CITIGROUP INC C
May 04, 2011 - 5:43pm EST by
Firmgmt
2011 2012
Price: 4.51 EPS $0.35 $0.40
Shares Out. (in M): 29,120 P/E 12.9x 11.3x
Market Cap (in $M): 131,910 P/FCF NA NA
Net Debt (in $M): 1,583K EBIT 10,951 12,500
TEV ($): 1,715K TEV/EBIT 12.0x 10.6x

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Description

 

Citigroup Equity - BUY!!!

1.                        Executive Summary

 At current prices of ~$4.50/share (0.9x tangible book value), Citigroup equity represents a highly favorable risk-reward proposition. There is much uncertainty surrounding the value of Citigroup's "bad" bank, Citi Holdings, causing the equity to trade at enticingly cheap levels.

 

Citigroup's tangible book value (TBV) at 1Q11 is $129.5bn, or $4.69/share, and the equity trades at ~$4.50/share (~$132bn market cap), or 0.9x TBV. Based on our analysis of the company's loan books, I believe the downside to the equity is approximately $4.00/share, while the long-term upside is $10.00/share, representing 110%/(17%) up/down dynamics. My base case valuation for Citigroup by year-end 2011 is 1.4x TBV of $5.00/share, resulting in a stock price of $7.00/share, or 13x 2012 consensus EPS of $0.55/share. I believe the market will re-value the equity upon the earlier of Citi Holdings assets shrinking to a non-material level (~10% of total assets) or Holdings stops producing losses (I anticipate this will happen in late 2011 or early 2012).

Looking at Citigroup on a sum of the parts basis reveals how cheap Citigroup equity trades. This analysis shows an equity valuation of $5.21 to $7.45/share, with $4.66-$6.18/share of value in Citicorp. At the current price of $4.50, I believe investors can buy Citicorp at a discount and Citi Holdings for free, although I estimate $0.55-$1.27/share of value in Citi Holdings.

Citigroup also offers strong downside protection. The bank is one of the best capitalized banks in the world, at 11.3% tier 1 common equity, in large part due to the Treasury's $25bn conversion of its TARP preferred investment into common equity (at $3.25/share). By recapitalizing the bank, the Treasury has created a super-capitalized bank that is ready to lend into a lender-friendly market and grow earnings profitably. In addition, by performing stress tests on the loan portfolio, one must conclude that the loan books are quite well-reserved.

2.                        Recent Events

In early December, the Treasury exited the remainder of their Citigroup investment at $4.35/share, for a published profit of $12bn (even Paulson would be happy with that!), completing the restructuring of Citigroup's balance sheet. The technical overhang of the Treasury's selling program was lifted as a result, and the stock rallied to $4.80/share within one week of Treasury's exit. Treasury's exit represents an important development in our Citigroup trade. The exit of the government puts a stamp of approval on Citigroup as a sound banking institution and as a result, I believe Institutional investors are much more likely to invest in Citigroup equity. Of note, per FactSet, institutional ownership of Citi equity was 48% at the time of the exit, much lower than peers Wells Fargo (78%), JPMorgan (76%), and Bank of America (69%). I believe this gap will shrink over time, as Citi continues to make progress on exiting Citi Holdings and returning to normalized earnings.

 

In mid-April, Citigroup reported 1st quarter net income of $3.0bn ($0.10/share), just ahead of the Street consensus of $0.09/share. First quarter results were a bit better than consensus, driven by better trading volumes in the Investment Bank and a reserve release of $3.3bn. The stock, which was trading at ~$4.40/share prior to the results, has traded up to current levels of $4.50/share. Capital levels continue to be strong at 11.3% tier 1 common (highest among JPM, BAC, C, and WFC), the Company is well reserved at $36.6bn (247% of non-performing loans), and credit trends continued to improve (net credit losses of $6.3bn were down $2.1bn from the first quarter of 2010, 90 day delinquencies improved $1.8bn sequentially, and 30-89 day delinquencies improved $2.0bn during the quarter).

 

On the macro front, the U.S. economy continues to improve gradually. Particularly meaningful to the banking sector are trends in unemployment and initial jobless claims, as these measures have a strong correlation to credit losses. Since last August, the unemployment rate in the U.S. has declined from 9.6% to 8.8% as of the end of March. Initial jobless claims have been mixed recently but the trend is clearly improving - from a 52-week high of 504,000 on August 13th to a 52-week low of 383,000 on February 4th. These trends point to greater stability in the labor market and have led to improving credit costs for the entire banking sector.

3.                        Equity Valuation - Sum of the Parts

As a refresher, Citigroup announced in the first quarter of 2009 that it was splitting the business into a "good bank, bad bank" structure, with Citicorp being the good bank and Citi Holdings being the bad bank. Citicorp is comprised of the bank's Regional Consumer Banking (RCB) franchises and the Institutional Clients Group (ICG), which includes the Investment Bank, and the Transaction Services business, which provides a variety of services to financial institutions and corporations such as agent/trust, custody, and cash management. Citi Holdings is comprised of the Brokerage & Asset Management business (90% of which is SmithBarney, which has been sold into a JV with Morgan Stanley); Local Consumer Lending, which includes a variety of Western Europe and U.K. banking branches the Company is looking to exit and a North American consumer lending business (residential mortgages, auto loans, student loans, credit card loans, and personal installment loans); and the Special Asset Pool, which includes securities, SPV assets, leveraged lease loan commitments, and other portfolios originated out of the Investment Bank that have been poor performers.

In the past several months, my work has focused on understanding the run-down of Citi Holdings, updating my Sum of the Parts analysis, and estimating normalized earnings for Citigroup once Citi Holdings has been exited.

Citi Holdings

Winding down Citi Holdings has two benefits to the Company: 1) The market will become more comfortable that Citigroup will not need to recognize outsized losses on these assets, and 2) release of capital to Citicorp, where the Company can profitably employ these funds to grow earnings. Citigroup has continued to wind down Holdings through asset sales, natural run-off, and charge-offs. Holdings assets declined from $421bn at Sept 30 to $359bn at year-end. In the last two years, Holdings assets have declined $445bn from $804bn (37% of total assets) to $337bn (17% of total assets). The Company indicated on their 4Q earnings conference call that the natural run-off rate of the portfolio is running at $12bn per quarter.

In the fourth quarter, Citi completed the sale of StudentLoan Corp to Sallie Mae and Discover Financial. The sale removed $32bn of assets from Holdings and resulted in an after-tax loss of $480m (1.5% of assets sold). Since the beginning of 2008, Citi has completed sales of Holdings assets totaling $106bn and experienced net run-off and amortization of $49bn.

Various news reports indicate that Citi is in early rounds of bidding for CitiFinancial, a North American consumer finance business within Holdings. Suitors for the business include Apollo Management, Blackstone, Carlyle Group, TPG Capital, and Santander Bank. We also believe Fortress, which recently acquired American General Finance, also a North American consumer finance business, from AIG, may want the company as well in order to control the consumer finance space outside of major North American markets. CitiFinancial has ~$32bn of loans and $2bn of book value. We would view a sale of CitiFinancial at or near book value (which we fully expect to happen) as a positive for the Company given the significant amount of assets and capital the sale would release from Holdings.

The other major business up for sale at Holdings is the North American retail branded credit card business ($46bn of assets). However, management has indicated this business has improved substantially and they would not sell the business unless they received an acceptable offer. There has even been some analysts on the sell-side who have called for Citigroup to re-characterize the retail branded credit card business as part of Citicorp.

I expect Citi to completely wind down Holdings by 2014. With $12bn per quarter of natural run-off and average asset sales of $5bn/quarter (excluding the StudentLoan Corp sale and potential sales of CitiFinancial and the credit card business), we expect Holdings assets to decline to approximately $240bn by year-end 2011, $158bn by 2012, $81bn by 2013, and $0 by 2014 (see below for our Holdings wind down projections).

The most interesting take-away from the analysis of reserves at Citi Holdings is that Citigroup will not need to provision for credit losses in Holdings starting in late 2011/early 2012. Assuming Citi continues to make provisions of 70% of charge-offs (as it has in 3Q and 4Q10), and If Holdings charges off 1.2% of its assets annually, which I believe is a conservative assumption given it matches the most recent charge-off rate and the trend in charge-offs has been declining gradually since peaking in 3Q09 at 1.4%, Holdings will be provisioned well enough that it will not need to provision for any further losses in Holdings by late 2011/early 2012, resulting in Holdings producing profits in 2012, 2013, and 2014. This run-off analysis results in equity value of $29bn in Citi Holdings, or 0.67x current book value of $44bn.

In addition to valuing Holdings as a consolidated run-off portfolio, we have valued each pool of loans individually. For each pool, we projected out cash flows and charge offs assuming no asset sales and conservative charge-offs. The exercise of going through each loan pool made us comfortable that the value of Holdings is in the range of $25-35bn. For example, if we mark Holdings at 150% of non-performing assets, as we did in our mid case, the value of Holdings is $28bn. These marks assume severities on all current non-performing assets are 100%, non-performing assets will increase 50%, and that severities on these future non-performing assets will be 100%. Given the mix and performance of the assets in these loan pools (credit trends have been improving in Holdings for several quarters), I believe the marks are very conservative.

Given our valuation of Holdings, we can imply the marketplace's valuation of Citicorp.

Using our range of Holdings equity values, the market is valuing Citicorp at a range of 1.2x - 1.5x tangible book value. If we value Holdings at $30bn, then Citicorp is trading at 1.3x TBV. I feel comfortable that Citicorp is worth well in excess of 1.3x TBV. Citicorp is very well-reserved for potential loan losses. Total reserves at Citicorp of $15.8bn cover NPAs and + 90-day accruing loans of $8.8bn nearly 2x. Nonperforming assets at Citicorp were never large through the credit crisis and trends have been positive lately. As a result, I feel it appropriate to value Citicorp on an earnings basis. Given the returns on assets that the Citicorp unit has produced through the credit crisis (1.0-1.2% consistently), it is easy to justify valuations well north of 1.3x TBV.

I believe the value of Citicorp equity ranges from 1.6x - 2.2x TBV. Note that JPMorgan (which I also view as cheap) trades at 1.5x TBV currently and that Wells Fargo trades at 2.1x TBV currently. When we compare each business segment to its peers, it is clear that Citicorp's portfolio of businesses is solid and that the valuations above are conservative.

 Two quick examples: Transaction Services generated $3.6bn of net income in 2010, almost 50% higher than State Street at $2.1bn and Bank of New York at $2.2bn. Further, the business generated 5% returns on assets, compared to 1.3% at State Street and 1% at BoNY. These two companies trade at 11x and 18x LTM earnings, respectively, and we are valuing the Transaction Services business at 10-14x LTM earnings. Second, the LatAm RCB generated $1.9bn LTM net income, 8% net interest margins, and 2.6% ROAs. Two larger, pure play LatAm banks (Itau and Bradesco) generated 7.5% and 7.9% net interest margins and 2.5% and 1.3% ROAs, respectively. These two banks trade at 3.0x and 2.5x TBV and 10x and 16x LTM earnings, respectively. We have valued the LatAm RCB at 9-13x earnings.

4.                        Equity Valuation - Normalized Earnings

In the last two years, Citicorp has produced $16bn of revenue / quarter and $3.8bn of pre-tax income / quarter, or 1.3% returns on assets (on a pre-tax basis). Given the past two years has been a period of depressed earnings for the banking sector, we believe Citicorp has room for improvement in profitability. Another reason we believe Citicorp profitability will improve is the changing geographic mix of Citicorp assets.

Since the beginning of 2009, Citicorp assets have grown 34% in Asia and 25% in Latin America, as compared to 9% in EMEA and just 6% in North America. Citicorp makes higher returns in Latin America and Asia than in EMEA and North America, and given Citi's strong market presence in these growing developing markets, we expect growth opportunities in these markets to drive strong and improving earnings for Citigroup for the next several years.

On a consolidated basis and post the wind down of Citi Holdings, I estimate total Citi assets of approximately $1.6 trillion. If Citigroup is able to generate ROAs of 1.1-1.3% (in line with recent historical performance at Citicorp), the Company will produce $17 - $21bn of net income annually. We also believe Citigroup will be able to lever its common equity approximately 10-12x, resulting in returns on equity of low to mid teens, on a normalized basis. I assume the market will value Citi's earnings at 10-12x.

5.                        Downside Protection

The downside risk to the equity is very well protected - both reserves and capital levels are strong.

Let's start with reserves. I have stress-tested the balance sheet in two different ways. First, I looked at Citigroup on a consolidated level using the government's work from the May 2009 Supervisory Capital Advisory Program (SCAP) test results based on year-end 2008 financial statements to estimate potential future losses. The SCAP test estimated losses for each of the banks considered to be "systemically important" under an adverse economic scenario, which the government assumed to be -3.3%and 0.5% real GDP growth in 2009 and 2010, 8.9% and 10.3% unemployment rate in 2009 and 2010, and housing price drops of 22% and 7% in 2009 and 2010, respectively. This analysis resulted in $53bn of future losses to work through. If we adjust the current TBV of $129bn and give the company credit for current loan loss reserves of $36bn, the adjusted tangible book value would be $112bn, or ~$4.00/share. We would note that Citi is currently running at a better rate than the government's adverse scenario forecasts for real GDP and unemployment rate, while there appears to be further downside in housing prices.

Second, I drilled down into each of the buckets of Citigroup's loan book, with help from various loan expert groups. This analysis resulted in estimated future losses of $68bn. If we adjust the current TBV of $129bn and give the company credit for current loan loss reserves of $36bn, the adjusted tangible book value would be $97bn, or ~$3.50/share. We would highlight that if it took two years for Citigroup to work through $68bn of losses in its portfolio, this would represent an annual charge-off rate of 4.7%. To put that in context, Citigroup charged off 3.0% of its loans in 2008, 5.5% of its loans in 2009, and 5.0% of its loans in the last twelve months, so two more years of 4.7% would represent very little improvement in credit quality. We know from various sources and recent results across the US banking sector that credit quality is in fact starting to improve and we therefore feel confident that these loss estimates are conservative.

These two methods of stress testing the balance sheet results in future losses of $50-70bn. As noted, the Company has $36bn in reserves for loan losses currently. If we assume the Company is conservative and maintains reserves for loan losses at 1.5% of gross loans (historical average annual charge-off rate is ~1.0%), that would result in a target reserve level of $10.5bn (1.5% of $700bn). At the high end of our loss estimate ($70bn), the Company would need to provision $34bn for loan losses over the next two years, or ~$17bn per year, a level we are comfortable with given the Company generates approximately $40bn of annual pre-tax pre-provision income. The high end of these loss estimates still results in the Company building tangible book value over the next two years.

Turning to capital levels, Citigroup is one of the best capitalized banks in the market, in large part due to the Treasury's $25bn conversion of its preferred equity position into common equity. The banking sector is also much better capitalized than historical standards. As can be seen in the graph below, the sector is higher capitalized than at any point in recent history. We need to go back to the Great Depression era for a comparable level of capitalization among the banks.

 One key question for the marketplace is the standards for capital levels that will eventually be adopted by regulators. Given normalized returns on assets of 1-1.5% for the industry (and the recent financial regulatory reform measures adopted by the U.S. have largely left the normalized ROA levels unchanged), leverage levels will determine the returns on equity the businesses can generate. We learned a lot about Basel's intentions for bank leverage levels in the fall. The Committee published guidelines that Tier 1 common equity should be a minimum of 8%, among a number of other recommendations. We are not concerned with the impact of Basel III guidelines on Citigroup given the Company's current common Tier 1 ratio of 11.3%. Furthermore, capitalizing the banks at 8% tier 1 (or 12.5x leverage) would allow the businesses to generate reasonable equity returns (12.5-18.8%, assuming ROA of 1-1.5%). While these returns will not approach the pre-crisis levels of 20-25%, clarity on capital levels going forward would allow the stocks to re-price to 10-13x forward P/E from current 7-9x levels.

6.                        Key Assumptions / Risks

The major risks to an equity investment in Citigroup include 1) health of the U.S. economy and in particular job market fundamentals, 2) regulatory risk related to capital levels and restrictions on certain business activities that may limit return on assets, and 3) execution risk by Citigroup in exiting Holdings at reasonable levels while maintaining focus on its core businesses.

One other major assumption I've made is that the equity can trade at 1.4x TBV by year-end 2011. No doubt a lift in the multiple from 0.9x to 1.4x will be driven in large part by the Company's progress on exiting Holdings. Given my projections of where Citi Holdings will be by year-end, I believe the equity could trade to 1.4x.

From a consolidated level, I believe Citigroup could trade at 1.4x TBV by year-end 2011. The banking sector has traded as high as 3.5x TBV in the past twenty years. I believe the most relevant period for comparison is the period from 1991-1995, the last time period the market experienced a banking crisis. The sector traded around 1.5x until the sector worked through its bad loans and the U.S. economy experienced clear growth, which helped to fuel higher returns on equity.

7.                        Pros/Cons of Equity Position at $4.50/share Level

Pros

Cons

  • Highly capitalized and well reserved relative to peers and historical levels
  • Healthy mix of consumer and commercial businesses
  • Strong international and domestic deposit franchises
  • Trading at cheap levels both to peers and historical levels
  • Favorable lending environment w/ high spreads and conservative underwriting
  • Re-pricing catalysts include: Holdings wind down, global economy uplift, clarity on target capital levels, higher institutional ownership levels
  • Investing in banks leads to exposure to the macro economy and in particular, trends in job growth and unemployment
  • Citi Holdings tail could be 6-7 years, given its large exposure to residential mortgages

 

 


 


Catalyst

Several catalysts exist to propel a re-evaluation of Citigroup's stock. First, the Treasury's exit of its investment in Citigroup will help to bring more institutional investors back in into the name. Second, winding down Citi Holdings and improving credit trends will lead to the market re-evaluating its concerns with Citi's credit quality. Third, more clarity on regulatory reform, specifically in the area of required capital levels, will lift the entire banking sector. Lastly, we believe the attractiveness of Citi's franchise will allow the equity to trade at similar or higher valuations to its peers. Citi generates approximately 57% of its revenues internationally. Citigroup's exposure to international markets will drive earnings growth as Citi exits Holdings and recycles capital into these high returning and growing businesses.
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    Description

     

    Citigroup Equity - BUY!!!

    1.                        Executive Summary

     At current prices of ~$4.50/share (0.9x tangible book value), Citigroup equity represents a highly favorable risk-reward proposition. There is much uncertainty surrounding the value of Citigroup's "bad" bank, Citi Holdings, causing the equity to trade at enticingly cheap levels.

     

    Citigroup's tangible book value (TBV) at 1Q11 is $129.5bn, or $4.69/share, and the equity trades at ~$4.50/share (~$132bn market cap), or 0.9x TBV. Based on our analysis of the company's loan books, I believe the downside to the equity is approximately $4.00/share, while the long-term upside is $10.00/share, representing 110%/(17%) up/down dynamics. My base case valuation for Citigroup by year-end 2011 is 1.4x TBV of $5.00/share, resulting in a stock price of $7.00/share, or 13x 2012 consensus EPS of $0.55/share. I believe the market will re-value the equity upon the earlier of Citi Holdings assets shrinking to a non-material level (~10% of total assets) or Holdings stops producing losses (I anticipate this will happen in late 2011 or early 2012).

    Looking at Citigroup on a sum of the parts basis reveals how cheap Citigroup equity trades. This analysis shows an equity valuation of $5.21 to $7.45/share, with $4.66-$6.18/share of value in Citicorp. At the current price of $4.50, I believe investors can buy Citicorp at a discount and Citi Holdings for free, although I estimate $0.55-$1.27/share of value in Citi Holdings.

    Citigroup also offers strong downside protection. The bank is one of the best capitalized banks in the world, at 11.3% tier 1 common equity, in large part due to the Treasury's $25bn conversion of its TARP preferred investment into common equity (at $3.25/share). By recapitalizing the bank, the Treasury has created a super-capitalized bank that is ready to lend into a lender-friendly market and grow earnings profitably. In addition, by performing stress tests on the loan portfolio, one must conclude that the loan books are quite well-reserved.

    2.                        Recent Events

    In early December, the Treasury exited the remainder of their Citigroup investment at $4.35/share, for a published profit of $12bn (even Paulson would be happy with that!), completing the restructuring of Citigroup's balance sheet. The technical overhang of the Treasury's selling program was lifted as a result, and the stock rallied to $4.80/share within one week of Treasury's exit. Treasury's exit represents an important development in our Citigroup trade. The exit of the government puts a stamp of approval on Citigroup as a sound banking institution and as a result, I believe Institutional investors are much more likely to invest in Citigroup equity. Of note, per FactSet, institutional ownership of Citi equity was 48% at the time of the exit, much lower than peers Wells Fargo (78%), JPMorgan (76%), and Bank of America (69%). I believe this gap will shrink over time, as Citi continues to make progress on exiting Citi Holdings and returning to normalized earnings.

     

    In mid-April, Citigroup reported 1st quarter net income of $3.0bn ($0.10/share), just ahead of the Street consensus of $0.09/share. First quarter results were a bit better than consensus, driven by better trading volumes in the Investment Bank and a reserve release of $3.3bn. The stock, which was trading at ~$4.40/share prior to the results, has traded up to current levels of $4.50/share. Capital levels continue to be strong at 11.3% tier 1 common (highest among JPM, BAC, C, and WFC), the Company is well reserved at $36.6bn (247% of non-performing loans), and credit trends continued to improve (net credit losses of $6.3bn were down $2.1bn from the first quarter of 2010, 90 day delinquencies improved $1.8bn sequentially, and 30-89 day delinquencies improved $2.0bn during the quarter).

     

    On the macro front, the U.S. economy continues to improve gradually. Particularly meaningful to the banking sector are trends in unemployment and initial jobless claims, as these measures have a strong correlation to credit losses. Since last August, the unemployment rate in the U.S. has declined from 9.6% to 8.8% as of the end of March. Initial jobless claims have been mixed recently but the trend is clearly improving - from a 52-week high of 504,000 on August 13th to a 52-week low of 383,000 on February 4th. These trends point to greater stability in the labor market and have led to improving credit costs for the entire banking sector.

    3.                        Equity Valuation - Sum of the Parts

    As a refresher, Citigroup announced in the first quarter of 2009 that it was splitting the business into a "good bank, bad bank" structure, with Citicorp being the good bank and Citi Holdings being the bad bank. Citicorp is comprised of the bank's Regional Consumer Banking (RCB) franchises and the Institutional Clients Group (ICG), which includes the Investment Bank, and the Transaction Services business, which provides a variety of services to financial institutions and corporations such as agent/trust, custody, and cash management. Citi Holdings is comprised of the Brokerage & Asset Management business (90% of which is SmithBarney, which has been sold into a JV with Morgan Stanley); Local Consumer Lending, which includes a variety of Western Europe and U.K. banking branches the Company is looking to exit and a North American consumer lending business (residential mortgages, auto loans, student loans, credit card loans, and personal installment loans); and the Special Asset Pool, which includes securities, SPV assets, leveraged lease loan commitments, and other portfolios originated out of the Investment Bank that have been poor performers.

    In the past several months, my work has focused on understanding the run-down of Citi Holdings, updating my Sum of the Parts analysis, and estimating normalized earnings for Citigroup once Citi Holdings has been exited.

    Citi Holdings

    Winding down Citi Holdings has two benefits to the Company: 1) The market will become more comfortable that Citigroup will not need to recognize outsized losses on these assets, and 2) release of capital to Citicorp, where the Company can profitably employ these funds to grow earnings. Citigroup has continued to wind down Holdings through asset sales, natural run-off, and charge-offs. Holdings assets declined from $421bn at Sept 30 to $359bn at year-end. In the last two years, Holdings assets have declined $445bn from $804bn (37% of total assets) to $337bn (17% of total assets). The Company indicated on their 4Q earnings conference call that the natural run-off rate of the portfolio is running at $12bn per quarter.

    In the fourth quarter, Citi completed the sale of StudentLoan Corp to Sallie Mae and Discover Financial. The sale removed $32bn of assets from Holdings and resulted in an after-tax loss of $480m (1.5% of assets sold). Since the beginning of 2008, Citi has completed sales of Holdings assets totaling $106bn and experienced net run-off and amortization of $49bn.

    Various news reports indicate that Citi is in early rounds of bidding for CitiFinancial, a North American consumer finance business within Holdings. Suitors for the business include Apollo Management, Blackstone, Carlyle Group, TPG Capital, and Santander Bank. We also believe Fortress, which recently acquired American General Finance, also a North American consumer finance business, from AIG, may want the company as well in order to control the consumer finance space outside of major North American markets. CitiFinancial has ~$32bn of loans and $2bn of book value. We would view a sale of CitiFinancial at or near book value (which we fully expect to happen) as a positive for the Company given the significant amount of assets and capital the sale would release from Holdings.

    The other major business up for sale at Holdings is the North American retail branded credit card business ($46bn of assets). However, management has indicated this business has improved substantially and they would not sell the business unless they received an acceptable offer. There has even been some analysts on the sell-side who have called for Citigroup to re-characterize the retail branded credit card business as part of Citicorp.

    I expect Citi to completely wind down Holdings by 2014. With $12bn per quarter of natural run-off and average asset sales of $5bn/quarter (excluding the StudentLoan Corp sale and potential sales of CitiFinancial and the credit card business), we expect Holdings assets to decline to approximately $240bn by year-end 2011, $158bn by 2012, $81bn by 2013, and $0 by 2014 (see below for our Holdings wind down projections).

    The most interesting take-away from the analysis of reserves at Citi Holdings is that Citigroup will not need to provision for credit losses in Holdings starting in late 2011/early 2012. Assuming Citi continues to make provisions of 70% of charge-offs (as it has in 3Q and 4Q10), and If Holdings charges off 1.2% of its assets annually, which I believe is a conservative assumption given it matches the most recent charge-off rate and the trend in charge-offs has been declining gradually since peaking in 3Q09 at 1.4%, Holdings will be provisioned well enough that it will not need to provision for any further losses in Holdings by late 2011/early 2012, resulting in Holdings producing profits in 2012, 2013, and 2014. This run-off analysis results in equity value of $29bn in Citi Holdings, or 0.67x current book value of $44bn.

    In addition to valuing Holdings as a consolidated run-off portfolio, we have valued each pool of loans individually. For each pool, we projected out cash flows and charge offs assuming no asset sales and conservative charge-offs. The exercise of going through each loan pool made us comfortable that the value of Holdings is in the range of $25-35bn. For example, if we mark Holdings at 150% of non-performing assets, as we did in our mid case, the value of Holdings is $28bn. These marks assume severities on all current non-performing assets are 100%, non-performing assets will increase 50%, and that severities on these future non-performing assets will be 100%. Given the mix and performance of the assets in these loan pools (credit trends have been improving in Holdings for several quarters), I believe the marks are very conservative.

    Given our valuation of Holdings, we can imply the marketplace's valuation of Citicorp.

    Using our range of Holdings equity values, the market is valuing Citicorp at a range of 1.2x - 1.5x tangible book value. If we value Holdings at $30bn, then Citicorp is trading at 1.3x TBV. I feel comfortable that Citicorp is worth well in excess of 1.3x TBV. Citicorp is very well-reserved for potential loan losses. Total reserves at Citicorp of $15.8bn cover NPAs and + 90-day accruing loans of $8.8bn nearly 2x. Nonperforming assets at Citicorp were never large through the credit crisis and trends have been positive lately. As a result, I feel it appropriate to value Citicorp on an earnings basis. Given the returns on assets that the Citicorp unit has produced through the credit crisis (1.0-1.2% consistently), it is easy to justify valuations well north of 1.3x TBV.

    I believe the value of Citicorp equity ranges from 1.6x - 2.2x TBV. Note that JPMorgan (which I also view as cheap) trades at 1.5x TBV currently and that Wells Fargo trades at 2.1x TBV currently. When we compare each business segment to its peers, it is clear that Citicorp's portfolio of businesses is solid and that the valuations above are conservative.

     Two quick examples: Transaction Services generated $3.6bn of net income in 2010, almost 50% higher than State Street at $2.1bn and Bank of New York at $2.2bn. Further, the business generated 5% returns on assets, compared to 1.3% at State Street and 1% at BoNY. These two companies trade at 11x and 18x LTM earnings, respectively, and we are valuing the Transaction Services business at 10-14x LTM earnings. Second, the LatAm RCB generated $1.9bn LTM net income, 8% net interest margins, and 2.6% ROAs. Two larger, pure play LatAm banks (Itau and Bradesco) generated 7.5% and 7.9% net interest margins and 2.5% and 1.3% ROAs, respectively. These two banks trade at 3.0x and 2.5x TBV and 10x and 16x LTM earnings, respectively. We have valued the LatAm RCB at 9-13x earnings.

    4.                        Equity Valuation - Normalized Earnings

    In the last two years, Citicorp has produced $16bn of revenue / quarter and $3.8bn of pre-tax income / quarter, or 1.3% returns on assets (on a pre-tax basis). Given the past two years has been a period of depressed earnings for the banking sector, we believe Citicorp has room for improvement in profitability. Another reason we believe Citicorp profitability will improve is the changing geographic mix of Citicorp assets.

    Since the beginning of 2009, Citicorp assets have grown 34% in Asia and 25% in Latin America, as compared to 9% in EMEA and just 6% in North America. Citicorp makes higher returns in Latin America and Asia than in EMEA and North America, and given Citi's strong market presence in these growing developing markets, we expect growth opportunities in these markets to drive strong and improving earnings for Citigroup for the next several years.

    On a consolidated basis and post the wind down of Citi Holdings, I estimate total Citi assets of approximately $1.6 trillion. If Citigroup is able to generate ROAs of 1.1-1.3% (in line with recent historical performance at Citicorp), the Company will produce $17 - $21bn of net income annually. We also believe Citigroup will be able to lever its common equity approximately 10-12x, resulting in returns on equity of low to mid teens, on a normalized basis. I assume the market will value Citi's earnings at 10-12x.

    5.                        Downside Protection

    The downside risk to the equity is very well protected - both reserves and capital levels are strong.

    Let's start with reserves. I have stress-tested the balance sheet in two different ways. First, I looked at Citigroup on a consolidated level using the government's work from the May 2009 Supervisory Capital Advisory Program (SCAP) test results based on year-end 2008 financial statements to estimate potential future losses. The SCAP test estimated losses for each of the banks considered to be "systemically important" under an adverse economic scenario, which the government assumed to be -3.3%and 0.5% real GDP growth in 2009 and 2010, 8.9% and 10.3% unemployment rate in 2009 and 2010, and housing price drops of 22% and 7% in 2009 and 2010, respectively. This analysis resulted in $53bn of future losses to work through. If we adjust the current TBV of $129bn and give the company credit for current loan loss reserves of $36bn, the adjusted tangible book value would be $112bn, or ~$4.00/share. We would note that Citi is currently running at a better rate than the government's adverse scenario forecasts for real GDP and unemployment rate, while there appears to be further downside in housing prices.

    Second, I drilled down into each of the buckets of Citigroup's loan book, with help from various loan expert groups. This analysis resulted in estimated future losses of $68bn. If we adjust the current TBV of $129bn and give the company credit for current loan loss reserves of $36bn, the adjusted tangible book value would be $97bn, or ~$3.50/share. We would highlight that if it took two years for Citigroup to work through $68bn of losses in its portfolio, this would represent an annual charge-off rate of 4.7%. To put that in context, Citigroup charged off 3.0% of its loans in 2008, 5.5% of its loans in 2009, and 5.0% of its loans in the last twelve months, so two more years of 4.7% would represent very little improvement in credit quality. We know from various sources and recent results across the US banking sector that credit quality is in fact starting to improve and we therefore feel confident that these loss estimates are conservative.

    These two methods of stress testing the balance sheet results in future losses of $50-70bn. As noted, the Company has $36bn in reserves for loan losses currently. If we assume the Company is conservative and maintains reserves for loan losses at 1.5% of gross loans (historical average annual charge-off rate is ~1.0%), that would result in a target reserve level of $10.5bn (1.5% of $700bn). At the high end of our loss estimate ($70bn), the Company would need to provision $34bn for loan losses over the next two years, or ~$17bn per year, a level we are comfortable with given the Company generates approximately $40bn of annual pre-tax pre-provision income. The high end of these loss estimates still results in the Company building tangible book value over the next two years.

    Turning to capital levels, Citigroup is one of the best capitalized banks in the market, in large part due to the Treasury's $25bn conversion of its preferred equity position into common equity. The banking sector is also much better capitalized than historical standards. As can be seen in the graph below, the sector is higher capitalized than at any point in recent history. We need to go back to the Great Depression era for a comparable level of capitalization among the banks.

     One key question for the marketplace is the standards for capital levels that will eventually be adopted by regulators. Given normalized returns on assets of 1-1.5% for the industry (and the recent financial regulatory reform measures adopted by the U.S. have largely left the normalized ROA levels unchanged), leverage levels will determine the returns on equity the businesses can generate. We learned a lot about Basel's intentions for bank leverage levels in the fall. The Committee published guidelines that Tier 1 common equity should be a minimum of 8%, among a number of other recommendations. We are not concerned with the impact of Basel III guidelines on Citigroup given the Company's current common Tier 1 ratio of 11.3%. Furthermore, capitalizing the banks at 8% tier 1 (or 12.5x leverage) would allow the businesses to generate reasonable equity returns (12.5-18.8%, assuming ROA of 1-1.5%). While these returns will not approach the pre-crisis levels of 20-25%, clarity on capital levels going forward would allow the stocks to re-price to 10-13x forward P/E from current 7-9x levels.

    6.                        Key Assumptions / Risks

    The major risks to an equity investment in Citigroup include 1) health of the U.S. economy and in particular job market fundamentals, 2) regulatory risk related to capital levels and restrictions on certain business activities that may limit return on assets, and 3) execution risk by Citigroup in exiting Holdings at reasonable levels while maintaining focus on its core businesses.

    One other major assumption I've made is that the equity can trade at 1.4x TBV by year-end 2011. No doubt a lift in the multiple from 0.9x to 1.4x will be driven in large part by the Company's progress on exiting Holdings. Given my projections of where Citi Holdings will be by year-end, I believe the equity could trade to 1.4x.

    From a consolidated level, I believe Citigroup could trade at 1.4x TBV by year-end 2011. The banking sector has traded as high as 3.5x TBV in the past twenty years. I believe the most relevant period for comparison is the period from 1991-1995, the last time period the market experienced a banking crisis. The sector traded around 1.5x until the sector worked through its bad loans and the U.S. economy experienced clear growth, which helped to fuel higher returns on equity.

    7.                        Pros/Cons of Equity Position at $4.50/share Level

    Pros

    Cons

    • Highly capitalized and well reserved relative to peers and historical levels
    • Healthy mix of consumer and commercial businesses
    • Strong international and domestic deposit franchises
    • Trading at cheap levels both to peers and historical levels
    • Favorable lending environment w/ high spreads and conservative underwriting
    • Re-pricing catalysts include: Holdings wind down, global economy uplift, clarity on target capital levels, higher institutional ownership levels
    • Investing in banks leads to exposure to the macro economy and in particular, trends in job growth and unemployment
    • Citi Holdings tail could be 6-7 years, given its large exposure to residential mortgages

     

     


     


    Catalyst

    Several catalysts exist to propel a re-evaluation of Citigroup's stock. First, the Treasury's exit of its investment in Citigroup will help to bring more institutional investors back in into the name. Second, winding down Citi Holdings and improving credit trends will lead to the market re-evaluating its concerns with Citi's credit quality. Third, more clarity on regulatory reform, specifically in the area of required capital levels, will lift the entire banking sector. Lastly, we believe the attractiveness of Citi's franchise will allow the equity to trade at similar or higher valuations to its peers. Citi generates approximately 57% of its revenues internationally. Citigroup's exposure to international markets will drive earnings growth as Citi exits Holdings and recycles capital into these high returning and growing businesses.

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