In an earlier article here, I argued that Citigroup (C) was substantially undervalued. Since then, the stock has surged by 14.2% - more than doubling the return of the S&P 500. Even though the Street rates the company a weak "buy" and substantially reduced expectations, Citigroup, in my view, still has a long way to rise. Capital One (COF), which differs with its focus on credit cards and consumer banking, is also an attractive financial, but comes with greater downside.
From a multiples perspective, both companies are cheap. Capital one trades at a respective 6x and 7.7x past and forward earnings while Citigroup trades at a respective 8.1x and 6.9x apart and forward earnings. Even though Citigroup has higher volatility with a beta of 2.6, management has been quite successful in de-risking the business. With American Express (AXP) having a beta of 1.8 - roughly in line with that of Capital One - Citigroup will consequentially benefit from higher risk-adjusted returns.
At the fourth quarter earnings call, Citigroup's CEO, Vikram Pandit, noted poor results due to a challenging global economy and how the company is addressing the situation:
"As you know, earlier today, we reported earnings of $1.2 billion in net income for the fourth quarter of 2011. This increased our net income for the year to $11.3 billion, up 6% from 2010.
The fourth quarter was dominated by the macro environment, and our earnings clearly suffered as a result. Market activity was down significantly and our clients reduced their risk. Any of our businesses geared to the capital markets, such as sales and trading, Securities and Fund Services and GTS and even investment sales and consumer banking were impacted.
Investor activity was particularly weak in December as reflected in the volumes we experienced. In light of the macro environment, we have been quite cautious. The situation in Europe is being driven by politics as much as anything else. And given its inherent unpredictability, we have prudently derisked and hedged our exposures, actions which have further impacted our revenues".
The important part here concerns how the company has "hedged [its] exposures". Charge-offs fell 9% sequentially while the Tier 1 Common Ratio rose by 10 bps. This greater liquidity offers a better floor on the impact of continued underperformance. Net interest margins rose by 7% q-o-q while average loans were flat. As I anticipated earlier, FICC trading was weak, dropping 24% q-o-q on top of a soft preceding quarter. The fourth quarter was overall weak at an EPS of $0.38 largely due to poor cost containment and a 11% y-o-y decline in revenue. Nevertheless, Citi trades well below book value despite strong growth and management expects a $3B reduction in costs in 2012.
Consensus estimates for Citigroup's EPS forecast that it will grow by 10.6% to $4.08 in 2012 and then by 15.7% and 9.5% more in the following two years. Of the 23 revisions to EPS, all have gone down for a net change of -6.5%. Assuming a multiple of 9x and a conservative 2013 EPS of $4.65, the rough intrinsic value of the stock is $41.85, implying 41.2% upside. If the multiple declines to 6x and 2013 EPS turns out to be 5.8% below consensus, the stock would fall by 10.1%.
Capital One similarly - and not surprisingly - has issues of its own. Losses and delinquency results continued to disappoint in November. US Card looses grew 9% to $193 while delinquencies grew 2%. ROE is further anticipated to decline by 150 bps to 9.5% in 2013. Even still, the US credit card business grew to $54.8B in November while the company maintained strong credit quality. Capital One has further fared well in the shadow of the onerous CARD Act.
Consensus estimates for Capital One's EPS forecast that it will fall by 11.5% to $6.02 in 2012 and then grow by 14.8% and 22.6% over the next two years. Assuming a multiple of 9x and a conservative 2013 EPS of $6.73, the rough intrinsic value of the stock is $60.57, implying 31.6% upside. If the multiple holds steady and 2012 EPS turns out to be 7.7% below consensus, the stoke would fall by 16.8%. Analysts have historically been 11% high on estimates, so the latter scenario should be weighed. Even still, the reward more than justifies taking on the risk.