March 13, 2012, is a date that will live in infamy for Citigroup (C) shareholders. That was the day the Federal Reserve rejected Citi's 2012 capital plan that would have returned meaningful capital to shareholders for the first time since the dividend was discontinued in early 2009. This news was particularly painful for CEO Vikram Pandit, I'm quite sure, as he spent most of 2011 telling anyone who would listen that 2012 would be the year Citi began to return capital to shareholders. Citi thought it could start to pay a meaningful dividend and buy back stock (likely a few billion in total) while still growing its estimated Basel III Tier 1 common ratio to at least 8% by the end of 2012.
Well, the Fed did not agree with this assessment. Under the stress test that estimated the effects of a severe economic slump, Citigroup's projected Tier 1 common capital ratio fell to 4.9%, just below the central bank's minimum requirement to past the test of 5%. Of course, we do not know exactly how the Fed performed this test. Nor do we know how the Fed characterized the potential losses on overseas assets, which generate approximately 50% of revenues. We also do not know how much capital (and in what form) Citi asked to return to shareholders. Regardless, it is time to move forward, with 2013 being Citi's year to shine.
Operationally, Citigroup has performed remarkably well. I say that with some caution because we as shareholders really do not know what is in Citi's loan book, or any bank's loan book for that matter. The mortgages in Citi Holdings (the segregated assets that Citi would like to sell or wind down) may be worth absolutely nothing, in which case Citi would be severely under-provisioning for those losses. But we have to take management at its word (which I think is good) and buy into what they are telling us.
What they are telling us is that credit quality has improved (which, of course, fits in with what the entire banking sector is saying), deposits are growing, capital markets and transaction services are performing well, and that the company is flush with liquidity. Earnings have been steady for the past two-and-a-half years at roughly $10 billion to $11 billion per year. Those earnings have increased tangible book value to $51.82 as of June 30, 2012, up from $41.91 just two years earlier (see 10-Q dated June 30, 2012). The company has tremendous liquidity, with $34 billion in cash as of June 30, 2012, and $1 trillion in short-term investments. The low-cost deposit base has been growing, enabling Citi to repay $11.9 billion in debt last month, which will save it north of $650 million a year in interest expense (assuming a 5.5% average borrowing rate). So why has the stock been an awful performer?
Click to enlarge image.
We know all the large money center banks are trading well below their historical book value multiples. The low interest rate environment, the European debt crisis, and uncertainties surrounding litigation and regulation (along with company-specific issues) are all contributing to these stocks trading below their historical multiples. But why is Citigroup trading at a valuation well below the other money center banks?
Bank of America
(Data as of Sept. 17, 2012.)
Certainly Citigroup deserves to be trading at a higher valuation than Bank of America. BofA has so many more issues than Citi, which I won't get into here, but I cannot imagine BofA is likely to return significant capital to shareholders in 2013. If the Fed didn't let Citi in 2012 and BofA didn't even ask for it, I cannot imagine the Fed would allow it in 2013 for BofA.
So why doesn't Citigroup trade closer to JPMorgan's or even Wells Fargo's valuation? The first reason is a big one and there is no easy fix. Neither JPM nor Wells were on the brink of failure during the credit crisis of 2008. Even though Citi has all new management, paid back all of TARP (with interest), and has worked hard to change its culture (and succeeded I believe), it still suffers from the stigma of all those problems of the past. That will take years of continued solid operational performance to overcome. The past two-and-a-half years have been solid for Citi, but it will need to string together several more "uneventful" years for it to be mentioned in the same breath as Wells Fargo.
Also, Citi does not pay a dividend -- not a meaningful one, anyway. The traditional investors in financials are there, in large part, because of the steady dividend yields. An investor looking for a decent 2%-4% yield certainly is not going to buy Citi; he or she will buy JPM, Wells, or one of the super regionals. This should hopefully change come March 2013 when Citi should be given permission to pay its first meaningful dividend since 2008. Citi is very well capitalized, profitable, and extremely liquid. It should be able to request and receive a 2%-plus dividend yield (based on the current stock price) when it submit its 2013 capital plan to the Federal Reserve in January.
The other option for returning capital to shareholders is, of course, to buy back stock. Certainly, this is an attractive option considering that the stock is trading so far below tangible book value. However, I would caution Citi that doing so will add little to shareholder value, and here's why:
The company would probably be permitted to repurchase $2 billion to $3 billion in shares in 2013. At the current market cap of $100 billion, it could buy back 2%-3% of the outstanding shares. While this would boost EPS and tangible book value per share slightly, it will not help increase the price/tangible book value multiple in a meaningful way.
I believe that a much better use of capital at this point in time is to sizably up the dividend and not buy back any meaningful amount of stock. Paying a 2% dividend could get the price/tangible book value multiple up to a more respectable 1.0 times, boosting the stock price to ~$50/share, which would be a 45% increase from the current stock price of $34.40. This is why I would focus on upping the dividend for the next couple of years and not be concerned with buying back meaningful amounts of stock. Citi shareholders have suffered from a low valuation for long enough. It is time to put some cash back in stockholders' pockets and boost the stock price while doing so.
Disclosure: I am long C.