July 30, 2014

Doug Kass on Citigroup

Over a month ago, I sold my Citigroup shares at a slightly lower price than where the shares currently stand. My concerns surrounded the Banamex fraud, the Comprehensive Capital Analysis and Review failure and the uncertainty over the deferred tax asset line and with Citi Holdings' future profits.

Since then, Citigroup has reported its second-quarter results, and I have been going back and forth with Jim Cramer, who is bullish on the stock.

After a lot of thought/input/analysis, I have reversed my previously neutral stance as the facts have changed.

Yesterday, I added Citigroup to my Best Ideas list.

Again, my principal concerns were that a very large percentage of the holding company's book value ($38 billion) was contained in a deferred tax asset, and that Citi Holdings' had a lot of capital tied up (and returns dragged down).

There is obviously a lot of value in not paying taxes. Moreover, if a bank management can consume the deferred tax asset, the bank will, in turn, generate excess capital above Basel 3 requirements (see below). The significance is that as deferred tax asset runs off, the bank's inferior (relative to peers) return on equity will improve, which allows the bank to return excess capital to shareholders and the valuation (P/E ratio) to expand.

Prior to the release of the last quarter, it was unclear that the full benefit of this asset could be utilized, so I had given less value to the deferred tax asset line. Markets generally don't give a lot of value to deferred tax assets (which are not allowed under Basel 3 capital calculations) and typically wait for actual capital to be returned.

With the release of second-quarter results, I have grown more optimistic that both the deferred tax asset and Citi Holdings have greater value than I previously thought.

These are the positive highlights contained in the recent profit report:

  -  Earnings have stabilized after a series of quarterly earnings cuts. Second-quarter 2014 EPS was a strong beat relative to consensus expectations. Loan growth and trading volume were very positive.
 -   An aggressive core expense cut has been obscured by litigation expenses.
 -   Stripping out nonrecurring items, Citi Holdings reported profit in excess of $200 million -- its first profit ever.

Assuming these trends continue, my (and the market's) deferred tax asset and Citi Holdings concerns will abate.

To quantify the importance (and as seen below), the deferred tax asset represents a relatively large percentage of Citigroup's tangible book value of $57 a share:

-   Citigroup's ongoing franchise earns approximately 15.5% on tangible equity of $33.25 a share, representing 58% of the bank's total equity per share.
-    Deferred tax assets represent $17 a share, or about 30% of Citigroup's tangible equity. The deferred tax asset line represents about a 450-basis-point drag to Citgroup's return on tangible equity, which is lowered to about 11% from 15.5%.
-    Citi Holdings ("the bad bank") comprises about $7 a share (or 12%) of the $57 a share total equity base. Before the release of second-quarter 2014 results, Citi Holdings earned about a 5% return on capital, further serving to drag total returns (by about 250 basis points) from 11% to 8.5%.

Assuming that Citigroup's ongoing franchise is valued at 1.25x book value (compared with 1.4x for JPMorgan Chase  (JPM) and worth $41.50 share, deferred tax asset is worth $10 a share and Citi Holdings is valued at $3.50 a share, I value Citigroup today at about $55 a share, over 10% above the current share price.

If, over time, Citigroup can move toward a 12% return on tangible book value (a conservative forecast for now), the shares can move into the mid-$60s over the next two years.

I currently have a quarter position in Citigroup, and I plan to add on any weakness that might occur. 

Article originally published on http://www.thestreet.com/story/12822220/2/rag-doll-taking-another-crack-at-citi-best-of-kass.html