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Rag Doll; Taking Another Crack at Citi: Best of Kass

Such a pretty face has been dressed in lace.

But the market is a forward-looking mechanism and has begun, well, to get ragged.

Going forward, err on the side of conservatism.

Taking Another Crack at Citi

Originally published on Wednesday, July 23, at 10:55 a.m. EDT

Citigroup (C - Get Report) is a former Kass Katch.

Over a month ago, I sold my Citigroup shares at a slightly lower price than where the shares currently stand. My concerns surrounded the Banamex fraud, the Comprehensive Capital Analysis and Review failure and the uncertainty over the deferred tax asset line and with Citi Holdings' future profits.

Since then, Citigroup has reported its second-quarter results, and I have been going back and forth with Jim "El Capitan" Cramer, who is bullish on the stock.

After a lot of thought/input/analysis (and help from Jimmy), I have reversed my previously neutral stance as the facts have changed.

Yesterday, I added Citigroup to my Best Ideas list.

Again, my principal concerns were that a very large percentage of the holding company's book value ($38 billion) was contained in a deferred tax asset, and that Citi Holdings' had a lot of capital tied up (and returns dragged down).

There is obviously a lot of value in not paying taxes. Moreover, if a bank management can consume the deferred tax asset, the bank will, in turn, generate excess capital above Basel 3 requirements (see below). The significance is that as deferred tax asset runs off, the bank's inferior (relative to peers) return on equity will improve, which allows the bank to return excess capital to shareholders and the valuation (P/E ratio) to expand.

Prior to the release of the last quarter, it was unclear that the full benefit of this asset could be utilized, so I had given less value to the deferred tax asset line. Markets generally don't give a lot of value to deferred tax assets (which are not allowed under Basel 3 capital calculations) and typically wait for actual capital to be returned.

With the release of second-quarter results, I have grown more optimistic that both the deferred tax asset and Citi Holdings have greater value than I previously thought.

These are the positive highlights contained in the recent profit report:

  1. Earnings have stabilized after a series of quarterly earnings cuts. Second-quarter 2014 EPS was a strong beat relative to consensus expectations. Loan growth and trading volume were very positive.
  2. An aggressive core expense cut has been obscured by litigation expenses.
  3. Stripping out nonrecurring items, Citi Holdings reported profit in excess of $200 million -- its first profit ever.

Assuming these trends continue, my (and the market's) deferred tax asset and Citi Holdings concerns will abate.

To quantify the importance (and as seen below), the deferred tax asset represents a relatively large percentage of Citigroup's tangible book value of $57 a share:

  • Citigroup's ongoing franchise earns approximately 15.5% on tangible equity of $33.25 a share, representing 58% of the bank's total equity per share.
  • Deferred tax assets represent $17 a share, or about 30% of Citigroup's tangible equity. The deferred tax asset line represents about a 450-basis-point drag to Citgroup's return on tangible equity, which is lowered to about 11% from 15.5%.
  • Citi Holdings ("the bad bank") comprises about $7 a share (or 12%) of the $57 a share total equity base. Before the release of second-quarter 2014 results, Citi Holdings earned about a 5% return on capital, further serving to drag total returns (by about 250 basis points) from 11% to 8.5%.

[Read: $25 Billion Deal and JPMorgan Stumble to Aid of Bronx Homeowner]

Assuming that Citigroup's ongoing franchise is valued at 1.25x book value (compared with 1.4x for JPMorgan Chase (JPM - Get Report) and worth $41.50 share, deferred tax asset is worth $10 a share and Citi Holdings is valued at $3.50 a share, I value Citigroup today at about $55 a share, over 10% above the current share price.

If, over time, Citigroup can move toward a 12% return on tangible book value (a conservative forecast for now), the shares can move into the mid-$60s over the next two years.

I currently have a quarter position in Citigroup, and I plan to add on any weakness that might occur.

At the time of publication, the author was long C, although positions may change at any time.
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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