Undervalued Citigroup Reports Great Results

Article Thesis

Bank stocks have performed badly this year, but underlying results are better than many had expected. This also holds true for Citigroup (NYSE:C), which was significantly more profitable than the market expected. This alone is not a reason to buy, but since shares are also trading at a very low valuation, there could be significant long-term value for investors while Citigroup’s shares are trading this low.

Q3: Better Than Expected

Banks’ stocks were hit hard this year. Citigroup’s shares, for example, have underperformed the S&P 500 index by ~50% in 2020 so far. This is due to the market’s belief that banks’ profits will be decimated due to a double whammy of a weak macro environment, coupled with record-low interest rates that lead to pressure on net interest margins. Those fears seem warranted to some degree after all the environment for banks indeed is weaker now than it was at the beginning of the year.

Whether the very steep share price drops are justified seems rather questionable, however, when we take a look at the actual results that Citigroup (and its peers) reported for the most recent quarter:

Source: Seeking Alpha

Yes, revenues were down, mainly due to a pressured net interest margin, but the decline was more benign than analysts had expected. Looking at the bottom-line performance, the discrepancy between what was feared and what occurred is even wider. Citigroup’s earnings per share of $1.40 beat the $0.91 estimate by $0.49, or more than 50%. One can, I think, say that expectations were trounced in this case, as profitability was on a whole other level compared to what analysts had predicted.

There are several reasons for that, including better trading revenues and profits compared to estimates, but one key reason is the provisioning for credit losses. Banks need to account for credit losses that are likely before they actually materialize, through provisions. Citigroup and its peers have increased their provisions by a lot during Q2 when lockdown measures hurt the economy, and it was expected that customers would not be able to pay back their loans to a significant degree. As it turns out, the performance of the US economy over the last couple of months was better than feared, which is why actual credit losses did not rise much. Citigroup and its peers, knowing about the fact that loan losses are below the level forecasted during the peak of this crisis, were able to reduce their provisioning substantially during their respective third quarters. Citigroup, for example, added $2.3 billion to its credit loss provisions during Q3, versus $7.9 billion during Q2. This naturally helped Citigroup’s bottom line quite a lot. Citigroup was not too aggressive in reducing provisions, after all, its provisions still were higher than actual net credit losses during the quarter ($1.9 billion). The level of provisions that the company added during the quarter thus seems appropriate.

Citigroup generated earnings per share of $1.40 on a GAAP basis. Annualizing this amount gets us to $5.60, which would equate to an earnings multiple of 7.7 for the bank at the current share price of $43. Q3 was still impacted by the pandemic, and it seems appropriate to assume that actual earnings power will be higher in the future, e.g. in fiscal 2021, or fiscal 2022.

When Citigroup is annualizing net profits of well above $5 per share in the midst of the pandemic, does it make sense that shares are trading for less than 8 times that amount right now, when there seems to be clear potential for the company to improve its profitability going forward? Provisions for credit losses will likely continue to decline on a sequential basis, and cost-cutting will bring down expenses going forward. At one point, the bank should also get approval for resuming its buybacks, which will be very accretive when done at a valuation that is this low.

Solid Capital Reserves

Citigroup’s common equity tier 1 ratio (CET1) stood at 11.8% at the end of the third quarter. This is not the highest among the big banks, but it is still a very solid level of available capital reserves.

Source: Citigroup presentation

In the above slide, we see that Citigroup’s CET1 ratio is close to the highest level it has been at over the last two years, and it actually is up compared to one year ago. Citigroup also managed to increase its capital reserves during the first three quarters of the current year, despite the pandemic impact. This seems to indicate that Citigroup is well-prepared for the fallout of the current crisis over the coming quarters. With strong capital reserve levels at major banks, the Fed will likely allow the banks to resume their shareholder return programs at one point in the foreseeable future. This should result in some dividend growth and some of the aforementioned buybacks that would be very value-creating at current valuations.

Citigroup’s tangible book value is ~$72 per share right now (book value is $84), and as we can see above, that book value has continued to grow over the last couple of quarters.

Valuation, Dividend, And Return Potential

Speaking of book value, Citigroup is trading at one of the lowest book value multiples in its peer group:

Source: Stock Rover

Citigroup’s book value multiple is just 0.5 (0.6 when only looking at tangible book value), which is well below the peer group average of 0.9. Citigroup is also looking rather cheap based on other valuation metrics, such as its earnings multiple of just 7.5. On top of that, Citigroup is currently offering one of the highest dividend yields in the industry, at 4.7%.

Even during the most recent, pandemic-impacted quarter, the quarterly dividend payout of $0.51 was well covered by the earnings per share of $1.40, for a payout ratio of just 36%. If a major bank with ample capital reserves needs to pay out less than 40% of its profits to finance its dividends, even during a pandemic, then that dividend seems sustainable, unless one makes ultra-bearish assumptions about the pandemic impact over the next couple of quarters.

With a dividend yield of close to 5%, not a lot of share price growth would be necessary for Citigroup to be a solid long-term investment. Due to the fact that shares are trading at a very large discount to book value, there seems to be a lot of room for share price gains. If Citigroup’s book value would not grow at all over the next 5 years, and if shares were trading at just 0.7 times book value by the end of 2025, then its shares would still return ~37% over that time frame, or 6.5% a year. Add in the dividend, and one would have total returns of ~11%. Note that this example, with no book value growth at all, seems like a quite bearish scenario, based on the fact that the bank even grew its book value year to date. And yet, even if that were to materialize, those that buy at current prices would benefit from double-digit total returns over the coming years. If Citigroup gets back to pre-crisis levels of profitability, and to a pre-crisis valuation, then total returns could be way larger. After all, Citigroup was trading for more than $80 in January, a return to that price would allow for a share price gain of ~90%.

Takeaway

With somewhat bearish assumptions for the future, Citigroup would still seem like a very solid investment, while it could turn into a great investment in a more bullish scenario where it fully recovers over the next couple of years. All in all, Citigroup thus looks too cheap to ignore right here, as market sentiment and analyst estimates seem to be too bearish on Citigroup. To some degree, this also holds true for Citigroup’s peers.

One Last Word

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Disclosure: I am/we are long C. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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