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.
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.
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?
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.
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
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).
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