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Citigroup, Stress Tests and Shareholder Gravy

NEW YORK (TheStreet) -- Citigroup (C) has quite a bit riding on this year's round of Federal Reserve stress tests, with a stubbornly low stock valuation and analysts' expectation of a major deployment of excess capital.

Citi's shares closed at $47.61 on Monday. The shares are down 9% this year, following a 32% return during 2013. The shares trade for 0.9 times their revised Dec. 31 tangible book value of $55.31, and for 8.3 times the consensus 2015 earnings estimate of $5.74, among analysts polled by Thomson Reuters. The consensus 2014 EPS estimate is $4.91, increasing from $4.39 in 2013.

Those are by far the cheapest price-to-tangible-book and price-to-forward-earnings ratios among large-cap U.S. banks.

One reason Citi is cheap is that the bank is still going through a multiyear transition to trim noncore assets placed within Citi Holdings, while simplifying its business and shoring up its capital ratios. Citigroup's 2013 return on average tangible common equity (ROTCE) was a mediocre 8.20%, increasing from 4.80% the previous year, according to Thomson Reuters Bank Insight.

Among the 24 component companies of the KBW Bank Index, only Bank of America (BAC) had a lower 2013 ROTCE than Citi, at 7.94%. But Bank of America's stock has a much higher valuation, closing at $16.30 Monday and trading for 1.2 times tangible book value and 10.1 times the consensus 2015 EPS estimate of $1.62.

One reason Bank of America trades higher than Citi is investors' perception that BAC's performance is so closely tied to the improving U.S. economy and housing market. Citi derives most of its revenue and earnings from outside the United States.

But UBS analyst Derek De Vries sees another problem, which is that Citigroup's valuation implies that the company's investment bank is "only worth 1x 2015 earnings." In a note to clients on Monday, the analyst said he arrived at that valuation by "applying competitor P/E multiples to Citigroup's different earnings streams, and attributing a net present value to the $42.5 bn of [deferred tax assets valuation allowance] DTA currently excluded from Citi's regulatory capital."

"We believe that isn't sustainable -- either the market needs to put a higher earnings multiple on Citi's investment bank, or management will de-emphasize the business line and return capital to shareholders," De Vries wrote.

Whether or not Citigroup chooses to deemphasize its investment bank and free up even more excess capital, investors are expecting a major announcement from the bank on March 26, after the Federal Reserve announces the results of its annual Comprehensive Capital Analysis (CCAR) and Review for major U.S. banks.

CCAR is really the second round of the Fed's annual stress-test process. First, the regulator will apply a "severely adverse" economic scenario to the banks' Sept. 30 financials, to see if the banks can remain well-capitalized with minimum Tier 1 common equity ratios of 5% through the scenario's cycle. Those results will be announced on March 20, after which the Fed will incorporate banks' annual plans to deploy excess capital through dividend increases, share buybacks and acquisitions, to the same severely adverse scenario.

Citigroup was approved last year to repurchase up to $1.2 billion in common stock from the second quarter of 2013 through the first quarter of 2014. The bank also left its quarterly dividend at a nominal penny a share.

De Vries expects Citi to be approved to raise the quarterly dividend to 15 cents and to receive Federal Reserve approval for $7.5 billion in share buybacks through the first quarter of 2015, which "is well above consensus (which we believe is ~$0.10 of dividend and ~$4-5 bn of share buyback)," he wrote.

A significant reduction in Citigroup's share count, combined with a lower level of excess capital, will push up EPS while raising ROTCE. Those factors, along with the bank's current low valuation, could feed plenty of growth for the stock over the next year. De Vries rates Citi a "buy," with a 12-month price target of $63, implying 32% upside for the shares.

Morgan Stanley analyst Betsy Graseck, in a note to clients on Feb. 25, wrote that Citi was "well positioned for a capital return hike given last year's 2nd best post stress test capital ratio, coupled with its lowest capital return in our coverage." Graseck expects Citigroup to raise the dividend to a nickel and to gain approval for $6.457 in buybacks. She rates Citi "overweight," with a price target of $62.00.

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