What is Citigroup (C) Worth?

Belief that credit quality at the largest lending institutions is improving continues to gather adherents. As bank balance sheets heal from their near mortal wounds it is time to look ahead and ask how much these banks can earn so investors can determine how much a share of stock is worth. In this regard it seems appropriate to focus on Citigroup (C) since it came so close to financial death, has a unique worldwide franchise, and did not acquire other troubled institutions during the financial meltdown.

Credit quality is clearly improving at Citigroup (C) as evidenced by the fact that non-accrual assets at the end of 2010 were 37% ($12.2 billion) lower than they had been at year-end 2009. This improvement helped Citigroup report net income of $10.6 billion for 2010 versus a loss of $1.6 billion in 2009.

Citigroup's board recently approved a base salary of $1.75 million for CEO Vikram Pandit. Pandit had vowed in 2009 to receive an annual salary of $1 until Citigroup returned to sustained profitability. This recent board action is therefore particulary interesting.

Given the implied belief that sustained profitability has returned at Citigroup, investors now need to ask how much Citigroup can be expected to earn going forward and how much of a dividend will it pay to shareholders. Future earnings and dividends will largely dictate price movements in C.

An appropriate way to determine future earnings is to focus on a bank’s return on total assets (ROA). This measure has always been a generally accepted, standard metric used to compare the relative profitability of banks. For example, high-earning banks typically earn more than 2% on their assets, while low-earning banks earn less than 1%.

The SEC filings of Citigroup during the relatively halcyon period from 1997 through 2006 revealed that its ROA ranged from a low of 0.79% in 1998 to a high of 1.66% in 2005. Its average ROA for that decade was 1.33%. Its dividend payout during this same time period ranged from a low of 13.98% of net income in 1997 to a high of 48.19% in 2004. Its average dividend payout from 1997 through 2006 was 27.95%.

At the end of 2010 Citigroup reported total assets of $1.915 trillion, more than 12% below its 2008 asset peak of $2.187 trillion, but up slightly from the end of 2009. It is likely that Citigroup is in the early stages of expanding its asset base; however, its rate of asset growth should not be expected to equal or exceed the 8.09% annual average achieved from 1997 through 2006 when its total assets grew from $680 billion to $1.484 trillion.

In a book I wrote for the American Bankers Association titled Asset/Liability Management I noted that high-earning banks had higher earning power ratios, which I defined as the ratio of interest earning assets divided by interest paying liabilities (EA/PL). Other things being equal, the bank with the highest earning power will be more profitable as measured by ROA.

A particularly healthy sign at Citigroup is the fact that its earning power is once again rising. From 1997 through 2010 Citigroup’s earning power (EA/PL) ranged from a high of 125.18% in 1999 to a low of 107.88% in 2008. Importantly, Citigroup’s earning power reached 113.59% in the fourth quarter of 2010, which is the highest reading since 2000. The recent increase in this important predictor of bank income reflects improving credit quality at Citigroup as loans return to accrual and the continued jettisoning of non-earning assets.

A conservative forecast using the above data suggests that Citigroup’s total assets can be expected to grow by 6% per year. Its ROA in 2010 was about 0.50%. Accordingly, it is reasonable to expect that Citigroup’s ROA should return to the 1% area in the near future and that it could comfortably payout 20% of net income in common stock dividends.

The application of these assumptions yields earnings per share for Citigroup of about $0.66 per share for 2011 and a dividend of about $0.12. By 2015 earnings per share should reach $0.85 and dividends $0.17.

At a current price of $4.82, Citigroup shares are valued at 7.3 times expected 2011 earnings and 5.7 times 2015 earnings. By comparison the S & P 500 and KBW bank indexes are both trading around 15 times earnings.

This brief analysis suggests that a significant increase in Citigroup’s stock price is possible as the turnaround at Citigroup gathers momentum and it returns to financial health. A doubling in the current price of C would put its price earnings multiple on par with other large corporations in its peer group and should not be ruled out.

Citigroup Undervalued

Valuation of common shares in bank holding companies has become a challenge as the amount of data released in SEC filings has increased. Analysts have responded by narrowing their focus to selected metrics such as the current share price divided by tangible common equity per share and net interest margin. An examination of these measures for six (6) of the largest bank holding companies shows significant variation and suggests that at the present time some are undervalued relative to others.

The bank holding company trading at the greatest premium above its tangible book value as of the close on January 21, 2011 was U.S Bancorp (USB) at 2.89 times. At the other extreme, Bank of America (BAC) and Citigroup (C) trade at the smallest premium to their tangible equity, 1.10 times. The second largest premium observed was for Wells Fargo (WFC), which trades at 2.34 times its tangible equity. It was followed by PNC at 1.65 times and JP Morgan (JPM) at 1.49 times.

Net interest margin (NIM) is the difference between interest income and interest expense expressed as a percentage of interest earning assets. It is normally presented on a taxable equivalent basis and is a measure of relative profitability of a banking franchise. An examination of the fourth quarter net interest margins reported last week in the SEC 8-K filings for the above six companies showed WFC had the highest at 4.16%, followed by PNC at 3.93%, USB at 3.83%, C at 2.97%, JPM at 2.87%, and BAC at 2.66%.

This brief analysis suggests that at the present time BAC and C are undervalued relative to JPM, while WFC and USB are overvalued relative to all the other bank holding companies examined.

Back From The Brink

The financial media is awash with speculation about major bank holding companies increasing dividends and/or buying back shares. While regulatory authorities have acknowledged that bank balance sheets are healing, those same regulators need to remember how difficult it was to raise bank capital within the past few years. Similarly, bank holding company board members need to carefully balance the care and feeding of shareholders with the need to re-establish sound dividend policies that will not have to be reversed.

An overly aggressive dividend policy runs a serious risk of financial embarrassment in the event that a dividend has to be cut in the future. A better option would be for a bank holding company to pay modest quarterly dividends and then augment them with a year-end extra dividend based on the full year results.

A review of the financials for Bank of America, JP Morgan, Citigroup, Wells Fargo, and U.S. Bancorp for the period from 2005 through the third quarter of 2010 suggests that none of them are strong enough to buy back shares. They all remain highly levered financial institutions that have benefited from a period of artificially low interest rates.

These five bank holding companies have significant amounts of goodwill on their balance sheets as a result of acquisitions and accounting treatments accorded by U.S. GAAP. Goodwill is represents the excess of the purchase price of an acquired entity over the fair value amounts assigned to assets acquired and liabilities assumed. Even though goodwill must be tested for impairment every year, its true value is very questionable and excluded from tangible common equity and Tier 1 capital calculations.

As of September 30, 2010 goodwill accounted for 35.60% of Bank of America’s common equity, 32.21% of U.S. Bancorp’s, 29.35% of JP Morgan’s, 21.35% of Wells Fargo’s, and 15.65% of Citigroup’s. Given the significant amounts of goodwill, the degree of financial leverage among the five aforementioned bank holding companies was gauged by reducing their common equity by goodwill and then expressing that more tangible amount as a percentage of total assets. This methodological approach revealed that Wells Fargo had the lowest degree of financial leverage at 7.49%, while JP Morgan had the highest at 5.48%. In between were Citigroup at 7.01%, U.S. Bancorp at 6.53% and Bank of America at 5.85%.

This brief analysis strongly suggests that it would be folly for the major bank holding companies to buy back shares of their common stock and/or establish large dividend payouts so soon after perching on the financial abyss. The general public, as well as shareholders, would be better served by these companies using their earnings to support loan growth. This generation of bankers needs to understand that the public’s appetite for bailing out banks has been satiated for the foreseeable future. Banks must therefore be operated with more common equity and less financial leverage.

Storm Clouds Gather

Bank stock investors have seen their investments soar during the past six weeks. The percentage gains in bank stocks have dwarfed all general market indices.

Citicorp ( C ) stock rose from the ashes of $0.97 per share on March 5th to an inter-day high of $4.48 on April 14, 2009. During relatively the same period, Bank of America
( BAC ) rose from its all-time low of $2.53 to $11.58; J P Morgan ( JPM ) rose from $14.96 to $33.70; Wells Fargo ( WFC ) rose from $7.80 to $19.67, and US Bancorp (USB) rose from $8.06 to $18.01.

Bank stocks initially perked-up when bank officials made favorable comments about their earnings for the first two months of 2009. They really took off, however, when WFC reported robust earnings for the first quarter, which were well above street estimates.

The observed volatility in the bank stock sector reflected the extremes of despair and optimism regarding a financially fragile economy. Nowhere has the battle between market bulls and bears been more evident.

For the past six weeks the voices of Paul Krugman, Nourel Roubini, Dylan Rattigan, Meredith Whitney and others have been muffled as their calls for nationalization were widely dismissed. Of course it didn’t hurt that Rattigan lost his perch, Whitney switched jobs, and Roubini was abroad for much of this time.

These pundits are about to be replaced by the angry voices of people being led to believe that the time for Washington to be reigned in is now. A coalition of commentators who favor small government and balanced budgets has chosen April 15, 2009 as the day to launch taxpayer protests against Federal bailouts. In general, the people leading this movement believe that the United States would be far better off if we allowed banks and businesses to fail.

It is highly likely that this populist movement will gather momentum as the unemployment rate rises and tent cities become more prevalent. Federal Reserve Chairman Bernanke has said that the economy will recover as long as we have the political will. At present, the likelihood of getting another spending bill through Congress is remote. As the anti-bailout movement gathers momentum, the possibility of additional spending packages will disappear entirely as the nation’s political will disappears.

If the current stock rally proves to be short-lived and the anti-bailout forces gather momentum, then the nation will be in for a long, hot summer of discontent and civil unrest. In such an environment, people working for specific organizations could become targets of discontent just as AIG executives have.

Bank Nationalization Fever Wanes

Remarks by Federal Reserve Board Chairman Ben Bernanke allayed fears of the federal government nationalizing major banks. Appearing before the House Financial Services Committee he said the major banks were not in jeopardy of failing and nationalization was not necessary.

Bernanke stated that nationalization is when the government seizes the bank, zeros out the shareholders, and manages the bank; and, they don't have anything like that planned. His remarks caused a significant rally in beaten down bank stocks.

The positive comments by the Fed Chairman came the day after President Obama’s optimistic State of the Union address. Their remarks were the first meaningful statements to effectively offset the cries for nationalization that had been increasingly dominating the print and cable media.

The loud voices favoring bank nationalization have suffered their first major setback. Those opposed to nationalization hope this is the first of many defeats that the talking heads will receive going forward. Baseless rhetoric by inexperienced pundits has simply become too much for the nation to bear.

Bank Nationalization Opponents Need To Thank Greenspan

Alan Greenspan, the former Chairman of the Federal Reserve, who many view as the primary culprit for today’s economic problems, has come out of hiding to express his views on the subject of bank nationalization. Greenspan told The Financial Times “It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring.”

Opponents of bank nationalization should thank Greenspan. After all, who in their right mind would rely on the views of a person weighed down with an admittedly broken economic model. He greased the skids for this slide into the abyss; he does not hold the solution.

Bank Nationalization is Wrong

The clamor for nationalizing big banks grows each day. Those favoring nationalization recommend removing all bad assets from bank balance sheets thereby wiping out, as needed, the equity of common shareholders followed by the interests of preferred stockholders and then the bond owners.

The bad assets would then become assets of the FDIC or a special entity established by the federal government. The new owners could then keep them or sell them to private investors, who are reportedly waiting anxiously to acquire these bad assets.

Proponents of this approach strongly suggest that nationalization is necessary for the nation to end its economic death spiral and begin a recovery. Bank nationalization also has widespread popular appeal, because it supposedly punishes the culprits for destroying the economy and it provides just punishment for making stupid decisions.

Nationalization is neither a necessary nor a sufficient condition to solving today’s problems. The treatment of Continental Illinois in the 1980s and the purported success of the RTC are not appropriate templates to follow. Such actions today could easily aggravate economic conditions by causing further consumer despair and calling into question the value of the U S currency and our U S government debt.

The truth is that de-leveraging by financial institutions, corporations, and individuals takes time. The bad assets on the books of the banks will disappear as they either heal, are liquidated, or are charged off through earnings. The debt of corporations will be reduced as corporations either take bankruptcy or use their cash flow to reduce debt. Individuals will similarly de-lever by either erasing debt through bankruptcy or curtailing consumption. During this period the level of economic activity will be negatively impacted unless the government expands its expenditures and levers its balance sheet. Nationalization of banks will not prevent this process from occurring.

The fact that “vulture investors” are among the most vocal supporters of nationalization testifies to the fortunes they made when the government engaged in widespread closures of financial institutions in the 1980s and 1990s. They can’t wait to once again be the beneficiaries of a large transfer of wealth courtesy of the federal government.

While fans of the RTC cover it in accolades, the beneficiaries of its largess chuckle. Here is what one person had to say about the RTC, “When working on a mortgage-backed trading desk back in the '80s, the RTC went to the street to solicit bids for the assets that they had taken over from the insolvent thrifts. We made a killing. It was an unadulterated field day. We bought the stuff at a discount to the projected cash flows and resold it within hours for huge profits. In anticipation of once again earning huge profits, the likely beneficiaries are doing their best to drive banks off the cliff so they can once again buy distressed assets at fire sale prices. It is the way of the street.”

Bank nationalization proponents claim that the only proper way to value banks is on the basis of liquidating value or tangible common equity. Such an approach is understandable, because that is in their best interests. Valuing banks on a going concern basis has no place in their playbook. Calling these investors “vulture investors” gives vultures a bad name!

Unwittingly, regular citizens, including the unemployed, have joined forces with these people to form an unofficial bank nationalization coalition. The fact that these disparate groups increasingly favor nationalization is disturbing and requires examination.

There are two issues that merit careful consideration before being swept up in this drive for nationalization. First, who determines what “bad assets” need to be excised from a bank being nationalized? Second. who determines the price of a bad asset at the time of its removal?

In the case where a loan is determined to be a bad asset and is transferred to another entity that borrower loses their right to renegotiate that debt with the original lender. This puts the borrower in a less favorable position than they would otherwise be, since the new holder of the loan would either be unable or less likely to lend more money, extend the term, and/or lower the interest rate. Borrowers and the local economy are better served by loans staying where they are originated.

Recent events with securitization prove beyond a reasonable doubt that original lenders have a greater likelihood of getting repaid. Accordingly, the intrinsic value of a bad loan on the balance sheet of a bank that made it is greater than the intrinsic value of that loan when it is housed and administered elsewhere. Furthermore, an original lender is far more likely to advance additional funds to borrowers, thus extending the economic life of a borrower.

Similarly, it can be argued that the intrinsic values of securitized assets held by a bank are greater than the comparable values if they are held by most private investors. This is so because banks benefit from having a much lower cost of funds, especially today. Banks also have more secure and virtually unlimited funds available thanks to expanded FDIC coverage, which removes the fear of bank runs, and an aggressively accommodative Federal Reserve. The intrinsic values of assets on the balance sheet of a bank today are understandably greater than what non-bank investors’ claim.

We cannot afford to experiment with nationalizing our banks. It is not necessary, especially in view of the fact they do not face deposit runs; their cost of funding is plummeting; they have very favorable interest spreads; and, their earning assets exceed their paying liabilities.

The truth is that almost all of the banks and savings and loans that were closed during the past 30 years would have survived if they had today’s deposit guarantees, deposit rates, and were given some time. The exceptions are those institutions that were caught by persistent negative interest rate spreads when interest rates soared and those banks closed because of fraud and malfeasance.

The federal government needs to ignore the cry for bank nationalization. This is not like the 1980s or 1990s.