Citi – Slightly Undervalued for a Reason

 Citigroup (C) is still slightly undervalued based on a discounted cash flow model despite currently trading only slightly off its 52 week high and having risen 36.76% over the last twelve months.  Citigroup is not unique in this regard.  The other three giant U.S. banks JPMorgan Chase (JPM), Wells Fargo (WFC), and Bank of America (BAC) have gone up 27.15%, 4.02%, and 39.38% over the last 12 months, respectively.  Wells Fargo was the notable underperformer relative to peers largely due to the impact of the fake accounts scandal. 

Valuation

None of these banks are trading at a huge discount to fair value after these impressive runs.  Our DCF model shows Citi, JPMorgan, Wells Fargo, and Bank of America trading at 92%, 95%, 98%, and 87% of fair value, respectively.  The DCF model considered a 10% discount rate, the earnings over the last 12 months, the current dividend, and the average long term growth rate from analysts covering the companies.  Specifically, the inputs for Citi are listed below:

• Quote: $72.25
• EPS: $5.19
• PE: 13.93
• Dividend: $1.28 (Yield: 1.73%)
• Long term earnings growth rate: 9.53%
• Discount rate: 10%
• Target Buy Price:  $78.7 (92% of current price)

Citi is cheaper than JPMorgan and Wells Fargo and slightly more expensive than Bank of America based on the DCF evaluation.  However, there is good reason for this slight undervaluation.  Citigroup had the lowest average annual growth rate over the last five years out of the four banks.  Additionally, Citigroup ranks lowest based on various profitability metrics.  For example, Citi has the lowest return on equity and profit margin among the big four.  The trailing twelve month profit margin for Citi was 23.6% compared to 31.7%, 35%, and 46.6% for Bank of America, Wells Fargo, and JPMogan, respectively.

We should also note that the average estimate for Citi’s long term earnings growth rate of 9.53% from analysts polled by Reuters seems rather optimistic.  One should note that the average annual growth rate of the last five years was 5.7%.  On a positive note, that gives at least some credibility to the growth rate used above, quarter over quarter earnings grew by 14.5%.  The latest 10Q shows EPS of $1.42 for the three months ending September 30^th compared to $1.24 for the same quarter in 2016.  While there is potential for Citi to achieve the 9%+ average annual EPS growth, especially with its operations in Latin America and Asia, there is plenty of uncertainty evidenced by the low end of the analyst estimates for the annual long term EPS growth which came in at 5%.  Using this more conservative forecast in the DCF model actually results in a target buy price that indicates that Citi is trading 15% above fair value.

Recent Results

Citigroup splits its results by three segments which include Global Consumer Banking (GCB), Institutional Clients Group (ICG), and Corporate/Other.  The GCB Group includes operations in North America, Latin America, and Asia offering local business and commercial banking, residential real estate loans, and asset management in Latin America.  It offers Citi-branded cards in all regions while offering retail services in North America.   The ICG provides Investment banking and treasury and trade solutions in addition to corporate lending.  It also offers markets and securities services in fixed income and equity markets.  This segment also generates some of its revenue from Europe, the Middle East, and Africa (EMEA).  Finally, the Corporate and Other segment covers operations and technology and global staff functions as well as other corporate expenses.  It also includes results of discontinued operations.

A review of the third quarter operating results shows that the quarter over quarter jump in EPS is largely attributable to the ICG which saw income increase by 15% quarter over quarter.  The ICG had net income increase by 24%, 15%, -2%, and 11% in North America, EMEA, Latin America, and Asia, respectively.  The bright spot in GCB was Asia.  Net Income from GCB increased by 15% in Asia while it actually declined by 16% in North America.  Latin America’s GCB segment saw modest income growth of 3% on a quarter over quarter basis.  Citigroup’s net income also got a boost by the reduced drag from discontinued operations compared to 2016.

Final Thoughts

While you can do a lot worse than investing in Citigroup, investors can likely find better places to put money at this point.  Citigroup is now fairly valued even if you use the more optimistic end of the long term growth estimates in your valuation calculations.  It also usually is not advisable to invest in the least efficient or least profitable company just because it seems cheaper.  There are some promising aspects of Citi’s business with its operations in Asia and Latin America providing real growth potential.  However, recent results show that Citi continues to lag its three big peers on most profitability and efficiency metrics.