With Citigroup's Recovery Years Away, 2 Banks For The Interim

Jan.12.12 | About: Citigroup Inc. (C)

By Robert Gordon

Citigroup, Inc. (NYSE:C) is the nation's third largest bank holding company, after J.P Morgan Chase (NYSE:JPM) and Bank of America Corp. (NYSE:BAC). Citi's main subsidiary, of course, is Citibank. For many years it was the largest bank in the country, but mergers by other banks, along with some downsizing by Citi, account for the change.

No banking company has fallen quite as far in the past few years as Citi. Not too many years ago, it was reporting profits of over $2 billion a year, and its stock was trading at over $500 per share adjusting for all the splits and reverse splits the company has undergone. Its stock was trading recently at about $30 per share. Its 52 week range is from $51.50 to $21.40, and its current P/E is 8. It has a market capitalization of $87.7 billion, and pays a quarterly dividend of one penny, for an annual yield of 0.10%.

In its third quarter of 2011, Citi posted what appeared to be earnings up 74% year over year to $3.8 billion, or $1.23 per share. However, most of that was not actual earnings. Almost $2 billion of its pre tax earnings was due to an accounting gimmick of revaluing existing debt. Of course, that revaluing is subject to being reversed in the future. Another $1.4 billion was the retrieval of what Citi believed was excess loan loss reserves. Some 85% of Citi's third quarter profit was non recurring.

More bad news for Citi is that in October of last year, Citi settled for $285 million claim that it had defrauded its own investors in a $1 billion dollar derivative deal based on the mortgage market. The federal district judge in New York City threw out the settlement, stating the settlement was not in the public interest. The case is scheduled for trial in July 2012.

Looking at Citi's current balance sheet and cash flows, I look first at the return on assets. Citi has a proud history of productive earnings, having a return on assets of at least 1.3% each year from 2000 through 2005. Analysts are expecting earnings in the 4th quarter of this year of $0.51 per share. If true, that would give the company full year earnings of $3.83 per share. At that level, the return on assets for the year is 0.58. Any bank should be able to generate earnings of 1.0% of assets or more. The other issue I look at is a bank's efficiency ratio. That is the ratio of non-interest expense, over the sum of net interest income, plus non-interest income. That percentage should be at or less than 0.60 as an indication that a bank has its expenses under control. Citi is on track for a 61% efficiency ratio this year.

To its credit, at least in my view, Citi took a tricky, albeit creative course in dealing with its extraordinary portfolio of bad debt. It formed a new subsidiary, Citi Holdings, to deal with those debts, and thereby employees of that division undoubtedly developed a particular expertise. At its inception, Citi Holdings held $730 billion of non performing and marginally performing assets. That amount was whittled down to $287 billion at the close of the third quarter. And, when Citi Holdings is wound down completely, there will undoubtedly be salvageable assets left. A thorough discussion of this is found here. Some believe that the creation of Citi Holdings was a means to segregate questionable assets as a prelude to spinning off Citi Holdings into a separate company.

In its drive to raise capital, Citi has sold elements that its former executives, Sandy Weill and John Reed, had cobbled together in an ill-fated effort to build the world's foremost “financial supermarket.” Some of the larger and more recent sales have included the June, 2011 sale to Axa Private Equity, the December, 2011 sale of Credit Mutuel Nord Europe, and in 2009 Citi sold much of its Japanese brokerage holdings to Sumimoto Mitsui Financial Group (NYSE:SMFG). Citi consistently justified these and other sales under the idea of reducing non-core holdings.

As with any business as large and complicated as Citi's, there are bright points. Citi's improved capital position, such as its 8.5% ratio of shareholders equity to total assets, is at its highest point in the past ten years. Its book value per share of $56 per share is nearly double Citi's recent trading range. Its core foreign markets are growing. Of course, it has a boatload of tax loss credits to carry forward. Lee Ainslee and John Paulson have positions. But Citi's core domestic business is shrinking, as the bank's North American consumer loan portfolio fell 9% in the third quarter of 2011 from the year earlier.

I do not doubt that some day, Citi will emerge as a smaller, focused, but still powerful New York bank. But that day is years away, and in the meantime, you might enjoy the stability, growth and income that banks like Wells Fargo & Company (NYSE:WFC) and U.S. Bancorp (NYSE:USB) can provide, which I've written about in detail previously.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.