Why We're Bullish on Citigroup

As part of our series on the credit crisis, we're taking a deep dive into  Citigroup (C). The stock is one of our highest-conviction picks. We think the upside is huge (about 75% at today's prices) and the downside is limited. In order to justify the current stock price, Citi would have to suffer unprecedented dilution--to the tune of another 4 billion shares outstanding. We think there is no more than a 5% chance of this happening, meaning we believe the odds are squarely in favor of investors at today's prices.

At $30 a share, the market seems to be demanding a 15% annual return from now to eternity to hold Citigroup's shares. These are the kinds of returns that investors expect from speculative investments such as one-product biotechnology companies or emerging-markets firms. We'd gladly accept that kind of return from a financial bellwether like Citigroup. At some point in the future, when all the fuss has died down, the market will reduce the risk premium it demands to hold Citi's stock, at which point we expect the stock to approach our fair value estimate of $53 per share. Investors with a long-term horizon should take advantage of the market's current fear to invest in Citigroup's shares.

Why Has Citi Taken Such a Beating?
Citigroup's tortuous ride from market darling to radioactive waste began shortly after visionary Sandy Weill turned over the reins to Chuck Prince in 2003. Since then, expense growth has consistently outpaced Citi's impressive revenue growth, a fact that frustrated shareholders to no end. Compensation costs were primarily to blame for this trend, as they climbed steadily from 26% of net revenues at the end of 2002 to 34.5% in 2006. Management was unable to "right-size" staff, especially after embarking on expensive acquisitions. Shareholders were reminded of Citi's inability to control its expenses every quarter, slowly raising their ire until some began to publicly call for Prince to resign.

Then, in 2007, a trifecta of events rapidly brought the situation to a head. First, the subprime mortgage problem flared up early in the year, ravenously consuming monoline subprime mortgage originators before moving up the food chain to venerable Wall Street firms. Citigroup, with its large mortgage and consumer finance businesses, was suddenly viewed as vulnerable.

Second, the market fretted about the fate of Citi-sponsored structured investment vehicles (SIVs). These are off-balance-sheet entities that ply the carry trade by borrowing in the commercial paper market and investing in longer-term securities. Commercial paper investors are usually money market funds and other short-term investors. This scheme works well as long as the commercial paper gets rolled over. Citi, as the world's largest financial institution, sponsors SIVs whose assets total about $100 billion, often providing a liquidity backstop to reassure the commercial paper investors. When the commercial paper market dried up over fears that the SIVs contained securities made up of subprime mortgages, investors feared that Citigroup would need to consolidate the assets of the SIVs that were unable to roll over their commercial paper.

The third and final blow came at the end of the third quarter and then a few weeks later, when Citi indicated it would take losses totaling $12-$15 billion, mostly by marking down its subprime securities portfolio. The market punished Citigroup's stock following this announcement precipitating the ouster of Prince.

The Case for Citigroup
In light of all these events, we still believe Citigroup is a compelling value. At Morningstar, we use a discounted cash-flow model to value companies. Our discounted cash-flow model suggests that Citigroup is worth $53 per share. Non-cash expenses such as increased provisions and mark-to-market losses that reduce reported earnings do not impact cash earnings. (Cash earnings represent the actual cash the bank collects for debtors net of what it owes its creditors.)

At Citigroup, that performance has not been nearly as poor as reported net income declines suggest. Credit losses on Citigroup's loan portfolio were up 14 basis points to 1.31% of loans in the first nine months of 2007, hardly numbers that suggest financial Armageddon. For comparison, Citi's charge-offs have averaged 1.67% of loans during the last eight years. This means that 2007, so far, is actually an abnormally good year for credit quality. Credit performance on Citigroup's subprime securities was also well within historical norms. Our models had already accounted for increased charge-offs over the next five years, so we didn't feel the need to lose our heads while the market decapitated itself.

Unfortunately, non-cash expenses such as the markdown of assets and increased provisions do have an indirect effect on a bank. Because these items affect reported net income, it has an effect on the bank's GAAP equity base, a metric that regulators use to judge whether a bank is well capitalized. Because of these elevated losses, Citigroup's capital ratios were not as strong as they once were. Therefore, we reduced our assumptions of Citigroup's balance sheet growth and factored in some uneconomic asset sales that the bank might need to undertake to avoid violating capital norms. This was the main reason for the modest reduction in our fair value estimate.

We used other methods to perform a reality check on our valuation. All of them indicate that our fair value estimate is in the right range. A dividend discount model using various assumptions for the long-term sustainable dividend growth rate and an 11% required rate of return gives a valuation range of $48-$58 a share. We've also illustrated a sum-of-the-parts analysis below.

Citigroup Sum-of-the-Parts Valuation Analysis
	2007 Earnings (run-rate) ($mil)	Multiple	Value ($mil)
Consumer Bank*	12,800	12.5	160,000
Investment Bank**	8,500	10.5	89,250
Wealth Management	1,950	15	29,250
Total Intrinsic Value			278,500
Shares Outstanding***			5,247
Share Price			$53.08
* Nominal profit run-rate after reversing provision buildup. ** Includes alternative asset management unit. *** Includes maximum dilution from the Abu Dhabi investment.

Upside to Our Valuation
So far, we've talked about Citigroup as it exists today. We believe there are several factors that could provide a boost to our valuation. Because banks borrow short-term and lend long-term, their profitability depends on the shape of the yield curve. During normal economic times, the yield curve is steep, meaning borrowing rates for terms less than one year are about 200-300 basis points lower than borrowing rates for a 15-year term. Because banks borrow short-term and lend long-term, and because lending rates are based on the yield curve, a steep yield curve means superlative profits for banks.

Over the past two years, the yield curve has been mostly inverted, meaning investors are charging more to lend for a term of one year than for, say, a 15-year mortgage. This scenario pressured the net interest margins of all banks, and Citigroup was no exception. By our calculations, its net interest margin for 2006 was 2.23%, well below the 3.67% it averaged over the past eight years. If net interest margins expand to 3.67% immediately, our fair value estimate would jump to $65 per share. We at Morningstar don't know when the yield curve will return to its normal shape; therefore, we don't use this scenario in our predictions. We do, however, know that the yield curve will eventually become steeper because investors demand a premium for locking away their money for a longer period.

Another upside to our valuation model is the eventual belt-tightening that Citigroup will have to do to remain competitive in the marketplace. The company has already slashed 17,000 jobs in 2007, and there are murmurs that it could slash up to 45,000 more jobs, or about 15% of its current work force. If this situation came to pass, it could result in big savings for Citigroup. Given that Citigroup spends nearly $31 billion a year in compensation expenses, it's reasonable to expect the company to realize cost savings of about $3 billion per annum net of taxes and some revenue loss. Such savings would add another $6 per share to Citigroup's fair value estimate.

Where Could We Be Wrong?
On the downside, we've identified the following risk factors:

Systemic risks to the financial system
We'd be remiss to neglect mentioning the biggest risk to Citigroup, a systemic risk to the financial system. Banks lend demand-deposits, which by definition means a bank needs to immediately repay a depositor his money. Hypothetically, if all a bank's depositors want their funds back immediately--a bank run--any bank, including Citigroup, would be insolvent overnight.

Systemic risks also appear in the form of  Fannie Mae (FNM) and  Freddie Mac (FRE). These institutions are charged with ensuring liquidity in the mortgage market. Because of their presence, banks are assured that any loans they originate that conform to these entities' guidelines can be sold to them. If trouble at these two institutions prevented them from performing their task, only the U.S. Treasury has the wherewithal to bail them out. This move, of course, will not happen without plenty of time-consuming political wrangling, an area where we have no special expertise. Meanwhile, there could be a widespread failure of financial institutions beginning with the weaker institutions, which would have a domino effect, so that even strong, well-capitalized institutions, given enough time, would fail.

Black box assets and liabilities
As of the third quarter of 2007, we estimate that Citigroup had about $362 billion of assets and $223 billion of liabilities that we would consider to be a "black-box" because there is scant disclosure of what makes up these instruments. For a particular balance sheet item, such as "home-equity loans," we know how those assets have performed historically, and we can make reasonable assumptions about the future performance. However, it is more difficult to predict the performance of line items such as "other trading assets," amounting to $39 billion, which have no additional disclosure. Citigroup has historically had such black box line items without any adverse surprises. But that could always change.

Further losses resulting in more dilution
If there are further unexpected losses either from markdowns of subprime assets, from losses in Citigroup's loan and trading portfolios, or from the black box line items, the company would need to seek another cash infusion similar to the one from the Abu Dhabi Investment Authority, but at possibly more draconian terms.

However, we believe there is limited downside to Citigroup's stock at $30 per share. We assume that any capital infusion will go toward supporting Citigroup's current balance sheet. Therefore, we assume there will be little need for the company to engage in a fire sale liquidation of its assets. With the current size of its balance sheet, the company's intrinsic value is close to $280 billion. To arrive at a $30 fair value estimate, close to where the stock is currently trading, the company would need to have about 9.3 billion shares outstanding, or close to 4 billion shares more than today, an unprecedented level of dilution for a major corporation. We believe such a scenario is highly unlikely, as it implies terrible happenings in the financial markets that would no doubt affect every other institution as well.

Unless we are expecting another great depression, we are confident that at around $30 per share, the downside risk on Citigroup is a lot smaller than the upside potential. And that is something we like to see in all our stock investments.