days.

Though the drop was likely exacerbated by a weak market during the past week, the correction seems to lack any fundamental basis besides no longer appealing to certain classes of investors - namely high frequency traders who had been using the low-priced stock with a massive float as their play toy and mom and pop investors who bought the stock under the fallacy that a low stock price indicates a cheap valuation. While the company may lose some portion of these two feeble investor classes in the near term, it should gain more buy and hold institutional investors in the long run.

Having reduced its shares outstanding by 90%, the company was able to reinstate a dividend, albeit a small one (one penny) at the moment. Besides enabling the company to reinstate its dividend, the reverse split will allow many mutual funds who do not purchase shares in stocks that trade below $10 to buy the stock. Also, the dividend will enable income-oriented funds, who are only allowed to buy dividend paying stocks, to buy the stock as well.

At current levels, Citigroup shares represent a compelling value, and its T-DECS (Dividend Enhanced Common Stock) an even better value. Trading at just .88x tangible book value, Citi shares are actually cheaper than Bank of America on a multiple of book value basis, even though Bank of America (NYSE:BAC) announced the worst financial results among the large U.S. banks by far with declines in nearly every reporting segment and continued issues mortgage-related problems.

Not only is Citi cheaper than Bank of America as a multiple of book value, it is cheaper on a trailing P/E basis and comparably valued on a forward P/E basis - Citi is currently trading at 11.5x 2010 EPS and 9.7x 2011 EPS compared to Bank of America at 13.6x and 9.2x, respectively (Citi and BofA trade are trading at 8x and 6x 2012E EPS, but both banks, especially BofA, has a lot to prove before they can achieve those estimates).

It is understandable that Bank of America shares trade at such low levels given it was not allowed to increase its dividends by the Fed, likely because its Tier I Common Equity ratio sits at just 8.6%, compared to Citi's 10.8%. Citi should be able to increase dividends over the next year and still be in a position to achieve BASEL III Tier I ratio of greater than 8%. Not only that, Bank of America has been plagued with "one-time" legal charges in the billions for several quarters related to the mortgage mess that came with the untimely acquisition of Countrywide, while Citi has done a commendable job winding down its Citi Holdings (bad bank) assets and bolstering its balance sheet.

Most of all, what attracts me to Citi is the fact that over half of revenues are generated in emerging markets in Latin America and Asia that should fuel growth in coming years, while improvements in U.S. credit continue to free up reserves and reverse declining loan volumes. The latter will obviously benefit all banks, not just Citi.

Don't get me wrong - I'm not saying that Bank of America is not a good value. I'm just saying that Citigroup is a better value, especially when one takes into account the additional risk and uncertaintly Bank of America faces with the magnitude of its mortgage mess. What really draws me to Citigroup though is the company's unique T-DECS (Dividend Enhanced Common Stock) securities (ticker: C-H) issued in December 2009. In my opinion, these securities provide the best risk/reward ratio in Citigroup, and possibly among all the big U.S. banks. I wrote a detailed analysis about the T-DECS a couple months ago in which I outlined many of the securities' features and mechanics, but here is a very brief recap.

Adjusting for the 1:10 reverse split, each unit converts into 2.540-3.175 shares of Citi common stock, equating to a conversion price of $31.50 - $39.40. The conversion ratio ratchets up as the stock falls below $39.40, essentially providing the investor a floor at $39.40 until the price approaches $31.50. I've been hoping the stock price would get closer to $40, which results in less potential downside. In addition, the securities pay 7.5% annual interest, the bulk of which is tax free. However, given the fact that the security has essentially become a play on the common, the premium in the price of the security essentially offsets all future interest income.

Through maturity, there is $13.125 of interest payments remaining, which means that the T-DECS should have a floor of $113.125 unless the price falls below $31.50. The securities are currently trading at 120, which means the downside potential is about 6%, even if the stock falls nearly 25% to $31.50. On the other hand, if the stock rises 25%, the theoretical value of C-H would rise 20.5%, meaning the upside is over 3x the downside at current levels.

On top of that, if an investor wants to lock in his/her gains now, one could sell January 2013 $50 calls for a return of over 6%, which would hedge the potential 6% downside risk in C-H and lock in a gain of 20% with no downside risk unless the stock falls by more than 25%. In my opinion, 6% downside is not much risk for unlimited upside, so I'd hold C-H unhedged and see how high the stock can go in the next couple years.

Disclosure: I own C-H -- that is, Citigroup Inc PRFD 'H'.