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Digging Deep for Citigroup's Value

NEW YORK ( TheStreet) -- Shares of Citigroup (C - Get Report) are among the cheapest for any bank relative to forward earnings estimates, and Oppenheimer analyst Chris Kotowski believes investors aren't looking deeply enough to see the company's potential.

When we looked at all U.S. bank stocks at the end of 2013, using data supplied by Thomson Reuters Bank Insight, we were surprised the small-cap HomeStreet (HMST) of Seattle traded lowest relative to consensus 2015 earnings estimates, but it was no surprise to see JPMorgan Chase (JPM - Get Report) and Citigroup among the five cheapest U.S. bank stocks.

JPMorgan's shares closed at $59.00 Monday and traded for 9.3 times the consensus 2015 earnings estimate of $6.36 a share, among analysts polled by Thomson Reuters.  The consensus 2014 EPS estimate for JPM is $5.99.  JPMorgan Chase's stock valuation has been held back by investors' (well-grounded) perception of a political and regulatory target on the company's back.  Following a third-quarter net loss that was driven by a $9.15 billion provision for litigation reserves, JPMorgan's fourth-quarter residential mortgage-backed securities legal tab swelled to $17.5 billion.  This included the landmark $13 billion settlement with the Department of Justice and other government authorities, as well as a $4.5 billion settlement with private institutional investors.

Citigroup's stock trades even cheaper, closing at $53.81 Monday and trading for 9.1 times the consensus 2015 EPS estimate of $5.94.  The consensus 2014 EPS estimate is $5.31.

In a note to clients Monday, Kotowski wrote, "We think that the consensus view is that Citi is fairly valued at $52 or 9.7x consensus estimates for 2014 because those consensus earnings would equate to roughly a 9.7% [return on tangible common equity], and why should one pay a double-digit multiple for a single-digit ROTCE?"

Good question.  The answer lies in boatload of excess capital.

Citigroup has been following through on its "good bank/bad bank" strategy for several years.  The company's main operating unit is Citicorp, while nonperforming assets and other non-core assets have been placed into the runoff subsidiary, Citi Holdings.

Citi Holdings had $122 billion in assets as of Sept. 30, representing just 6% of Citigroup's total assets, and declining 29% from a year earlier and 59% from two years earlier.

According to Kotowski, "one needs to disaggregate Citigroup into two components and value each separately. Component one is a well-performing global bank which is earning an attractive ~17% on its ~$95B of required equity and a pool of ~$68B of excess capital that is not currently productively employed."

"The market is acting as if that ~$68B of excess capital were a negative but it's not, it can only be a positive. One does not know when and how one will get that back, but in the long run it is capital that will be returned to shareholders," he added.

Oppenheimer's 12-to-18-month price target for Citigroup is $64, implying 19% upside from Monday's' close.  But Kotowski believes that Citicorp alone should have a "fair value" of $64 by the end of 2015.  "To this one should add the net present value of the ~$68B of excess capital. We put that value at $9-$14 per share."

A major portion of the roughly $68 billion in excess capital is in the form of a valuation allowance for deferred tax assets (DTA), which Kotowski believes Citigroup is "very likely to recover.  Citigroup's DTA excluded from regulatory capital was $44.5 billion, as of Sept. 30.

"Thus, if one were to value Citi on a sum-of-the-parts basis, one would get a value of between $73 and $78 per share. This is what makes us view Citi as the last great bargain in financial services," Kotowski wrote.

Citigroup has been among the cheapest bank stocks on a price-to-forward-earnings basis for many years, but the stock has continued to recover nicely.  The company's long-term shareholders -- that is, those who went in before the credit crisis, before the government bailout and before the dilutive common-equity raises are still way down on their money, but it's been a great ride for newer investors.

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