Market Continues to Under-Appreciate Citi

| About: Citigroup Inc. (C)

Citigroup (NYSE:C) reported fairly positive earnings last week, with EPS of $1.09 versus consensus estimates of $0.96. Excluding one-time gains from the sale of subprime securities, Citi's earnings would have been about $0.99, suggesting a smaller outperformance than the headline numbers suggest. After an initial pop, investors sold off after reading the details, and sadly Citi was not invited to the party for the rest of the week when markets jumped by over 300 points.

Compared to Bank of America (NYSE:BAC), Citigroup's results look stellar, yet Citi is being lumped with its lagging peer. Bank of America just reached a $8 billion mortgage-related settlement and added $20 billion to its reserves, whereas Citi continues to wind down the troubled assets remaining in Citi Holdings. Citi's problems look to be largely behind it, and the company is on the path to stronger growth and improved profitability, yet its shares trade at just 0.6x book value (0.8x tangible book value). Such a valuation would make sense if there was considerable risk that current book value may erode or if the company is unable to generate any return on equity. However, analysts expect book value to rise over 20% by 2013, valuing the company at just 0.5x 2013E book value. The company also looks cheap on a forward P/E basis, trading at just 7-8 2012E EPS. I believe Citi provides the best combination of growth and value among the large banks and through its dividend enhanced convertible securities (ticker: C-H) offers the best risk/reward ratio I have found in the industry.

So why did investors shrug when Citi reported last week? Citi delivered strong top-line figures driven by very strong investment banking results and strong loan growth in emerging markets; however, expenses increased much more than analysts expected. Specifically, investment banking compensation was high and discretionary spending and overhead came higher than expected as well. I agree that cost control is very important, especially in a slow-growth environment; however, Citi provides the best exposure to these emerging markets among the U.S. banks, and arguably among any bank in the world. I do not want to digress about why I'd rather invest in Citi versus HSBC (HBC) or Standard Chartered (OTCPK:SCBFF), but let me just say European contagion.
I believe that Citi's investments in these two areas will pay off in the long-run. A shift towards a more fee-based business will provide opportunity for multiple expansion, as will stronger growth in Asia. Short-term oriented traders may not like investment in infrastructure and operations, but long-term value oriented investors appreciate it. I do agree that investment banking compensation has to be reigned in if performance does is not up to par, however.
Citi is positioning itself to go head to head with the largest banks in the world. After a couple years of trying to reign in its operations and regain control, management finally seems to be looking at the big picture. Best of all, management has reiterated that it intends to return capital to shareholders beginning next year. Even with increased dividends and share buybacks, management expects to reach a 8-9% BASEL III capital ratio by the end of 2012, seven years before it needs to reach 9%. With arguably one of the strongest capital positions in the industry, Citi is expected to return massive amounts of capital back to its shareholders.
Morgan Stanley (NYSE:MS), in a July 17 research report, estimated that Citi will return 8% of its current market capitalization back to shareholders in the form of dividends by 2014 and an additional 38% of current market capitalization in the form of share buybacks -- a return of over 45% in the next three and a half years. Morgan Stanley estimates that Citi will still be above 9% BASEL III at the end of 2012, despite the increased returns to shareholders. All of this bodes even better for investors in C-H as they will not only enjoy the built-in downside protection of the securities, but they will also receive the tax-free interest payments, all dividends and most of the upside in share price.
Last quarter, the troubled assets in Citi Holdings declined $29 billion to $308 billion, representing 16% of total assets, down from 38% in 2008. Analysts expect another roughly $100 billion to roll-off in the next year, bringing Citi Holdings to below 10% of assets. Morgan Stanley estimates that Citicorp (core business) had an ROE of nearly 11% last quarter, but overall ROE was dragged down to 7.6% by Citi Holdings. As Citi Holdings makes up less and less of overall assets, Citigroup should be able to generate double digit ROEs, making the case even stronger that the stock should trade above book value, and definitely above tangible book value. Analysts see Citi Holdings completely wound down in the next three to six years, depending on market conditions.
At the risk of sounding like a broken record, I believe that this is the best opportunity to invest in Citigroup shares, specifically the C-H securities, before Citigroup begins increasing its dividend payouts. Citi's diversified exposure to emerging markets in Latin America and Asia is unparalleled. It revealed that its exposure to the PIIGS is minimal at just $13 billion net (with improved hedging to reduce counterparty risk). Its investments in faster growing businesses should pay off over the coming years. And best of all, management seems to be genuinely interested in returning significant capital to shareholders. C-H is unlikely to fall below $110, barring a drastic move in the market or in Citi common stock. Meanwhile, analysts like JP Morgan, Morgan Stanley and Goldman Sachs all have price targets approximately 50% above current levels ($65, $58 and $55, respectively), suggesting a massively positive risk/reward ratio that I haven't found in any other stock in quite a while.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long C-H