Stabilized by massive government capital injections in the depths of the financial crisis, Citigroup now offers investors something unusual for a U.S.-based bank: the possibility of loan growth. Thanks to its presence (see chart below) in developing economies (more than one-fourth of its 2010 consumer banking revenue came from Asia, Latin America, the Middle East, and Central and Eastern Europe), Citigroup is poised to continue adding high-margin loans to its balance sheet while many of its peers in the U.S. and Europe suffer from low interest rates and minimal loan demand in deleveraging developed economies.
Citigroup's turnaround is by no means complete. Citi Holdings — the bank's $289 billion collection of unwanted assets — still accounted for 15% of the balance sheet as of September 30 and resulted in more than $9.5 billion in charge-offs and $1.6 billion in net losses through the first nine months of the year. These assets are likely to eat away at earnings for several more quarters and contribute to slow to negative balance sheet growth for the company as a whole. It's also possible that more of these assets could return to Citicorp — the "good bank" portion of the business — as the economy improves, much as the retail partner credit card business did in the third quarter.
Citigroup has been improving its capital ratios dramatically. Near insolvency in late 2008, the company boasted a Tier 1 common equity ratio of 11% as of Sept. 30, 2011, in addition to reserves sufficient to cover 5% of the loan book as of the same date. These levels position the company to withstand a significant deterioration in credit quality. At the same time, Citigroup can afford to invest in fast-growing markets in Latin America and parts of Europe, the Middle East, and Africa, where consumer loan yields can be up to twice the level the bank receives in its North American consumer business.
There is a perceived risk that U.S. banks have big risks to European sovereign debt, but Citigroup's position there is manageable. As seen in the chart below, the riskiest portion of Citi’s exposure is arguably the $1.5 billion exposure to sovereigns; however, this represents less than 1% of book value of Citigroup. I think that the concerns related to tangible book value are manageable. Even in the event of a full write-off of Citi’s GIIPS net exposure of $7.1 billion, which is unlikely particularly given developments out of Europe, shares would still be trading at 0.7 times tangible book value.
In 2012, Citigroup should have the opportunity to begin returning capital to shareholders. Citigroup's stock has traded below tangible book value for much of 2011 and at a single-digit multiple of analyst's normalized earnings estimate. If management chooses to embark on an aggressive share-repurchase program while the stock is trading at a substantial discount to the average fair value estimate (and regulators allow such a plan), shareholders could benefit enormously.
The most interesting fact about Citi is the disconnect between the current valuation of 0.6 times tangible book value and a conservative forecast of return on tangible equity (ROTE) of 9% in 2012 and ability to generate a double-digit ROTE for the core Citicorp in the coming two years. If Citigroup could generate solid book and tangible book value growth in 2012 and 2013 that should lead to an improved valuation and further support upside in the shares. Furthermore, the company has made significant strides in reducing risk and improving its capital and liquidity position in advance of the implementation of the Basel III capital rules. It is interesting to read that Citi shares have not traded at these tangible book multiples since third quarter 2009 — at which point the company was unprofitable, risk was higher, and capital were levels lower. Risk has been materially reduced since then; the company has returned to sustained profitability. In addition, non-performing assets have declined 150 bps and net charge-offs have declined 180 bps. Capital levels have been strengthened with the Tier 1 common equity ratios improving 200 bps and Tier 1 ratios improving 210 bps since that time period. I think that as Citi can demonstrate that they can sustain double-digit ROTEs, shares could trade at a premium to tangible book value in the mid-term.