Citigroup Inc (C): Speculative Megabank Or Future Dividend Growth Machine?

Citigroup Inc (NYSE:C) more than tripled its quarterly dividend earlier this year, but few people can forget the terror of the 2008-2009 financial crisis. Unlike our favorite recession-resistant dividend stocks, some of the world’s largest financial institutions were on the brink of utter collapse and threatened to plunge the global economy into a prolonged depression.

Citigroup was among the largest of the mega-banks to require a government bailout, with the US government pumping $45 billion into the bank in order to cover losses on $301 billion in toxic mortgage assets.

However, since that time new regulations and a new management team at Citigroup have made an impressive, if still incomplete turnaround. This could create potential for long-term, deep value dividend investors building their portfolios to get in on the ground floor of what could become a great, if still risky, dividend growth stock.

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Let’s take a look at Citigroup’s business and, more importantly, what changes management has made to ensure that one of the world’s largest banks never comes close to wiping out both the global economy, and shareholders, again.

Business Description

Citigroup is America’s 4th largest bank, but the smallest of the four megabanks, which include JPMorgan Chase & Co. (NYSE:JPM), Wells Fargo & Co (NYSE:WFC), and Bank of America Corp (NYSE:BAC). It operates in over 160 countries, serves over 200 million retail customers, is the world’s largest issuer of credit cards, and is one of the largest banks in the world with almost $1.4 trillion in total assets.

Citigroup’s business can be broken down into three segments:

North American Consumer Banking

Retail banking and credit cards:

Q3 2016 % of total sales: 26.2%

Q3 2016 % of total net income: 25.2%

International Consumer Banking

Retail banking and credit cards outside North America:

Q3 2016 % of total sales: 17.3%

Q3 2016 % of total net income: 14.2%

Institutional Clients Group

Institutional asset management, investment banking, corporate lending, and stock and bond trading:

Q3 2016 % of total sales: 45.1%

Q3 2016 % of total net income: 53.7%

Business Analysis

There are numerous metrics needed to understand banks, but the five most important are: earnings per share (from which dividends are paid), tangible book value per share (the underlying intrinsic value of the bank’s net assets), common equity Tier 1 capital (which represents how secure the balance sheet is), the efficiency ratio (what portion of revenue goes towards funding operations), and the dividend payout ratio (security of the current payout).

Citigroup’s turnaround is thanks to its much better management team. For example, compared to his predecessor Vikram Pandit, whose expertise was in investment banking and hedge funds, Michael Corbat, CEO since 2012, is a better-rounded banker. Specifically, Corbat served in numerous consumer banking roles around the globe, as well as the CEO of the company’s wealth management division.

Under his leadership, as well as that of Chairman Michael O’Neill, who successfully turned around Bank of Hawaii Corporation (NYSE:BOH), the company has focused on becoming a much sounder, leaner, and more conservative bank.

This has so far resulted in a focus on three main areas: cost cutting, selling off poorly performing assets (such as its Brazilian, and Argentinian retail arms, and Japanese brokerage division), and strengthening the bank’s balance sheet.

For example, Corbat has overseen the closing of many of Citigroup’s less profitable branches and the laying off of employees, starting with 84 locations and 11,000 workers in 2013 that saved the bank $900 million per year.

Thanks to such efforts, for the first nine months of 2016 Citigroup has an efficiency ratio (operating expenses/revenue) of just 56%, down 3% from last year and the lowest of all the US megabanks.

More importantly from the perspective of shareholders, who want to avoid another 2009 meltdown, the balance sheet is the strongest it’s ever been. Specifically this can be seen with the growth in the bank’s common equity tier 1 capital ratio, or CET1.

Common equity tier 1 capital is just shareholder equity (net assets) plus the bank’s retained earnings over time. It represents the bank’s core capital and what must absorb any losses the bank may face during an economic downturn.

The CET1 is the ratio of common equity tier 1 capital to the bank’s risk-weighted assets, with the limit set by regulators based on a bank’s size and strategic importance to the global economy. Citigroup’s minimum CET1 is 9.0% but as you can see, management has been methodically improving this ratio far over that minimum.

Source: Citigroup Earnings Presentation

In fact, Citigroup’s CET1 is now at the highest level in the bank’s history and a big reason that the Federal Reserve recently allowed the bank to more than triple its quarterly dividend from 5 cents per share to 16 cents earlier this year.

However, as impressive as Citi’s turnaround has been, that doesn’t mean the bank still doesn’t have a long way to go to achieve the same quality standards as best in breed rivals, JPMorgan Chase and Wells Fargo.

Thanks to interest rates remaining near zero in the US, and at their lowest level in history worldwide, Citigroup has struggled to boost its sales, and earnings.

In fact, year-to-date the bank’s revenue and EPS are down 8%, and 17%, respectively. That’s despite a 4% reduction in expenses and a solid 4% reduction in share count, courtesy of the bank’s aggressive buyback program.

The declining earnings are mainly a result of Citigroup’s net interest margin, the spread between its borrowing and lending costs, being under pressure by continued low interest rates.

Now there is good news for Citigroup on this front. Should interest rates rise by even 1% in the US, Citigroup’s net income would rise by $1.4 billion, or roughly 10% compared to the last 12 months (according to the company’s 10-Q).

Since the Federal Reserve expects interest rates to rise by 2.75% over the next four years, Citigroup could potentially be looking at a 27% boost to its bottom line. And that’s not even counting further cost reductions or share buybacks.

This potential to profit from rising interest rates, as well as its strong presence in developing markets such as Asia and Latin America, means that Citigroup has a potentially bright future ahead of it. That assumes, of course, that management’s new conservative, “whatever you do, don’t blow up the bank” mentality seeps into its entire corporate culture.

Given that management has been so good over the years at focusing on long-term growth, as seen by its impressive ability to grow tangible book value per share (up 7.7% year-over-year in the last quarter) despite falling sales and earnings, Citigroup’s corporate culture has indeed shown progress.

Key Risks

While Citigroup has managed impressive improvement since the bank was nearly destroyed during the financial crisis (unlike Wells Fargo or JPMorgan Chase which still made billions in profits thanks to their more conservative banking cultures), investors need to keep in mind that Citigroup remains the lowest quality and most speculative of America’s megabanks. Specifically, there are four major risks to keep in mind.

First, thanks to Citigroup’s large investment banking arm, Citigroup has the second highest exposure to derivatives of any bank, according to the Office of the Comptroller of the Currency.

Now, understand that, while the CDOs (credit default swaps) that ultimately turned a downturn in the US housing market into a global financial meltdown are one kind of derivative, not all derivatives are equally dangerous.

Derivatives are merely a “financial contract whose value is derived from the performance of underlying market factors, such as interest rates, currency exchange rates, and commodity, credit, and equity prices.”

Most derivatives, such as options and interest rate swaps (what makes up the majority of bank derivative holdings), are designed to hedge against abrupt changes in important economic metrics (such as interest rates) and smooth out a bank’s cash flows. The global market for derivatives is enormous, over $2.5 quadrillion dollars (34.25 times the size of the world economy in 2015).

Remember that this isn’t necessarily the same toxic CDOs that blew up the world economy in 2008, so there’s no need to start stockpiling canned food, bottled water, guns, and ammo in the bunker.

But derivatives, especially in the quantities owned by megabanks, can make it more challenging to determine a bank’s true assets in the event of a black swan, or completely unexpected financial event.

An example of this was the sudden and unexpected default of Russia on its loans in 1998 which brought down Long-Term Capital Management and required a bailout by the Federal Reserve to prevent a potential global finance crisis.

In other words, during times of financial panic, when derivative prices can go haywire, a large derivatives book can mean unexpected changes in asset prices, both up and down, that can substantially deviate from the bank’s balance sheet in normal times.

Essentially, big banks can be thought of as “black boxes,” in which investor capital goes in, profits come out, but you aren’t quite sure of what’s in there.  This doesn’t necessarily mean that you shouldn’t invest in big banks; however, you need to be highly selective and make sure that you have confidence in management that the derivatives the bank does have won’t nuke the balance sheet when the world’s next inevitable financial crisis does occur.

The meltdown of 2008-2009 serves as a pretty good “worst case scenario.”  The way that JPMorgan Chase and Wells Fargo not just survived but remained profitable and even helped the government bail out other major failed banks is a big reason why those two megabanks are priced at premiums to their book value.

Bank of America and Citigroup, which imploded due to excessively risky credit derivatives, trade at deep discounts to book value, because investors aren’t yet sure whether their current balance sheets are really as safe as they appear.

In other words, while all the megabanks have fortress balance sheets today, Wall Street isn’t sure that Bank of America’s and Citigroup’s fortress walls aren’t laced with dynamite that could explode the next time there’s a global financial surprise. This means that anyone investing in these two “fallen” megabanks needs to be especially aware of the potential risks and make sure to keep their positions small and only as part of a well-diversified portfolio.

A second major risk is that interest rates may not rise nearly as fast as the Federal Reserve currently expects, keeping net interest margins compressed. That’s because the US economic recovery has been extremely weak. In fact, it’s the weakest since 1949.

Now economists have argued for years over the cause of this. Various hypotheses have been offered, everything from: slow recoveries are normal after massive financial collapses, to a secular stagnation resulting from the aging of America’s population, to slower productivity that’s resulted from all the low hanging revolutionary innovations having already been plucked.

Regardless of the actual cause or causes, the fact is that the Federal Reserve has been lowering its long-term interest rate forecast for four years now, and the financial markets aren’t exactly confident in its current projections.

In fact, despite the Fed’s prediction that we’ll see three rate hikes by the end of 2017, right now financial markets are only pricing in a single 25 basis point increase through September of 2017, with the odds of a second at only 33.6% according to the CME Group.

That’s probably due to the weakening of US economic data over the past few months, which has resulted in both the Atlanta and New York Feds decreasing their forecasts for Q3 and Q4 US GDP growth.

In fact, the New York GDP Nowcast is at 2.2% growth in Q3 and 1.4% in Q4. That fourth quarter projection is for the same disappointing growth that the US recorded in the first half of 2016, and which has resulted in the Fed holding its fire when it comes to rising rates.

In other words, the long suffering megabanks, who are counting on rising rates to fatten their net interest margin spreads, might not get nearly the help that they are expecting or hoping for.

A third risk to keep in mind before investing in Citigroup, is that, due to its vast size and complexity, it is likely to take the longest to turnaround, assuming it can truly be turned around at all.

As you can see, Citigroup isn’t even close to the profitability of JPMorgan or Wells Fargo, and despite management’s confidence that it can achieve a long-term ROA of 2.25% (which would make Citigroup one of the most profitable banks on earth), in the most recent quarter there were several unexpected cost increases reported by the company. That means that future profitability for the bank may be far lower than management, shareholders, and Wall Street expects.

Source: Morningstar

This brings me to the final risk, greater and harsher regulations. After the financial crisis new regulations such as Dodd-Frank imposed stricter limits on the banking business. Now many of these changes, such as higher capital ratios (i.e. lower leverage), were needed to minimize the chances of another collapse and taxpayer bailout.

However, the same increase in Tier 1 capital ratios that is a sign of a stronger balance sheet also means that the bank can’t lend out those reserves, resulting in lower profitability; especially if interest rates continue to remain low.

Another regulatory risk is to the dividend itself. This is a result of the big banks now being overseen by the Federal Reserve, who must sign off on their annual capital return plan to shareholders.

In other words, if Citigroup’s annual Stress Test results, which simulate another great recession to see how the bank would fair, don’t go well, its ability to increase its dividend, or even pay one at all, might disappear.

Of course we can’t forget to mention the ultimate doomsday scenario for the big banks: the return of Glass-Steagall, which would effectively break them up.

The Wells Fargo fraudulent account scandal has only inflamed public opinion against large banks. And while an actual return of Glass-Steagall isn’t likely to pass Congress, the potential for a break up of “too big to fail” banks is something investors must always keep in mind.

Dividend Safety Analysis: Citigroup

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Citigroup’s dividend and fundamental data charts can all be seen by clicking here.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

Citigroup Inc (NYSE:C) has a Dividend Safety Score of 76, suggesting that the company’s dividend is very safe despite Citigroup’s less than stellar history of banking profits, which include: major losses in the 1980’s from emerging market bonds, commercial real estate losses in the 1990’s, and of course its brush with death in 2008, Citigroup’s current dividend is actually pretty secure.

The strong Dividend Safety Score is due to Citigroup having by far the lowest payout ratio of its peers: Citigroup 7%, Bank of America 18%, JPMorgan Chase 32%, Wells Fargo 37%.

However, that isn’t necessarily due to management wanting to be especially conservative, but rather because the Federal Reserve just allowed it to raise its dividend for the second time since the financial crisis.

In other words, because Citigroup was the most at risk bank, only after six long years of turnaround efforts did regulators finally believe it was safe enough to increase its token payout.

However, one must give Citigroup its due. Management has done a stellar job in creating a fortress like balance sheet that is only getting stronger with time. That could help the Federal Reserve grant the bank permission to increase next year’s capital return program, up from $6 billion this year. Most of that will come in the form of buybacks, but dividend investors should still see a nice boost as well most likely.

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Citigroup’s Dividend Growth Score is 55, which indicates that the company’s dividend growth potential is about average. Of course that’s almost entirely due to the disastrous effects of the financial crisis, in which dividend payouts went from $21.6 per share in 2007 to $0 in 2010. Until the crash, Citigroup’s shareholders enjoyed superb dividend growth from what appeared to be a blue chip stock:

With Citigroup’s payout ratio still at an extremely low level, the Federal Reserve likely to raise rates in December, the bank’s balance sheet at record strong levels, and a buyback program that could reduce share count (and dividend cost) by 5% or so in 2017, Citigroup seems poised for another nice dividend increase in the next year or two.

In fact, over the next decade, it wouldn’t seem out of reach for Citigroup to compound its dividend at a double-digit annual rate. The company may never join the list of Dividend Aristocrats, but it could still reward shareholders with strong income growth.

Of course, never forget that despite the impressive dividend growth potential this bank possesses, that’s only because the dividend is rising from a very low base of 4 cents per share.

In other words, the dividend growth and capital gain potential is a direct result to the tragic mistakes of the previous management that brought a $600 stock to $1 in three short years due to a complete failure of risk management and the need to recapitalize the bank through massive shareholder dilution.

Valuation

When it comes to bank valuation, the price to tangible book value ratio is the gold standard because it compares the share price to the objective intrinsic value of the bank.

It also serves as a useful tool for comparing the quality of bank with its peers. For example, from the table below you can see that not only is Citigroup currently trading at a 21% discount to its tangible book value per share (liquidation value), but it’s also one of the most undervalued global banks on relative basis and far below what it has historically traded at.

Source: Gurufocus

This massive discount is the market’s way of telling investors that Citigroup is the lowest quality (i.e. most speculative) big bank. For example, Wells Fargo, which, over its 164 year history has survived a number of depressions, banking crises, recessions, and world wars, is seen as a rock solid bank that cannot just survive any crisis the world throws at it, but still turn a profit.

In other words, the market is willing to pay a substantial premium for Wells Fargo because of the confidence that, even with the current scandal rocking the bank, the company will continue to generate solid profits and dividends for shareholders over many years to come.

Of course, the better Citigroup’s turnaround goes and the longer management can continue to grow both the strength of the balance sheet and tangible book value per share despite the brutal banking conditions of today, the greater the chance that this discount will decrease. This is why Citigroup might offer the best potential for capital gains of any of America’s megabanks.

Turnarounds are often hairy and can take many years of time to regain the trust of investors. For that reason, they can sometimes deliver exceptional returns. However, there is always the risk that things don’t turnaround or get worse.

While this seems unlikely given the new capital requirements and risk-reducing regulations facing the banks, Citigroup’s marred history and opaque balance sheet will not be forgotten anytime soon.

Conclusion

Citigroup Inc (NYSE:C) has come a long way since the dark days of the financial crisis, and the new management team has done a great job turning around what was truly one of the worst banks on earth.

However, don’t forget that there is a reason that Citigroup remains the most undervalued American megabank, and possibly one of the more interesting “dirty value” stocks in this overheated market.

That’s because Citigroup’s previous management left its balance sheet shattered beyond the bank’s ability to repair itself without a Federal bailout. While the new management culture appears to be as conservative as that at JPMorgan Chase or Wells Fargo, until we pass through another economic downturn shareholders of Citigroup are taking it on faith that its black box of derivatives is truly now as relatively benign as that of its more proven cousins.

In other words, Citigroup remains the most undervalued but most speculative megabank you can own.

Wells Fargo is the only bank stock I own (see my original Wells Fargo thesis here) because it’s so hard to get comfortable with balance sheet risk and trust issues with management (of course, less than a year after purchasing my initial stake in Wells Fargo the scandal broke out, but that’s another story). I like the company’s business mix, which lacks much of the volatile investment banking and trading operations of its peers.

Overall, Citigroup is a speculative dividend growth stock that will likely never find a home in my Top 20 Dividend Stocks portfolio. There are too many risks and trust issues that I can’t get comfortable with. I’m not the only investor saying this, which is why Citigroup’s stock could go on to do very well if management proves us wrong over time.

Disclosure: None