Citigroup, Inc. (Citi)
In the first quarter, Citi’s share price appreciated materially from a depressed level at the end of 2011, and in recent weeks, declined back to similar levels. We have believed for some time that Citi is a well-capitalized financial institution trading at a substantial discount to intrinsic value. We have also believed that Citi’s ability to return capital to shareholders principally through share repurchases will be an important catalyst for value recognition by shareholders.
Shortly after the first quarter ended, the Federal Reserve released the results of its annual stress test for large U.S. financial institutions and Citi reported earnings. These annual stress tests attempt to determine how a severe economic downturn would impact the capital of the largest U.S. banks. In conjunction with the stress test, the banks submit a proposal to return a specified amount of capital to their shareholders over the next several years. Based on the test’s results, the Fed either approves or rejects the banks’ proposals.
We believe this year’s stress test results showed that Citi is one of the best capitalized U.S. banks, which would make it unlikely to need to raise capital even in the event of a continued severe and long-lasting economic downturn. Unfortunately, the Fed did not approve Citi’s proposal to return what we believe was $5 billion to $8 billion of capital to its shareholders.
The Fed requires that banks maintain at least a 5% capital ratio after undergoing the stress scenarios, which is a measure of a bank’s equity capital relative to its risk-weighted assets. If Citi had been allowed to return the amount of capital to shareholders that it proposed, it would have achieved a 4.9% capital ratio, 10 basis points below the required minimum. Unfortunately, the Fed took a “thumbs-up” or “thumbs-down” approach to the capital return request – if the bank’s request was one dollar above the minimum as determined by the Fed, its request was denied.
Citi is required to resubmit a capital plan in the next few months. Based on the amount of capital that Citi generated in the first quarter of this year, the bank’s capital is now above the minimum 5% capital ratio by a wide margin if it were to resubmit the same capital request. In light of the currently uncertain environment, however, Citi has elected not to seek to return capital to shareholders in 2012, delaying a potential valuation catalyst into 2013.
In the first quarter of this year, Citi reported one if its strongest earnings results in the last several quarters. Revenue increased at a healthy rate in its core businesses, credit costs continued to improve, and capital levels continued to increase. With this progress, Citi generated a more than15% return on tangible equity in its core business. Citi’s core businesses also generated operating leverage, as revenue grew more quickly than expenses. Citi’s historic inability to generate operating leverage in previous quarters had previously been a red flag for investors.
Citi remains extremely cheap relative to our estimate of intrinsic value – it trades at less than60% of tangible book value, about six times last year’s underlying earnings per share and about four times normalized earnings per share after giving credit to its net tax assets and excess capital.
The intrinsic value of Citi has increased meaningfully over the course of our ownership of the bank while the stock price has declined substantially. We believe that the continued generation of profits and increase in growth of tangible book value will ultimately cause investors to revalue the bank at prices approaching its intrinsic value.