This serves as the kick-off article in a series I'm writing analyzing the risk/reward profile of large-cap U.S. bank stocks. I've built forecast models for each bank, which take a unique approach to estimating the stock's expected average value and potential downside risk over time. Based on my analysis, long-term holders should own Citigroup (C) for a 20% expected base-case IRR. Additionally, my expected downside IRR is only -1% for investors with a 3-year or greater holding period. This return profile beats Bank of America (BAC), JP Morgan Chase (JPM), Wells Fargo (WFC), and US Bancorp (USB).
This article is broken up into the following sections:
- Sensitivity Analysis
- Bottom Line
RESULTS--Very Compelling Risk/Reward Profile For Citi
The table below shows my risk/reward ratio (i.e. base-case IRR over downside IRR) and my expected Price-to-Tier-1-Common ratio (P/T1C), stock price, & IRR in my base-case and downside scenarios. So for example, if your holding period is 3 years, I'm forecasting that the stock will trade at 0.85x Tier 1 Common Equity (or $44), which including expected dividends, produces a 21% IRR. I'm also forecasting that roughly 10% of the time, the stock will trade below 0.46x Tier 1 Common Equity (or $24), which including expected dividends, has a negative IRR of 1%.
While not shown here, I've completed a similar analysis for the 4 other large U.S. banks (BAC, JPM, WFC, & USB) and I believe Citi offers the best combination of upside with downside protection. Stay tuned for additional articles on each of these banks.
METHODOLOGY--A Unique Approach To Analyzing The Big Banks
I've built a reasonably simple model (available for free download HERE), which forecasts Tier 1 Common Equity Per Share (T1C/shr) as defined under Basel I. I arrive at my T1C/share estimate by projecting a Return on Tier 1 Common Equity (ROT1C), which helps me estimate net income. I then make a few more assumptions around DTA utilization, dividends, buybacks, and share count growth to project year-end T1C/shr. My forecasts are shown below:
I then estimate the stock's value using a range of Price-to-Tier-1-Common Equity Ratios (P/T1C). By multiplying my T1C/shr estimate by a P/T1C ratio, I can generate an estimated price for the stock. Since I don't know what the *right* P/T1C ratio is, I've layered on a probability distribution for each P/T1C ratio across different time periods. One general assumption I have made, is that over time the base case P/T1C ratio will migrate toward the appropriate P/T1C based on my long-term ROT1C assumption. This is discussed in more detail in the Assumptions section, but for Citi I believe the long-term P/T1C ratio should approach 1.1x. Below, I show my probability distribution assumptions for each period.
To calculate my base-case estimated P/T1C for each period, I multiply my probability assumption by each P/T1C ratio in the range and sum up the results. This creates a weighted average P/T1C for each period, which is my base case assumption. I can do the exact same math to estimate my base-case price. Below I show a table which walks through this math for the 2014 period. Note that I use my 2013 year-end T1C/shr estimate of $47 to calculate my 2-year holding period target price of $38.
Once I have my estimated base-case price, I can add the cumulative dividends I expect to receive over that period ($0.44) to the price and calculate an IRR. As my calculation essentially implies that all dividends are paid at the end of the period, it understates the true IRR. Below, I show the IRR calculation for my base-case assumption in 2014 (2-year holding period).
IRR = [(Pricet+n + Cumulative Dividends) / Pricet+0] ^ (1/n) - 1
- Pricet+n = $38
- Cumulative Dividends = $0.44
- Pricet+0 = $26
- n (holding period) = 2yrs
IRR = 22% in my base case scenario w/ a 2-year holding period
To calculate my downside scenario, I again use my probability distribution graph. With this graph I can estimate the bottom 10% P/T1C ratio. For Citi in 2014, my downside scenario estimates a P/T1C ratio of 0.44x. Said another way, 10% of the time, I expect my P/T1C to be equal to or worse than 0.44x in 2014 (after a 2-year holding period). This analysis is somewhat similar to a VaR calculation in that it doesn't estimate the max downside, but the expected loss at a given probability. Below, I attempt to show where that downside scenario falls on my 2014 probability distribution graph for Citi.
Now on to my actual forecast model. To forecast Tier 1 Common Equity growth, my model essentially starts with 2011 year-end Tier 1 Common Equity and then grows it each year as follows:
Beginning of Period (BOP) T1C
- Add net income
- Add disallowed Deferred Tax Asset (DTA) utilization
- Subtract dividends
- Subtract buybacks
End of Period (EOP) T1C
Additionally, I also forecast the average number of diluted shares in each period. I assume that shares have a natural growth to them of 1.5% from the firm issuing shares to employees but that this growth is offset by buybacks.
I discuss the assumptions embedded in my forecast model in more detail in the next section.
ASSUMPTIONS--Try To Be Conservative In My Forecasts
My analysis relies on many, many assumptions and while I've tried to be conservative in making these assumptions, some readers will disagree with my inputs. For this reason, I've made my model available to anyone who wants to do their own analysis and stress the model or look at how less conservative assumptions affect the outcome. Below, I walk through the biggest drivers of my model.
To forecast Net Income in 2012-2014, I start with the street's GAAP EPS estimates from Thomson Reuters of $3.91, $4.63, and $5.09, respectively. I then layer on additional losses of $2.5b, $2.0b, and $1.5b, respectively. These additional losses help compensate for my view that the street tends to be overly optimistic and layers in a bit of good old fashion conservatism. For 2015-2020, I forecast a Return of Tier 1 Common Equity (ROT1C) for each year, which I cap at 10.25% in 2020.
To arrive at my 10.25% long-term sustainable ROT1C, I use history as my guide and perform a modified DuPont Analysis. I look at the last 10yrs of data unmodified (i.e. I leave the 2008-2009 financials losses in without making any adjustments). This assumption essentially assumes that a traditional credit cycle tends to include a crash like we saw in 2008, a reasonably conservative assumption, but not insane considering we have Europe hanging over our heads. My modified DuPont Equation is as follows:
ROT1C = Profit Margin x Asset Turnover / Regulatory Capital
- Profit Margin = Net Income / Revenue (pre-provisions)
- Asset Turnover = Revenue (Pre-provisions) / RWA1
- Regulatory Capital = Tier 1 Common Equity / RWA1
1 RWA = Risk-weighted Assets as defined under Basel 1
In the table below, I show the historical average, one standard deviation up & down, and median for the full history and the last 4 quarters for each component of my DuPont analysis. The full data series is available as part of the model and was constructed using both CapIQ & Bloomberg data.
Using this table as my historical guide, I then make estimates for what each of these components can be going forward taking into account the many, many regulatory changes that are being implemented across the industry. The biggest change I'm forecasting is that regulatory capital will need to increase almost 50% above the 10yr historical average. Below I show my estimates and my forecast ROT1C based on these estimates.
Long-term Appropriate P/T1C Ratio
Next using the dividend discount model and making a few adjustments I can back into the appropriate P/T1C given an assumed payout ratio, discount rate, and ROT1C. The math works as follows:
Dividend Discount Model: Price = Dividendt+1 / (requity - g)
- where g = ROT1C x (1 - PayOut)
- where Dividendt+1 = Dividendt+0 x (1 + g)
- where Dividendt+0 = T1C x ROT1C x PayOut
P/T1C = ROT1C x PayOut x (1 + g) / (requity - g)
Making the following assumptions:
- PayOut Ratio = 60% (includes both dividends & buybacks)
- Discount rate = 10% (my standard hurdle rate)
- ROT1C = 10.25% as calculated above
Plugging in the assumptions above to my equation, I arrive at a P/T1C ratio 1.09x. In my analysis, I forecast that by 2019, Citi should trade right around that level in my base-case.
Deferred Tax Asset Utilization
I have assumed the firm is able to utilize between $4b to $8b per year of its $41b of disallowed DTA. Citi has $52b of DTAs sitting on its balance sheet, but for regulatory purposes the DTA component of Tier 1 Common Equity can not exceed 10%. This essentially excludes approximately $41b from the firm's T1C calculation. However, as the firm generates positive net income it can offset some of its tax expense by utilizing its DTA. This essentially has the effect of allowing T1C to grow at a faster rate than would be expected by net income alone.
I have assumed that the firm pays only a token $0.01/quarter dividend during 2012, but that the firm gets regulatory approval to pay additional dividends in 2013. I then assume that the firm will increase its dividend eventually targeting a 30% payout ratio. My dividend assumptions and payout ratios are shown below.
I have assumed the firm makes no stock buybacks in 2012, but begins repurchasing shares in 2013 once it has received regulatory approval to do so. I then assume the firm implements a regular share buyback program. My buyback assumptions and buyback payout assumptions are shown below.
Probability Distributions for P/T1C Ratios
As I discussed above, I've made a series of assumptions around the likelihood of each P/T1C ratio being the correct future ratio. I generally assumed that the weighted average P/T1C would migrate toward the appropriate long-term P/T1C of 1.1x that I calculated using the dividend discount model above. This of course may not happen, but feel free to change my probability distributions as you see fit.
SENSITIVITY ANALYSIS--Understanding The Biggest Drivers
Bottom 5% Expected Returns
In the table below, I update my return analysis looking at the bottom 5% of expected returns (my previous downside scenario was the bottom 10%). This provides some perspective on what kind of returns investors should expect if things really get ugly.
3x Larger Additional Losses in 2012-2014
In the table below, I show how my returns are affected if I triple my additional losses for each of the next three years. In this scenario, I'm forecasting additional losses in 2012-2014 of $7.5b, $6.0b, and $4.5b, respectively (vs $2.5b, $2.0b, and $1.5b previously). Again, my loss estimates are deducted from the street consensus estimates. My average base-case IRR over all time periods falls to 16% (vs 20% previously).
Lower Terminal ROT1C Estimate to 8% (vs 10.25% Currently)
In the table below, I show my updated return profile if I cap my ROT1C at 8% (vs 10.25% previously). I have updated by P/T1C distribution tables by shifting my probabilities 0.2x to the left. This essentially targets a long-term P/T1C of 0.9x, which is roughly what you'd expect the multiple to be if the ROT1C drops. My average base-case IRR over all time periods falls to 9% (vs 20% previously). While this is a significantly lower IRR, investors with a long-term time horizon can still expect a double-digit return and relatively limited downside.
Eliminate the Benefit From DTA Utilization
In the table below, I show what the return profile would look like if I entirely eliminated the benefit I anticipate the firm will get from utilizing its deferred tax assets. My average base-case IRR over all time periods falls to 16% (vs 20% previously).
BOTTOM LINE--Buy Citi Stock
Citi offers a very compelling risk/reward for investors with a longer-term time horizon (3years +). Based on my analysis, the stock currently offers a 20% IRR in my base-case scenario and the downside risk appears relatively limited. In my view, Citi is the most compelling investment within the large-cap bank space.
Again, I intend to make this article the first in a series analyzing each of the five largest U.S. banks. As always, your comments and questions are appreciated. And thanks for making it through such a LONG article, sorry about that!
Additional disclosure: I have previously written two articles recommending BAC, but I now find Citi to be the more compelling investment opportunity.