Citigroup Offers Attractive Risk-Reward Opportunity

I recently took a position in Citigroup (NYSE:C). I think the stock has the potential to double or triple over the next three to five years with relatively little risk of permanent loss of capital from current levels. The stock was hammered by bad judgment and poor risk management. Prior shareholders were massively diluted. The bank now appears to be moving past the crisis and is well-financed. Its new management is focused on capitalizing on Citi’s unique strengths.

The Business

Citi is well positioned to capitalize on globalization with its unique global franchise and assets in approximately 140 countries. Under Vikram Pandit’s leadership, the bank is focused on a core strategy of serving affluent, globally-oriented retail customers and multinational corporations. Citi already has a leading position in serving these markets and this strategy exploits Citi’s competitive advantages. This strategy gives Citi large exposure to faster growing markets in Latin America and Asia.

Management

Vikram Pandit is a very smart, high-integrity CEO, who is driven to “right the ship” and put his mark on Citigroup. He was hand-picked by Robert Rubin, who, notwithstanding criticism for his prior role at Citi, has been around a lot of very talented people. Pandit had no part in Citi’s prior leadership regime that led to Citi’s near collapse. In addition, he has been characterized as being prudent with regard to risk, which is obviously an important trait in someone running a large bank. Finally, I like his strategy of focusing the bank on areas where Citi has competitive advantages and shedding non-strategic assets. Pandit is also on record as wanting to begin returning capital to shareholders in 2012.

What is the downside?

The first question to focus on with Citigroup is, “What is the downside?” How do you get comfortable with the Citigroup’s bad loans and what they mean to its intrinsic value?

In my judgment, although the company is still dealing with its credit problems, they have turned the corner, and over the next few years they will work through the bad loans and return to normalized earnings. I look at this as similar to Buffett’s investment in Well Fargo in 1989 and 1990 after the California real estate crisis.

To get comfortable with Wells Fargo, Buffett assumed a worse-case scenario where 10% of its loans would become problematic leading to eventual losses averaging 30% of principal. Buffett concluded that Wells Fargo’s annual pre-tax earnings power was sufficient to “roughly break even” in such a scenario. Buffett wrote that he was happy to invest in a company with Wells Fargo’s economics and valuation, even if he had to face the possibility that the company would generate no earnings for a single year.

Consider the mathematics of Citi’s situation. Citi currently has gross loans of $608 billion. If 15% of those loans were to go bad and all the principal were to be lost – a scenario far more draconian than that envisioned by Buffett (and arguably deservedly so) – it would be a loss of $97 billion. Citi has loan loss reserves of $41 billion, so the net loss would be $56 billion. Citi generated $38 billion of pre-provision, pre-tax income in 2010 so such a meltdown would amount to far less than two years of earnings. Citi’s actual loan loss reserves are less than 7% and it has slowly begun to release reserves as conditions improve.

Here is what Bruce Berkowitz said about getting comfortable with Citigroup in an interview with Morningstar.

In the U.S., this was not a bankruptcy, but it’s gone through a scrubbing process, very similar to a bankruptcy, by the U.S. Treasury. Citigroup has spent a good amount of time with the U.S. government and many of its financial regulators, going through every liability and asset in the books.

After such a period of time, you normally are able to count the cockroaches. That is, the liabilities have been under a microscope for quite a period of time. There’s been huge capital injections by the government. There’s been a massive amount of dilution to old shareholders. And you’re starting to see some stability, the beginnings.

It’s very much what I call now the pig in the python. You have to look at their liabilities. So you have to look at their bad debt, and you have to continue to watch how the company is digesting its bad debt.

At the same time, you have to see the new debt that’s coming in, the new loans that they’re giving out. It’s fascinating. It amazes me, with financial institutions, the extent, the amount of new loans that are being created in relation to the total loan portfolio.

So it’s just now, in my opinion, a question of time, an ingestion period, where how many more quarters is it going to take before the new loans start to outweigh the old, existing loans?

Valuation

Like Buffett, I focus on earnings power when valuing a bank, as opposed to book value. The key driver in a bank’s earnings is normalized return on assets (ROA). Citigroup has a long history of strong returns on assets with normalized ROA. Moreover, Citigroup has reorganized and is now focused on growing its core, higher return franchises, and it is shedding its non-core assets. Pandit’s guidance is for a normalized ROA of 1.25% to 1.5% on Citigroup’s assets, not including the assets that are marked for eventual divestiture or run-off.

I think these levels represent Citi’s normalized earnings power.

In my base case, I assume Citigroup will grow assets at a CAGR of 3% over the next three years and reach a normalized ROA of 1.4%. This puts normalized EPS three years out at about $.80 a share. (This may prove conservative given Citi’s new asset mix and exposure to emerging markets.) At its current price of about $4.90 that is about six times normalized 2014 earnings. In addition, I estimate that the assets in Citi Holdings and Citi’s $21 billion operating deferred tax asset could be worth another two dollars a share, which would drop the multiple to less than four times earnings.

If ROA only reaches 1.2% and the other assets are only worth $1 per share, the current price is still only about 5 1/2 times 2014 earnings.

I believe the current price, strong reserves and liquidity, and the quality of the global franchise provide a margin of safety and that investors are being compensated for the risk involved.

Catalysts

Price moving above $5 per share (economically meaningless, but possibly important to some institutional buyers).  Citi’s institutional ownership is less than 50%, whereas Wells Fargo and US Bancorp’s are 76% and 67%, respectively.

Return of capital to shareholders in 2012

Continued improvement in operating results

Other Positives

Large positions held by high quality value-oriented funds: Pershing Square (Ackman), Fairholme (Berkowitz), Paulson, Appaloosa Management (Tepper), Viking Global Investors (Halvorsen), MFP Investors (Price), and Kingdom Holdings (Alwaleed).

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

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15 thoughts on “Citigroup Offers Attractive Risk-Reward Opportunity

  1. Andrew

    I think you would agree that reading an annual report of a company before you buy it is important. I have tried to read their 10-K, but it is almost impossible to put your mind around it.

    Did you ditch this due diligence in your purchase of Citi?

    I do think that your analysis of the worst case scenario is intellectually honest but I do not think that its possible to get your mind around the assets of Citigroup. Wells Fargo is a much easier beast to conquer as they are very focused on vanilla banking.

    Reply
  2. Greg Speicher Post author

    Andrew, thanks for your comment. I studied C’s 10-K and other disclosures. Citicorp, which is the core strategic business, is very much focused on core vanilla banking. The more opaque (toxic assets) have been put in the Citi Holdings. These risker assets have been dramatically reduced, taken large mark-to-market write-downs and have strong reserves. They are being held until they can be sold at rational prices or until they run-off.

    My thesis largely centers on the Citicorp assets going forward (about 80% of the current assets). At the end of the day, all investments in banks require judgment. Although you are more comfortable with Well Fargo’s loan portfolio, you have no way to look at the individual loans. You are trusting that management has made prudent decisions and has adequate reserves. The key is to have a margin of safety and to be properly paid for the risk taken. There is a fair amount of uncertainty with C, but at the current prices and with the assets it holds, as I said in my write-up, I think the risk of permanent loss of capital is low and the upside good.

    Reply
  3. James Wilton

    Thank you for your blog.

    Regarding the Citigroup idea, if the stock were to triple it would be equal in size to XOM, the largest market cap company. That seems unlikely to me. Have you thought about it in that sense?

    C’s historical market cap peak was around 270B in 2007.

    Reply
  4. Greg Speicher Post author

    James, thanks for your question. Thinking about the limitations of size when making an investment is important. Buffett has often reminded us of the impossibility of growing Berkshire’s earnings in the future at a rate that even comes close to its past rate of growth.

    The key concept here is to always quantify to see if an investment thesis makes sense.

    In the case of Citi, it already has $1.6 trillion of strategic assets (and $400 billion of non-strategic assets that it will divest or let run-off). To achieve $2 trillion in assets is very plausible going forward as it would only require growth of 25% over three to five years. Citi has large exposure to emerging markets which are growing GDP at high single-digit rates.

    If it generated an ROA of 1.5%, that would be $30,000 billion in earnings. At a market multiple of 15, it would sell for $450 billion. By comparison, XOM earned $30 billion in 2010.

    Granted, this is an optimistic case and Citi would not be undervalued at those levels. Nevertheless, I believe it falls within a fairly reasonable range of outcomes – although arguably at the higher end.

    Also, consider that the market cap does not need to triple for the stock to triple. Citi can use capital generated from Citi Holdings and excess cash generated from its deferred tax assets to repurchase shares. These assets may be worth as much as $1-$2 per share.

    Moreover, if Citi proves to have excess capital when the Basel III accord is finalized, it may have additional capital to use to re-purchase shares.

    Reply
  5. tony B.

    What do you think about the Citigroup TARP warrants? Series A expire 1/4/2019 strike at $10.61, currently trades around $1.00 and series B expire 10/28/2018 at strike at $17.85 and currently trades around $0.25.

    Reply
  6. tony B.

    I keep an eye on all the publicly traded TARP warrants but tend to steer clear of bank stocks since there’s easier ways to make money in the stock market without having to figure out if loan impairment/loss provisions are plausible. Nevertheless, if you’re right about Citigroup the warrants will generate a much higher percentage return than the common stock.

    Reply
  7. Jeffery Lane

    Greg, Thanks for your insights. I am reading The Greatest Trade Ever, by Zuckerman. On page 241, the author states that Prince, the former CEO of Citi, received $110 million, an office, an assistant, a car, and a drive. The reason I raise this point is how Buffet handled Saloman Brothers and John Gutfriend by cutting off his financial support and ultimately winning an arbitration decision against Gutfriend.

    I guess what I am getting at is corporate governance. Clearly you believe that Citi has now established good or better governance, but I would like to hear your thoughts, if you are willing to share.

    Reply
    1. Greg Speicher Post author

      Jeffrey, I do believe that Pandit has established better governance at Citi. This is a judgment based on reading numerous transcripts, articles, and watching videos of Pandit.

      He was not part of old guard and is moving Citi back to much more plain vanilla banking. He also has the intellect and credentials (PhD from Columbia in finance) to understand complex financial instruments. You can’t manage what you don’t understand. His reputation at JP Morgan and at his hedge fund was one of prudence. Although he is a wealthy man from selling his hedge fund to Citi, he reduced his pay to $1 in 2009 and 2010. The board recently raised his salary to a relatively modest $1.75 million, which I think is well deserved. Citi earned $10 billion in 2010. These moves may be largely symbolic and you can be sure that Pandit will be well taken care of down the road, but I believe they reveal something about the man’s character.

      As a safeguard, since obviously I am not privy to anything but what is in the public domain, I concur with Bruce Berkowitz in taking comfort that the U.S. government has been all over Citi’s books for the past two years. Every assets and liability has been put under a microscope. The freewheeling gun-slinger days are over (at least for a few years).

      Finally, regarding governance, here is part of Pandit’s testimony before Congress in March 2010. http://www.citigroup.com/citi/press/2010/100304a.htm

      Given Citi’s size and global reach, and its exposure to subprime-related asset classes, the systemic factors at the root of the financial crisis, and their confluence, combined to impact Citi’s financial performance dramatically.

      In response, we have taken responsibility for putting our own house in order. As a result, Citi is now a smaller institution that is focused on being a bank – not a financial supermarket. We are building on our distinctiveness as a global bank where everything is ultimately centered on helping our clients and customers connect with the world and facilitating the flow of capital that we believe is a catalyst to a U.S. economic recovery through manufacturing, exports and trade. And, we have developed a culture of responsible finance, including through a different approach to risk management, asset liability management and risk return.

      First, we have raised capital, sold businesses to generate additional capital and reduced assets. The actions we took in 2009 included exchanging certain preferred securities and trust preferred securities held by the U.S. Government, private investors and public investors for common stock and raising new capital from the public markets in December as part of our agreement to repay TARP. As a result of our actions, Citi’s capital ratios are among the strongest in the financial industry. At the end of 2009, our Tier 1 Common Capital was $104.5 billion, up almost $82 billion from the end of 2008. Our Tier 1 Capital ratio – a key measure of capital strength – was 11.7%, while our Tier 1 Common ratio was 9.6%, up from 2.3% a year earlier.

      Second, we have rebuilt our senior management team. In particular, we have focused on strengthening risk management through regular stress testing and scenario analyses. Our Chief Risk Officer has not only changed the way we look at risk but he has made sure that we have risk managers assigned to oversee businesses, regions, and important product areas. At the same time, our Board of Directors has installed seven new members, all of whom have significant experience in financial services, and our Board has established a separate Risk and Finance Committee, comprised entirely of independent directors, to focus on risk oversight issues. We have also structured our compensation programs to ensure they further incentivize performance that contributes to the long-term success of the company and do not encourage excessive risk taking.

      Reply
  8. Thomas Papapolyzos

    Very nice analysis. Although Citi still faces some challenges, in general I agree with your analysis. Besides its portfolio cleansing efforts, the main bet for C is on the emerging markets opportunities, where it holds a dominant position. Hoping (what a bad and costly word for investors) that the international enviroment and especially China will be ok, the C can double easily within three years. Personally I own C shares, but being a somehow “true believer” in this opportunity, I have also bought C leaps (Jan2013 calls 5.0 strike at 0.98 per contract).

    Thanks for the analysis anyway.

    Regards
    Thomas Papapolyzos

    Reply
  9. Frank DeLaglio

    Greg, there’s so much about the banking sector that remains unknowable, on and off balance sheet items, and those items have proven themselves significant enough to actually pose risk towards the ability of these businesses to remain going concerns. So the risk here is a demonstrable loss of all capital if the company declares bankruptcy.

    There’s also plenty of evidence to suggest that “ain’t a damn thing changed” since the bailouts.

    http://www.huffingtonpost.com/dennis-santiago/off-balance-sheet-derivat_b_550145.html

    http://www.bloomberg.com/news/2011-01-18/citigroup-46-gain-masks-flawed-mortgages-freddie-mac-calls-not-acceptable.html?cmpid=yhoo

    There are plenty of attractive risk-reward opportunities available in the market today that cap your downside somewhere above the very real possibility of zero.

    Reply
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