Buy Big Bank Stocks and Give Regionals a 'Breather': Merrill Lynch (Update 2)

Citigroup

Citi's shares closed at $34.60 Tuesday, returning 32% year-to-date, following a 44% decline during 2011.

The shares trade for 0.7 times their reported June 30 tangible book value of $51.81, and for 7.6 times the consensus 2013 earnings estimate of $4.55. The consensus 2012 EPS estimate is $4.07.

For the 12-month period ended June 30, Citigroup's operating return on average assets (ROA) was 0.55%, while the company's return on average tangible common equity (ROE) was 7.22%, according to Thomson Reuters Bank Insight.

Citigroup will announce its third-quarter results next Monday. The consensus among analysts is for the company to report a profit of 96 cents, declining from a dollar a share in the second quarter (excluding credit and debit valuation adjustments), and $1.23 during the third quarter of 2011.

Penala's price target for Citigroup is $45, offering "the most potential upside" among the large-cap bank stocks she covers. The company is "one of the more misunderstood banks," she said, "in that investors view outsized risk in its international operations and overlook its EPS leverage to a US housing recovery."

Citigroup CEO Vikram Pandit's long-term "good bank/bad bank" strategy for Citigroup is to pursue growth in the company's international operations, while placing noncore assets -- including the company's 49% stake in the Morgan Stanley Smith Barney joint venture, which the company is selling to Morgan Stanley (MS) -- within the Citi Holdings subsidiary, and allowing them to run off.

Penala said that within Citi Holdings "is a $100bn residential first mortgage and home equity portfolio (15% of total loans), $6.9bn of nonperforming loans (NPLs), and 9.3% reserve/loans ratio," illustrating that the runoff subsidiary has much to gain from a housing recovery, and also has plenty of excess reserves, which can eventually be recaptured in earnings.

"Over time, we expect C to return 25% of market cap to shareholders," through dividends and share buybacks, the analyst said.

Penala also said that "a housing recovery could mean improving inflows of new defaults and better than expected realized values on the residential portfolio, accelerating credit leverage to EPS," and that "if housing continues to recover, we believe portfolio managers looking to increase weight in banks will invest in C incrementally given fair values at regionals and underweight positioning in C."

C data by YCharts

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