Description

Background:

We believe Citigroup common equity has minimal downside and the potential to double over three years. Although the write-up focuses on valuing Citigroup stock, we consider C 12/2017 $60 call options priced at $5 to be a more compelling way to play Citi, and have the potential to appreciate 4-12x for a 60-145% 3-year IRR.

Risk/Reward:

We find Citi call options to be unusually inexpensive due to 1) low volatility and 2) ample liquidity.  With C stock at $50 and 12/2017 $60 options at $5, to break even investors only need ~10% annual appreciation to reach a $65 stock three years from today, which can be thought of as a) Citi’s current price today (which we believe is significantly undervalued) + b) a portion of Citi’s $7+ annual FCF.

In a reasonable base case, the options could be worth 4-6x the current price and 8-12x with share buybacks.

Valuation

Citigroup consists of three components, 1) Citi Corp, their main retail banking / institutional securities business 2) a deferred tax asset (DTA), and 3) Citi Holdings, a collection of non-core assets being liquidated.  We value each separately.

Scenario 1: No buybacks:

-          C could be worth $80-$90 at 12/17, or a 4-6x return for the options. 

o   Citi Corp: we believe Citi Corp. can earn $5+/share in sustainable GAAP EPS, At 10-12x EPS and 1.3-1.5x TBV, Citi Corp alone is worth $50-$60 today.

o   DTA: Citi has a $36B DTA that shields $3B or $1/share of cash taxes annually but is excluded from GAAP EPS.  At a 17.5% discount rate, this is worth $14.6B or $5.50/share at 12/17.

o   Citi Holdings: Citi Holdings is liquidating at ~20% per year, or $1.20/share.  At a 17.5% discount rate, Citi Holdings is worth $8B or $3/share at 12/17. 

o   Cash: Between now and the expiration of the options at 12/17, Citi Corp could generate $22/share of excess capital ($5 GAAP EPS + $1 tax savings + $1.20 from Holdings x 3 years).

Scenario 2: Buybacks

-          Including share buybacks, Citi could be worth $100-$120 at 12/17, or a 8-12x return for the options.

o   Using the $22/share of cash generated between 2015-2017, by 12/17 Citi has the potential to repurchase 1.3B shares at the current price, or ~45% of its market cap. 

o   Re-running the valuation above but with 1.7B shares outstanding vs. 3.0B today yields the following:

§  Citi Corp: $8.82 of GAAP EPS x 10-12x = $88-$106/share

§  DTA: $14.6B NPV or $9/share at 12/17

§  Citi Holdings: $8B NPV or $5/share at 12/17

§  Cash: $0, as it will be spent on buybacks

Risks

-          If C stock trades below $65 at 12/2017, the options will be worth $0.  Risks include:

o   Regulatory: Regulators may introduce new regulation that forces systemically important financial institutions like Citi to build higher levels of capital, which could consume a portion of the $23 in cash we expect Citi to earn.

o   CCAR: C failed the 2014 CCAR, a major headwind.  Another failure would delay return of capital and more seriously, signal that the Fed could force Citi to make structural changes.

o   Legal: Authorities have proven especially talented at extracting exorbitant fines from large banks, and on-going fines could consume Citi’s cash.

o   Credit: Although Citi has dramatically restructured and de-risked its business, a negative macro environment could dramatically lower EPS and/or destroy TBV.

o   Trading: 25-30% of Citi’s earnings come from fixed income trading, which is facing structural headwinds.       

Catalysts

-          CCAR: In March 2015, the Fed will announce stress test results and should allow Citi to return capital for the first time since the crisis. 

-          Regulatory: Clarity on capital levels should reduce uncertainty.

-          Legal: Declining fines should reduce uncertainty.

-          Interest Rates: Though not included in our EPS estimates, each 100 bp increase in rates should increase EPS by $0.40, or 8%.

Disclosure:

We and our affiliates are long C stock and options and may buy additional securities or sell some or all of our securities, at any time. We have no obligation to inform anyone of any changes in our views of C. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

I do not hold a position of employment, directorship, or consultancy with the issuer.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

CCAR: In March 2015, the Fed will announce stress test results and should allow Citi to return capital for the first time since the crisis. 

-          Regulatory: Clarity on capital levels should reduce uncertainty.

-          Legal: Declining fines should reduce uncertainty.

-          Interest Rates: Though not included in our EPS estimates, each 100 bp increase in rates should increase EPS by $0.40, or 8%.