How To Play The Recovery With Citigroup

| About: Citigroup Inc. (C)

The US financial industry has recovered nicely since the shenanigans of 2008-2009. Even so, there is much skepticism in regards to banking stocks, and as a result banks are still undervalued. One of the best opportunities in this sector is Citigroup (NYSE:C). Citigroup's current share price can be somewhat misleading, considering the 10-for-1 reverse split the stock undertook on May 9, 2011. To put the effect of the reverse split in perspective, Citigroup hit an all-time high of $570.00 (reverse-split-adjusted) in December 2006. The reverse-split-adjusted all-time low of $9.70 was reached in March 2009, and everyone thought the company was good as dead. The stock has rebounded since to the mid-30's, however this does not fairly value the company given how well its has been doing the past few years.

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This is somewhat misleading; the company is actually worth closer to what it was pre-crisis (in terms of market capitalization) than the share price would indicate. Citigroup suffered massive dilution is the wake of the bailouts and relief programs they took part in 2008 and 2009. First, in October 2008, Citigroup raised $25 billion in financing from the TARP program, then an additional $20 billion bailout in December.

However, Citigroup was quick to repay the government in both stock and cash. In February 2009, Citigroup converted $25 billion of preferred shares held by the government to common shares at a PPS of $3.25 ($32.50 in post reverse-split terms). In December 2009, Citigroup raised $20.5 billion in two separate offerings in order to repay the government's $20 billion stake that resulted from the TARP program. At the end of the day, existing shareholders' ownership stakes were diluted down to 26% of what they once were, but the company regained its independence, canceling its loss-sharing agreement with the government in the process of repayment.

In March 2011, with almost 30 billion shares outstanding as a result of the dilution, Citigroup thought it would be a good idea to do a 10-for-1 reverse split. At the same time, they decided to reinstate a quarterly dividend of one cent per share. Citigroup anticipates raising the dividend and beginning share buybacks in 2013 and beyond to enhance shareholder value.

Citigroup currently trades at 8.8 times 2012 projected earnings of $3.80 per share. When you factor in the fact that analysts expect the company to grow their EPS at a 12% rate for the next 3 years, this sounds like an absolute bargain. Of course, the risk involved with the financial sector justifies a discount to historical P/E multiples. However, with positive factors such as a strengthening real estate market, stabilizing credit market, and a winding down of outstanding distressed assets, this multiple is warranted, if not a bit too low. For instance, if real estate values were to recover, consumers would have more home equity to potentially access, hence more bank loans and more profits for banks. If the credit markets loosen up at bit, more prospective homeowners will be able to qualify for mortgages and other loans, and again, more profits for the bank.

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The above chart shows how Citi's P/E multiple has gone from a high of 22.7 times TTM earnings, down to around a -20 multiple, up to the level it is currently at. Now, I don't think Citi will be trading at a 20+ multiple again anytime soon, however as the economy continues to recover, the multiple will increase to around the historical value of 15-17 times earnings.

Assuming that the stock only trades at the 8.8 multiple for the next few years, let's see what that will do to the PPS if the analysts are correct. Analysts expect Citi to earn $4.53 in 2013 and $5.06 per share in 2014. This translates to a target price of $39.83 in early 2014, and $44.52 in early 2015, which would be a 32.2% upside from the current price. However, I think these targets are very low because of the earnings multiple they are based on, as discussed earlier. Being conservative with my estimates and my trading strategy, I want to play Citi with a long term call spread. Unlike during most of Citi's history, an investor won't miss out on a significant dividend by owning options instead of the stock, which is a popular argument against the strategy.

I would make a play for Citi using my 1-year price target of $39.83. Too much uncertainty is involved beyond that time frame. I want to buy the January 2014 $35 calls for $5.20 and sell the $40 calls of the same expiration for $3.30, a net debit of $1.90. This spread would be worth $4.83 at expiration if my target is accurate, so that would be a gain of $2.93, or 154% in a 16-month period. I prefer this to owning the stock right now because of the favorable risk/reward ratio it creates.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.