Citigroup: Banking on a Turn

How's this for a paradox? Citigroup's economists and financial analysts are positive about corporate profits, the stock market, and the American and world economies. "The onus is on the worriers" to defend their downbeat case, economist Steven Wieting wrote in late March. Tobias Levkovich, Citi's equity-market strategist, thinks Standard & Poor's 500-stock index, which closed at 1417 on March 28, will reach a record 1600 by the end of 2007. That's 11% higher than it is today.

By contrast, Merrill Lynch seems on the verge of declaring a recession. Yet Merrill's stock has pounded Citi's shares (symbol C) over the past five years. So have the shares of Goldman Sachs, Bank of America and Wells Fargo. If it could, Citi would probably publish a buy rating on its own stock -- it likes most of the big banks and financial services sectors -- but its shareholders have a right to be frustrated. A never-ending series of strategic changes and acquisitions and divestitures hasn't paid off. Citi's stock closed at $50.97 on March 28, down just 0.2% on a day when the overall market fell sharply. The stock is well above its 2002 low of $24, but still below its record high of $59, set in 2000. And it's up only 6% since July 2004.

Yet there's a glimmer of hope for Citi shareholders. Three news developments in the past two weeks suggest better times ahead. One is the assortment of statements by Federal Reserve chief Ben Bernanke that the economy is slowing but not destined to shrink. If Bernanke is on the mark, the next move in short-term interest rates will be down. As we shall see, that would boost Citi's lagging profits.

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Second, Citi says it won't try to buy ABN AMRO, the giant Dutch-based global bank and securities firm. (Citi earlier bought ABN's mortgage company.) This mega-deal would have given Citi a European clone of itself but would also have saddled it with all kinds of questions about cross-cultural relationships, overlapping business franchises, the appropriate emphasis between banking and securities, and more. Citi still has plenty of new business acquisitions to integrate, both foreign and domestic.

Third, news broke that Citi is prepared to cut its overhead dramatically, by more than $1 billion, by firing people and closing redundant facilities. The details are due in April, and the reception this plan gets from analysts will play a big role in the stock's near-term performance. So will the next quarterly earnings report, due out April 16.

While you wait -- and there's always the chance of a surprise write-off or a legal hassle with this company, given its history of regulatory entanglements -- analysts are straining to see the bright side. In a March 19 upgrade to buy for "aggressive" investors, A.G. Edwards analyst David George pointed out with a mess of numbers that a small cut in the interest rates Citi pays to its depositors should result in massive earnings increases. This deposit "leverage" exceeds that at other big banks so, if the Fed eases, it could send Citi's 2007 earnings to $5 a share, versus Thomson First Call's current average estimate of $4.50. That should suffice to send the stock to the $60s.

Even if the Fed stands pat a while longer, Citi is cheap. That's why Bank of America's John McDonald upgraded the stock to a buy rating on March 28. He says the stock, trading at 12 times his 2007 earnings estimate and 10 times his '08 forecast, is cheaper than peer banks. (Other measures such as dividend yield, now at 4.2%, and price to book value point to the same conclusion.) Throw in cost savings to come, and McDonald writes that "even modest improvement" in management performance will push the stock to the high $50s.

I won't kid you. This is a catchup story, and laggards in competitive industries don't always close the gap. But there is a precedent for a Citi renaissance. As told by former Vanguard Windsor fund manager John Neff in the book John Neff on Investing, Citi crashed to what is now the split-adjusted equivalent of $1 in 1991 because of bad loans to real estate developers and struggling Latin American governments. Neff looked deeper into the company and saw that the main parts of the business -- consumer banking and credit cards -- were making as much money as the real estate was losing. Get rid of the problems, and you have a sound company selling at a cheap price. Neff and staff did so, and Windsor investors benefited greatly.

Today, Citigroup is the third-largest holding in Windsor and the second at Windsor II. If Citi was doomed to be forever awful, the smart managers of these big funds wouldn't own such large stakes. Citi may be speculative, but this is one bet worth making.