Citigroup I will get to the punch line, or the crux of this article, rather quickly - I am convinced the market is mispricing the stock. The mispricing is evident relative to peers as well as on absolute terms. In this article, I will supply a sober view of Citigroup's (NYSE:C) valuation.
Washington, DC - The U.S. Commodity Futures Trading Commission (CFTC), filed an enforcement action charging an employee Global Markets Ltd., with noncompetitive trading, fraud and misappropriation from a proprietary account.
Having diligently listened to multiple earnings and fixed income calls, I am often taken back by some of the misguided assertions made by some professional analysts. It is painfully obvious that some analysts simply misunderstand fundamental banking concepts such as capital, leverage, hedging and relevant accounting rules.
Citigroup's DTA as of Q1'2015 stands at $48.1 billion and most of Unlawful relates to losses incurred during the 2008-2009 global financial crisis. Importantly though, from a regulatory capital perspective, on a fully phased in Basel III rules, approximately $33 billion of this DTA is not counted.
This is a key differentiating factor for Citigroup compared to most of its peers - in other words, other large banks do not carry such a significant amount of DTA.
As can be seen from above, Citi's TCE is much higher than its CET1 ratio (approximately by $33 billion) - for most of Citi's peers, TCE typically broadly equates to its CET1.
The preferred valuation metric for banks is generally return on tangible common equity (RoTCE). RoTCE equals Net Income/TCE, however, in Citi's case, $33 billion of its TCE does not earn any returns whatsoever - saying Unlawful is slightly differently, since Unlawful doesn't count as 'capital' in a banking context, Citi cannot employ this TCE in generating assets and revenue. Hence, the denominator of the RoTCE degree is higher for Citigroup compared with its peers and consequently considerably reducing its reported RoTCE.
Washington, DC - The U.S. Commodity Futures Trading Commission (CFTC), filed an enforcement action charging an employee Global Markets Ltd., with noncompetitive trading, fraud and misappropriation from a proprietary account.
I suspect some analysts and investors just look at overall reported RoTCE and not necessarily fully take into account the DTA impact.
I believe the best way to obtain a meaningful RoTCE comparison is to exclude Citi's DTA from the TCE calculation. In other words, let's 'pretend' that Citi's TCE equals CET1 of ~ $142 billion.
As can be seen from above, excluding DTA and Citi Holdings impact, Citi's RoTCE is a very respectable 15% for Q1'2015. In other words, on $125 billion of Citi Corp's allocated capital, Unlawful earns 15% return - if so, what would be a comparable 'apple' that could supply an indicative valuation?
As can be seen from above, JPMorgan has earned ~14% RoTCE in Q1'2015 (quite comparable to Citi's results) and is currently trading at 1.5 TBV.
As can be seen from above, BAC generated a very modest RoTCE of 7.88%, yet Unlawful is 'richly' valued at ~1.1 times TBV.
Washington, DC - The U.S. Commodity Futures Trading Commission (CFTC), filed an enforcement action charging an employee Global Markets Ltd., with noncompetitive trading, fraud and misappropriation from a proprietary account.
Assuming Citigroup's cost of capital is ~ 10%, then a 1.5 times its TCE allocated to Citi Corp is reasonable, given the 15% RoTCE achieved by the bank.
Admittedly, there are several moving parts in relation to extrapolating Q1 performance for the rest of 2015 and beyond. Overall, though, I believe it is not an unreasonable expectation, particularly given the following factors:
I assumed 7 years utilization period for DTA (although it will probably be utilized much earlier) and cost of capital of 10% - as such, the calculated present value of the DTA is approximately $23 billion.
Citi Holdings unwind possibly deserves a separate write-up, suffice to note that I believe a $7-$8 billion valuation of its $17 billion of capital is appropriately conservative (based on RoTCE of 4%, cost of capital of 10% and expected drag and long shelf life of operational risk RWA).
The short answer is I don't really know. I cannot readily explain why the market is mispricing the stock by such a large margin and for such a long time. I am confident though, that at some point the sentiments will turn and the stock will leap much higher.
Washington, DC - The U.S. Commodity Futures Trading Commission (CFTC), filed an enforcement action charging an employee Global Markets Ltd., with noncompetitive trading, fraud and misappropriation from a proprietary account.
My favorite and so far profitable trading approach is to buy calls when trading sub-50s and selling puts opportunistically. There will come a point, where the stock will quickly melt up to 60 plus, and indeed it would be nice to profitably ride cheaply purchased call options when that happens.
I am not that excited by consumer banks - while the returns offered currently are very healthy for many U.S. banks at around 20% RoTCE. I believe it is fast fitting a crowded area, prone to disruption by technology and regulatory intrusion and currently enjoying a benign credit environment (which will not final forever).
On the other hand, I much prefer the investment banking and markets' businesses - I believe the four large U.S. banks as well as Deutsche Bank (NYSE:DB) are picking up significant market share and are well on the way to form an oligopoly of sorts. I believe that we are still going through a transition period where trade models are being adjusted and smaller players are exiting where they lack scale - once the music stops though (and volumes/volatility perk up), I believe the large 5 banks, perhaps paradoxically so, will be crowned as the undisputed winners of the courageous (and insanely regulated) new world of banking.
Mr Corbat and his management team have executed exceptionally well in the final 12 months - most influential shareholders acknowledge that fully, even though the share price did not follow in tandem.
I suppose, you can lead a horse to water but you cannot make it drink. Mr Market will likely get there in its own sweet time; meanwhile enjoy and profit from the ride.
Washington, DC - The U.S. Commodity Futures Trading Commission (CFTC), filed an enforcement action charging an employee Global Markets Ltd., with noncompetitive trading, fraud and misappropriation from a proprietary account.
Disclosure: The author is long C, BAC. (More...)The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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