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Why Citigroup (C) Might Be The Best Bank

Added on by Lee Ho Fook.

Citigroup (NYSE: C) continues to remove itself from the shroud of the financial crisis and leverage its global presence to grow stronger and more profitable. According to Insider Monkey's hedge fund database, Citi is the most loved big-bank stock among hedge funds as of the third quarter (read more about why). Among these hedge funds are notable billionaires David Tepper of Appaloosa Management and Ken Griffin of Citadel Investment Group. It can be argued as to whether Citi is indeed one of the most loved bank stocks, but it is harder to argue that Citi is not one of the cheapest bank stocks around.

Citi posted fourth quarter 2012 results that came in well below estimates, with the bank showing $0.69 per share of earnings, compared to expectations of $0.96 per share. The big miss was due to new legal costs of $1.29 billion, or $0.27 per share, and a previously announced corporate restructuring charge of $1.03 billion, or $0.21 per share. In its earnings announcement, Citi helped alleviate cost structure concerns by planning to further cut cost with the slashing of 11,000 jobs and closure of a number of branches, which the bank expects will save around $1.1 billion in expenses. 

Relatively new CEO, Michael Corbat, had this to say about Citi's earnings results...

Our bottom line earnings reflect an environment that remains challenging, with businesses working through issues like spread compression and regulatory changes, as well as the costs of putting legacy issues behind us. 

Despite a 29% earnings miss the stock has remained relatively flat; I take the resilience of the stock as a positive. Namely, that investors recognize Citi's benefit from an improving economy, bringing with it increased investment banking activity and expansion of credit.

The coming retirement of the baby boomers should add volume to Citi's wealth management business over the next several years as well. Although its recent past has been rocky, Citi is in a better position today to take advantage of the economic trends occurring now and into the future. The bank continues to work down its non-core asset portfolio and increase fee-generating business. Citi Holdings and problem asset portfolio was reduced by 31% during the third quarter, now making up only 9% of the bank's total assets.

Broad based industry drivers. Citi appears to be making necessary maneuvers, such as reducing its workforce and downsizing under-performing departments in order to remain flexible and stay competitive with its peers. Rising interest rates going forward will alleviate some of the margin pressure that all banks have suffered in the aftermath of the financial crisis. Citi will be able to earn a better spread on what it pays its depositors and receives from its debtors. As the economy improves, merger and acquisition activity should pick-up as companies realize synergies and capitalize on relatively low borrowing rates - bringing a boom to the investment banking division. As credit standards become more lax after tightening during the recession, Citi will be able to make more loans and take more risk in its credit card division. Revenue garnered through interest should grow and add significantly to earnings. Citi stands to shake free from its legacy costs in future quarters and get back to the business of making loans, underwriting, and managing assets.

Inherent risks. Although there are many positives concerning Citi and its stock going forward, the risks involved cannot be ignored. Citi still suffers from margin pressure orchestrated by the Fed. Interest rates are expected to rise, after a steady decline over the last three decades, but nothing is certain. It is assuring, however, that rates do not have much room to go lower if they did. Washington D.C. is dysfunctional, fortunately for banks, so any threat of breaking up mega banks such as Citi has subsided and will not be realized anytime soon.

All the too big to fail banks, Citi, Bank of America (NYSE: BAC), and J.P. Morgan alike, suffer from the same risks such as margin pressure, economic stagnation, and political backlash. Therefore, the risks are more industry-wide currently than idiosyncratic, especially for Citi since it has improved its balance sheet and returned to profitability from the depths of the financial crisis. Wells Fargo (NYSE: WFC) has emerged as a juggernaut in the home mortgage area, but its focus is domestic while Citi's is global. A reduced share in some areas of its business in the United States can be offset by increased shares in other areas, such as investment banking and corporate banking, around the world.

Wells Fargo is a weaker choice for being the top investment banks given its loan loss provisions and declining revenue from mortgage refinancings. Well Fargo posted fourth quarter EPS that came in at $0.91, versus $0.73 for the same quarter last year, but its net interest margin fell 0.10% to 3.56%. 

As far as Bank of America's recent earnings announcement, the bank managed to post $0.03 EPS, compared to $0.15 for the same quarter last year. The earnings drop was attributed to a 25% revenue decline. Bank of America also has an elevated cost structure thanks to reduction of its legacy assets. The bank's trailing twelve month profit margin comes in at 2.7%, where Citi's is at 7.9%.  

Room to grow. Citi's stock has steadily climbed during the past year and has more room to do so. Furthermore, once the Fed approves Citi to increase its dividend, an even greater run-up in the banking stock could come about. Citi currently pays the lowest dividend yield of its major peers.

Out of 32 analysts covering Citi's stock, ten have it as a strong buy and sixteen have it as a buy. Four analysts rate Citi a hold while one rates it to under-perform and one rates it a sell. Therefore, the majority of analysts still see an upside to Citi's shares. Not to be ignored is the fact that insiders have been net buyers of Citi's stock over the past year, including a number of purchases in November of 2012 by directors. If anybody knows how a company will perform in the future, it is the company's management and directors.

Valuation. Citi has managed to reduce its debt since the height of the financial crisis and its return on assets has averaged a little over 0.5% in the past two years. Although the current return on equity -- around 6% -- is a long cry from the returns Citi has achieved in the past, it is a sign of Citi's improving business. The years of returns on assets of over 1% in the banking industry appear to be coming to an end as the industry has changed with increased regulation and transforming dynamics. Nevertheless, the return metrics continue to improve for Citi and will aid its shareholders in realizing gains on their holdings. Further, Citi still trades at a significant discount to its book value, currently at 70%. Historically, Citi has traded at a premium over its book value, and I can see Citi closing the gap between its book value and market value as the economy improves and normalizes. The banking industry average price to book ratio is around 1.0, and Citi also trades well below its major-bank peers on a price to book basis.

The average forward price to earnings ratio for the banking industry is around 11 times, where Citi currently trades at only 8 times. Given its superior expected earnings growth (see table below), Citi should begin to trade more in line with the industry over the next couple years as it shows out-sized earnings growth and an improving balance sheet.

Applying an industry average forward P/E of 11 to Wall Street's EPS estimates (below) and the potential upside for Citi's stock over the next two years could be upwards of 38%. It appears Citi's stock still has more room to run and an improving environment in which to do so.