Wed Jul 30 2014
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Buy This ‘Hated’ Stock While It’s Still An Incredible Bargain

A sideways stock chart can be deceiving. Just because a stock is directionless doesn’t mean that a company is struggling to improve results. It’s often simply the case that investors are waiting until the stock becomes more timely.

For banking giant Citigroup (NYSE: C), that time is now. Solid second-quarter results imply even better days to come in future quarters.I took a look at Citigroup last week and noted that the bank trades for less than 75% of tangible book value. In fact it hasn’t traded above book value in since 2010. As a point of reference, rival Wells Fargo (NYSE: WFC) for nearly twice tangible book value.

Citigroup’s pariah status among investors stems from a set of lingering problems. First, like all major U.S. banks, it has seen a drop-off in its trading and banking revenues, in part due to the crackdown associated with Dodd-Frank regulations.

Second, its industry-leading emerging-markets exposure is seen as more of a liability than a virtue these days, especially as concerns about China hang over many other Asian economies as well.

Third, a series of charges have led to very choppy quarterly results, and investors are clamoring for more predictability. On a positive note, Citigroup’s recent second-quarter results were fairly clean, and forward guidance also was fairly solid.
Lastly, Citigroup is under yet another management regime, as previous executives moved too slowly to trim the company’s bloated cost structure.

To be sure, the first factor (regulatory changes) are likely to permanently cap the upside of banking and trading revenues, even when the economy is at full boil. But let’s look more closely at those other factors to understand why Citigroup might make a fast move up to book value in coming quarters.

Citigroup’s decision to broadly expand its presence in Asia and Latin America, at a time when other banks are retrenching from those places, was a costly upfront move. Investments in branch networks and key talent have not yet produced solid cash flow. But they most likely will — and soon.

These emerging markets are home to a quickly expanding slate of high-net-worth individuals and fast-growing businesses, and Citigroup is already building leading market share in many countries (compared with European and U.S. rivals). Within a few years, this focus of resources should start to deliver solidly positive cash flow.

Meanwhile, efforts at taming the bloated cost structure are starting to pay off. Citigroup had more than $ 50 billion in annual expenses in 2011, but that figure fell to $ 48.4 billion last year, and according to consensus analysts’ forecasts, should drop to $ 45 billion by next year. Shaving $ 5 billion from overhead over the course of four years counts as a major restructuring.

And those cost cuts should lead to much better balance sheet metrics. For example, return on common equity is on a path to rise from 5.8% in 2011 to 7.7% by next year. That helps explain why tangible book value per share rose less than $ 2 in 2012, but by 2015 and 2016, should be rising roughly $ 5 a year.

Of course management hopes to start paying more robust dividends once it gets the green light from regulators, but some of that money will likely also go to share buybacks. It’s that regulator discussion that everyone is waiting for. Recall that in May, Citigroup’s request for more robust dividends and buybacks were blocked by regulators’ Comprehensive Capital Analysis and Review (CCAR) program.

Regulators have been concerned that Citigroup has too much exposure to risky assets and liabilities, which led to the need for a large amount of deferred tax assets (DTAs) and low levels of what regulators call Tier 1 capital (the safest kind). At one point, these DTAs accounted for one-third of tangible book value, but that number has already fallen to 23% and is headed to the mid-teens next year. And that should boost Tier 1 capital.

Analysts at Merrill Lynch note: “We expect C to generate $ 51 billion of additional Tier 1 common equity (assuming some distribution eventually) over the next 2.5 years — nearly a 40% increase from today’s level. As this occurs, DTA will become a significantly lower percentage of book, and excess capital should potentially help drive up dividend payments and stock buybacks.”

Risks to Consider: Citigroup’s considerable exposure could become a liability of those economies tumble.

Action to Take –> The prevailing wisdom is that shares of Citigroup will rally only when the bank passes a CCAR review, which is expected to take place next in the first half of 2015. But many investors, looking at the improving financial statements, think a regulatory green light is increasingly assured — and are starting to bid up shares now. They recently crossed the $ 50 mark for the first time in four months, and farsighted investors will build positions in Citigroup well in advance of the next CCAR review. Meanwhile, the sharp discount to tangible book gives this stock a solid cushion of safety if the market heads lower.

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