Since the onset of the financial crisis in 2008, few companies have been as polarizing as Citigroup (NYSE:C). Fortunes have been lost on the stock for large institutional investors as well as the average investor, and the trauma of seeing one of the largest banks in the world on the brink in 2008-2009 doesn't engender much confidence for the average investor who has difficulty separating past performance from future expectations. Today's day-trader mentality creates a paradox where most analysts believe that Citigroup is substantially undervalued, but few investors are willing to bet on the stock on the belief that over the short term it might decline.
Most bearish arguments for Citigroup revolve around some type of conspiracy theory concerning accounting, or a misstatement of facts regarding its rejected capital plan in the Comprehensive Capital Analysis and Review. To quickly answer these arguments it is important to realize that no company other than AIG (AIG) perhaps (here) faces more rigorous scrutiny from regulators with regard to its accounting and financial condition, so it is extremely likely that concerns over its accounting are misplaced. With a loan loss reserve ratio of 4.5% and with just about every credit metric improving quarter-over-quarter for the last two years, the concerns about Citi's financial condition could not be more off base. Citigroup actually held up quite well in the draconian CCAR, but the reason that they failed the hypothetical test was due to too demanding of dividend and buyback plans.
The value proposition for Citigroup is simple and I'd suggest buying the stock aggressively at current prices. Despite elevated loan losses, egregiously high legal expenses, and lackluster economic growth, Citigroup is likely to earn between $12- 13 billion in 2012. With a market cap just under $100 billion Citigroup has an earnings yield of between 12-13%. These trough earnings are likely to rise significantly as the company continues to wind down Citi Holdings, and as regulatory and legal expenses normalize.
Citigroup's first quarter earnings came out quite strong at $3 billion or 95 cents a share. This number understates actual earnings as the CVA/DVA which has no actual economic impact for Citigroup, weighed down earnings by $1.3 billion, and the company had about $500MM in one-time gains, which combined resulted in a net $811MM hit to earnings. Even more clarity can be found from looking at the performance of Citicorp (ex CVA/DVA) which posted net income of $5.1 billion for the quarter. Revenue was up 6% year-over-year while expenses were only up 1% respectively, meaning the core business is gaining operating leverage. Excitingly, Citicorp's loans grew 12% with consumer up 7% and corporate loans up 23%. These numbers are important because they give the investor an idea of the ongoing earnings power of the company. Citi Holdings continues to weigh down profits resulting in a net loss (ex CVA/DVA) of $1 billion for the quarter. Thankfully, Citi Holdings has been wound down to now representing only 11% of Citigroup's total assets so this albatross of losses should be coming to an end over the next couple of years.
While Citigroup's stock has been punished over the last year, business performance has been solid as tangible book value (TBV) has risen from $40.90 per share in the first quarter of 2010 to $50.90 per share in the first quarter of 2012, resulting in a 24.45% gain over a two year period. Tangible book value is the best proxy for liquidation value for most financial companies, and it likely understates the value of Citigroup by its omission of goodwill and the franchise value that has developed over the 200 year history of the company. Book value for the company currently sits at $61.90 representing nearly 100% appreciation potential if the stock can make it back to that level, which historically it has traded at a premium to.
We believe that Citigroup should conservatively earn 15% on tangible book value in a more normal economic environment, which would mean normalized earnings per share should be $7-8. This puts the normalized P/E at less than 5 given the current valuation which makes absolutely no sense if one believes that business value should equal stock value. The bank's Tier 1 Common Ratio stands strongly at 12.4% and the Total Capital Ratio is 17.6%.
Citigroup has some of the most exciting growth prospects of the large U.S. banks because 25% of consumer banking revenue comes from high margin emerging markets, and its diversified geographic footprint allows the company to allocate capital according to the best risk adjusted return areas. If its Latin American or Asian operations were spun off it is very likely that they would trade a substantial premium to book value to account for strong growth prospects in their respective regions. Citi's investment bank might not be as strong as that of JPMorgan (JPM) or Goldman Sachs (GS), but it is a solid competitor in a shrunken industry, and no bank in the world matches the overall geographic presence of Citigroup.
Citigroup's exposure to peripheral Europe is very manageable with net current funded exposure to the GIIPS of $9.1 billion. European banks woes should really be a boon for Citigroup as the deleveraging process opens up attractive lending and loan portfolio acquisition opportunities, ultimately resulting in strengthening relationships with core European clients. Citigroup's transactions business is underappreciated and they should be able to gain market share as other companies pull back from attractive businesses such as trade finance.
I'd like to see Citigroup get stronger in its North American banking structure by putting a greater emphasis on cross selling its wide breadth of products. There is no need to reinvent the wheel and I believe that the Wells Fargo (WFC) model of maximizing fee revenue and net interest margins provides the least risky opportunity to grow consumer banking revenues, and I'd like to see Citigroup have an inspired management team focus on improving in that area.
While downside seems very low for the investor with a reasonable time frame due to the significant discount to tangible book value at which the stock can be acquired at, huge upside could arise through prudent capital management moving forward. As Citigroup revises its capital plan pursuant to the requirements of the CCAR, the company should be announcing a smaller stock buyback which will be enormously accretive at these levels. Every dollar that's available should go to share buybacks as opposed to dividends until the company trades at tangible book value and buying dollars for 60 cents will only cause TBV to grow. Future profits not only increase the capital base through adding retained earnings but it also allows for the monetization of Citigroup's deferred tax assets. The realization of these assets will benefit the company from a regulatory capital perspective, allowing Citi to better utilize its enormous balance sheet and liquidity.
Vikram Pandit has done a good job with the company under really difficult conditions but I think more communication in terms of the capital strategy would be very helpful, and it is important for the company to really identify what it needs to do to be a better competitor in North American consumer banking. Improving business conditions and a more attractive valuation make Citigroup one of our two or three most compelling long term investment opportunities, so we'd suggest not waiting too long to get in as the opportunity might just pass you by.
