Citigroup Inc. (NYSE: C) is truly a global bank. With operations in more than 100 countries, it leads in consumer banking, credit cards, corporate lending, investment banking and brokerage. But its forays into the U.S. mortgage market, and its huge exposure to the U.S. retail and corporate banking markets, created huge losses from which the company is still recovering.
Citi, guided by a prudent and savvy investment banker, Vikram Pandit, has embarked in one of the most ambitious and difficult transformations ever attempted by a financial institution. It is shedding bad assets, cutting costs, raising capital and has segregated the impaired assets and businesses that Citi would like to dispose into a so-called "bad bank," a subsidiary by the name of Citi Holdings. The success of the restructuring will depend on both Citigroup's execution and on the underlying strength of the U.S. and global economies.
But therein lies the huge upside. As I have written before, there are few investment opportunities more profitable than the restructuring and turnaround of a business. And given the huge size of Citi's balance sheet and the fact that banks are pro-cyclical to the economies in which they operate, the potential gains are extremely large.
And how is the restructuring going? So far, so good. The bank just posted a profit and it is on its way to end the year in the black.
Indeed, Citigroup surprised the market with first-quarter earnings of $0.15 per share. Citi beat estimates on all fronts: consumer credit, trading activities, and valuations of its impaired assets in Citi Holdings. The bank now sports a 9.1% Tier 1 capital ratio.
This is a typical phenomenon of a classic cyclical play (banks) in an economy that does much better than the expectations. Remember, banks are leveraged to economic activity in the markets in which they participate. So, when things are good in the economy, they are really good for banks.
The details of Citi's first-quarter revealed an economic recovery that's accelerating faster than the market expected. In addition, the U.S. Federal Reserve's policy of zero interest rates obviously provides a huge boost by greatly reducing funding costs and expanding the net interest margin (the difference between borrowing and lending rates, which results in the gross profit of lending activities). It also boosts the economy and thus improves results for Citi.
In trading, three favorable factors helped:
- With Lehman Brothers Holdings Inc. and The Bear Stearns Co. gone, and with other competitors limited by new capital rules, there is less competition for Citi.
- Low interest rates provided very cheap funding for positions during a market trending up, and thus improved trading results.
- Finally, consumer credit keeps recovering, as are the mark-to-market holdings in Citi's large portfolio of impaired assets.
Keep in mind that the first quarter is typically strong in trading, and this quarter was no exception. The real surprise in this report is the strong performance in trading of fixed income. This reveals that the bank, despite a loss in reputation due to its impaired assets and government rescue, was able to retain market share in this business.
These three trends are likely to continue with some variance as we move forward.
Citi's trading revenue, which is comparable with its rivals, demonstrates the bank's resiliency in this activity. In fact, in most activities, Citi seems to be more stable than most of its competitors. Still, Citi is looking to stay focused on its incredible strengths in global consumer and corporate banking, de-emphasizing trading.
On the credit side, the very strong global recovery - especially in emerging markets - helped drive credit losses down. In the United States, however, consumer credit losses increased, but mortgage losses abated, leading to minimal charge-offs there.
Finally, Citi has created its own "bad bank" by shifting its impaired assets into Citi Holdings. Citi was able to reduce its exposure to these credits, and since the prior markdowns had been so dramatic, the bank actually was able to produce a profit as markets rallied. This positive trend in valuations has allowed Citi to continue paring its exposure to this sector.
Wall Street analysts will be raising earnings estimates in the months ahead as the U.S. economy keeps surprising to the upside. You see, payroll numbers have been very strong, and the revisions for prior month's activities also have been positive. This typically happens when things are getting better fast.
With a great first quarter that brings Citi into profitability, and the recovery accelerating, the government can start to unload one-fifth of its 27% stake in the bank.
That means Citi stock will have to get over the initial hump of share supply coming from the U.S. government selling the first 20% of its 27% stake. Traditionally, when the government offers securities for sale on any kind, the markets remain subdued until the sale is completed. And eventually, the remaining 80% of the government's stake will have to be sold.
Still, the bank has an incredible upside potential over many years. The typical bank return on assets (ROA) under normal market conditions should be around 1%. But today, Citi's ROA is barely positive, having just turned the corner. And, because of this and the many uncertainties about the bank and about the global economy, the stock is trading at barely above one time book value. This is at least half of a traditional valuation.
Long-term, the stock's value will more than double. As the global economy recovers over the next few years, and Citigroup keeps booking profits, it will eventually start growing its asset base. Therefore, the stock will benefit exponentially, given that banks are, by definition, leveraged institutions.
Also remember that policymakers in many advanced economies are afraid of deflation and are carrying out monetary and fiscal policies conducive to "re-flation." Banks are especially good at making money in inflationary times, and this should benefit Citi.
From a technical perspective the charts show a lot of promise. It looks like a traditional "cup and handle" formation, with a very long slightly upward-sloping right handle. And the stock is just now bumping from the bottom at the 300-day exponential moving average. This would be an area of strong resistance typically.
Given the supply Citigroup shares being unloaded by the government, Citi stock will keep trading sideways until the sale of this first tranche is completed. But once that is done, the stock should pop out very strongly.
Over time, the path will not be a straight line up. Remember that at some point the Fed will have to raise interest rates and end its policy of quantitative easing. But over the long haul, this stock should bring very pleasing gains to its holders.
That's why we are going to recommend a volatile, but potentially very profitable addition to our portfolio, by adding Citigroup.
Recommendation: Add Citigroup Inc. (NYSE: C) at market (**). Look to add on weakness subsequently over many months.
(**) - Special Note of Disclosure: Horacio Marquez holds no interest in Citigroup Inc.
[Editor's Note: Horacio Marquez knows how to make a market call. It was Marquez who told investors that lithium was going to be big - a year before other "experts" made the same call. Now Marquez has isolated the major profit opportunities being created by the possible broadband breakdown - a situation that the news media is only just now starting to understand. To find out all about those top profit opportunities, check out this new report.]
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