Why I'm Buying Citigroup

Andy Obermueller's picture

Friday, January 15, 2010 - 3:02pm

by Andy Obermueller

Next week the market will be focused on the nation's banks, as the top U.S. financial institutions report their quarterly earnings. Their earnings parade actually started today, with a quarterly report from JPMorgan Chase & Co. (NYSE: JPM), and it will continue next week with word from Bank of America Corp. (NYSE: BAC), Wells Fargo & Co. (NYSE: WFC), Goldman Sachs Group Inc. (NYSE: GS) and a half dozen smaller institutions before Wall Street changes focus on Friday with earnings announcements from General Electric Co. (NYSE: GE), McDonald's Corp. (NYSE: MCD) and Schlumberger LTD (NYSE: SLB).

J.P. Morgan's profit was up but revenue fell short of Wall Street's expectations, which pushed stocks lower Friday, though the Dow is still in positive territory for the year. The pullback in banking shares may present an opportunity.

I'll be buying Citigroup (NYSE: C) shares in anticipation of its Tuesday earnings release, to which I think the market will react favorably.

Wall Street expects a -$0.30 per share loss, the bank's ninth consecutive quarter in the red. But analysts' forecasts for this company tend to miss the mark, and I want to make sure I'm positioned for the possibility of an upside surprise. (An earnings surprise is just one of several "profit catalysts" that could boost a company's share price quickly.) Much of the risk of this position is mitigated by today's pullback: Morgan's revenue shortfall milked the rattlesnake and brought Citi shares within pennies of their low for the year.

There's another reason I like Citi: I think its worst losses are behind it. The bank is entering a new, post-crisis era: Its largest investor, Prince Alwaleed bin Talal of Saudi Arabia, has told Citi CEO Vikram Pandit in no uncertain terms that his honeymoon is over and he expects results, a clear signal that the worst has passed. Wall Street also has signaled it expects the bank to return to profitability in 2010, with a consensus estimate of $0.09 a share, though forecasts range as high as $0.23 a share.

The latest numbers from the Federal Deposit Insurance Corporation (FDIC) show that Citi had interest income of $35.1 billion and total interest expense of $10.6 billion, leaving it with $24.5 billion in net interest income. Of that, more than 80%, or $19.9 billion, was set aside to cover bad loans. In other words, without those bad loans, Citi would have had a $20 billion quarter instead of posting a loss. But here's the thing: Citi now has $493.8 billion in loans. Of those $35.3 billion are past due, and most but not all of which will have to be eaten and charged off. Of that $35 billion, however, half are wholly or partially guaranteed by the government, which means Uncle Sam will get the bill, not Citi. Here is the data from the FDIC.

  9/30/09 6/30/09 3/31/09 12/31/08 9/30/08 6/30/08 3/31/08 12/31/07
Total Loans $493.8 $515.9 $518.7 $544.9 $612.0 $644.1 $682.0 $677.1
Loss Reserves $23.3 $22.9 $19.4 $18.2 $16.1 $13.9 $11.9 $10.7
Past-due Loans $35.3 $30.9 $28.3 $24.8 $17.4 $15.7 $12.4 $11.1
Govt. Guar. $17.6 $15.8 $14.0 $3.6 $2.9 $2.5 $2.6 $2.4

Citi currently has $23.3 billion in its loan-loss reserve. Adding another $20 billion to it would imply that nearly 9% of its entire loan portfolio – nearly one in ten loans -- is worthless. That’s high: The net chargeoff rate for commercial banks is 2.8%, which Citi has covered by a factor of two. I think it’s unlikely Citi will be obligated to use such a great percentage of its net interest earnings to replenish its reserves. If it doesn’t, then those dollars go straight to the bottom line.

Shedding its bad loans has been a long and difficult process for Citi, to say nothing of the exorbitant expense. On Dec. 31, 2007, the bank held a portfolio of $677.1 billion in loans with a mere $10.7 billion in loss reserves. In the ensuing quarters, Citi has winnowed its portfolio to just under $500 billion in loans, with a reserve provision of $23.3 billion. The most difficult losses have been charged off. The bank is ready to come out from hiding, the shareholders are ready for profits and the regulators, alas, could do with a little vacation after these past 18 months.

Citi has long-term upside. It also is likely to see a pop with its earnings, which, at this point, have nothing but upside. I'm buying Citi shares today.

Andy Obermueller does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of C in one or more of its “real money” portfolios.