Citigroup's Normalization Period Coming with 65% Upside on Back-End

It has been 7 years since 2008 financial crisis, which left global banking system in ruins. Many asset classes have reached new highs since then, however banking sector remains undervalued.

Banks have historically linked Wall Street with Main Street. The relative performance of bank stocks, currently close to 75-year price relative lows,…” ML reckons this is because: “the transmission mechanism from policy to people is either broken or working extremely slowly this decade.”

I think the real reasons are a lot more mundane than Mr. Hartnett of the big bull stipulates. They are listed below.

Fair book value is hard to estimate
Book value requires adjustments for fair value, which can revise it up or down. Citibank Research recently adjusted to fair value books of 38 European banks, which resulted in revisions from -128% to +95%. (Source link: http://ftalphaville.ft.com/files/2014/06/Citi_fairvalue.png)

Restrictions on return of capital
Being constrained to adhere to specific regulatory capital requirement, banks were unable to return capital to shareholders and were forced to restrict dividends.

Low interest rate environment.
Systematically distorted ultra-low interest rate environment has put pressure on NIMs (net interest margins) which are now at a 20-year low of 3.11% in Q4 2014 in the US.

Endless waves of scandals and litigations
Here is an extract from Bloomberg article dated August 2013: “(Bloomberg) -- The six biggest U.S. banks, led by JPMorgan Chase & Co. and Bank of America Corp., have piled up $103 billion in legal costs since the financial crisis, more than all dividends paid to shareholders in the past five years.”

Loss of focus.
Many banks have wandered off their traditional credit creation paths into various business areas ranging from CLN underwriting to exotic proprietary trading strategies.

We believe that issues discussed above are subsiding there is a high potential for relative value mean reversion to historical averages vs other sectors. Further tailwinds are coming from gradual reduction in legal expenses, NIM expansion and subsequent earning normalization followed by increased return of capital to shareholders.

Corsus Capital is long Citigroup
To find our investment we have used various screeners based on parameters such as P/E, P/TBV, CET1, PB, efficiency ratio, DTA schedule etc. to identify a company that is not only trading at a significant discount to peers but also has a significant potential for re-rating. Such company is Citigroup (ticker: C). A Cherry on our pie is an attractive way to take advantage of this opportunity through warrants.

Overview
Citigroup has approximately 200m customers and does business in 160 countries. (Source: Ctitbank web site). It derives up to 50% of revenue from abroad. Its international diversification provides a natural hedge from FX fluctuations. 25% of revenue is fee based (Source: Reuters) whilst the rest comes from net interest.

Citigroup consists of 3+ main divisions: Global Consumer Banking (GSB), Institutional Clients Group (ICG) and Corporate/Other. The plus is Citi Holdings, a legacy ring fence structure, which contains various assets form the 2008 fallout, as well as non-core businesses Citigroup is looking to spin out. By creating Citi Holdings C makes it very easy to price the most volatile and hard to value assets on the balance sheet. For the sake of margin of safety, we assign them a value of 0.

Citigroup is cheap relative to peers
C is attractively valued vs peers based on forward valuation. At 9.6x times FW P/E and at 0.7x P/BV it is one of the cheapest banks out there.

Looking back Citigroup was not very profitable
At 0.4% ROA C demonstrated one of the worst profitability levels amongst US large cap banks.

Citigroup was cheap for a reason but its problems are fading away revealing an underlying business value which is much higher than market currently anticipates.

Recent stress test results dividends and buyback
After failing miserably in 2013 and failing on qualitative measures in 2014 Citigroup has passed FRB stress test with flying colours in 2015. Basel III CET1 capital ratio stood at 10.6%. US liquidity coverage ratio was 112%. (source Citigroup) This has allowed Citigroup to hike its dividends from the nominal 1 cent per quarter to 5 cents, a dividend yield of 0.38% based on C price as of close on 23/03/2015. This represents only 4% pay-out ratio so there is potential for further increase.

Ongoing Share Buyback
Citigroup currently has $7.8bn of ammunition to buy back its own shares and at current valuation, it should. At Q4 14 share count, this equates to $2.5 per share or 4.8% of share price as of 23/03/2015.

EPS Revision
2014 was a tough year for Citigroup, it has incurred $9.3bn of litigation costs and further $1.9bn in repositioning costs, which together represent about 14.54% of revenue. We assume that these costs are non-recurring and in 2015 Citigroup will revert to a more reasonable 250bps (management is guiding for 200bps) level of legal and repositioning costs.

We assume that Citicorp division will remain flat for the year and we expect GCB will increase its revenue by 2-3%, in line with peers and GDP growth. We assume that Citi Holding will simply break even in 2015. Adjusted for one off legal and repositioning costs 2014 ROA would have been around 80bps, Management is guiding for 90bps ROA, which looks achievable. Factoring those assumptions in our model gives us an estimate 2015 EPS of $5.4 per share.

Citigroup trades at a discount to book value net of “toxic” asset
Current book value per common share for C is equal to $66.16 (2014 10-K) which implies a 21% discount to closing price as of 23/03/2015 of 52.48.

Now in its 10K Citigroup provides TBV per common share as $56.83, which excludes MSRs. We would argue that such exclusion is fair since MSRs can be traded in the open market and actually have an estimated value based on their discounted revenue stream and can in fact be placed in the tangible assets section. This gives us a NTBV discount of 7.7% to market price of 52.48.

C has disposed of 84% of Citi Holding assets, which now comprise only $98bn or 5% of total assets. Since the value of those assets can be questioned we subtract it from the Book value discounts, arriving at 16% discount to BV and 1.7% discount to TBV.

Citigroup will benefit from positive momentum from interest rates increase
In case of interest rate hike there will be two main forces acting in opposite directions on bank’s profitability. As interest rates rise book value goes down, however that impact is more than offset by NIM expansion and resulting increase in earnings. This is particularly beneficial for Citigroup since is about 75% of revenue comes from Net interest payments whilst fees are only about 25%. A 100bps parallel shift in the earnings curve will result in additional net effect of $0.4 of EPS per share. We assume that fed will start hiking rates in July and will hike up to 50bps toward the year-end, so we take ¼ of $0.40 EPS increase for 2015.

SOTP

SOTP
EPS 5.4
Buyback 2.5
Interest Rate Rise 50 bps by 2015 end 0.10
NTBVPS, excluding Citi Holdings 54.0
Total: 62.0
Share Price Close 23/03/2015 52.5
Implied Upside Year End 2015: 18%
Assuming C will be trading in line with its TBV per share without Citi Holdings, we get an 18% upside just for 2015.

Looking 5 years out, assuming an 8% WACC, 2% organic EPS growth, gradual 1% per year interest rate hike until 3.5% in 2018, we will get additional earnings NPV of $21.7 by 2020. Which gives us a target price of $62+$21.7=$83.7, a 60% upside.

Now in the good old days it was not uncommon for a bank to trade at 2x its tangible book value per share. We assume that 1.5TBV per share is possible in 3 years. This gives us target price of $165 or CAGR of 46.5% over the next 3 years.

Whilst $165 per share scenario is very much possible in 3-years’ time, we believe medium case of $90.5 per share is achievable on a 12-18 month horizon.

Warrant Optionality
Like many other banks, C has outstanding TARP warrants. First one has a strike price of $178.5 and matures in 2018. At a price of $2.5 per share, it does not intrigue us much from a risk/return point of view.

Second warrant has a strike price of $106.1 and expires on the 04th of January 2019. It currently trades at $7.3 per share, implying a breakeven strike price of $113.4. At our 3-year target price of $170 you would be able to earn $57 USD per warrant implying almost a 7 fold return on investment.

Follow the leaders
C has some prominent investors on its shareholder list including Omega Advisors, Citadel and Baupost Group.