Bank Stock Could Soar 30% After It Exits the Penalty Box

David Sterman's picture

Monday, November 24, 2014 - 7:30am

by David Sterman

Michael Corbat has circled Jan. 5, 2015, on his calendar. That's when his administrative staff at Citigroup (NYSE: C) will turn in reams of paperwork for the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR).

And when regulators get back to Corbat in subsequent weeks, he may finally be able to breathe a big sigh of relief. 

Citigroup has tried -- and failed -- to get the green light before, which has prevented the bank from pursuing a massive stock buyback and dividend hike. Not only would a clean bill of health in the CCAR pave the way for a string of such shareholder perks, but the stock should make a rapid beeline up to book value, implying 25%-30% upside from current levels. 

Further, the longer-term potential upside is significantly higher thanks to strong positioning vis-a-vis interest rates and the U.S. housing market.

The previous rejection of the bank's dividend and stock buyback plans was a serious black eye, as it suggested Citi had failed to clean up its act more than five years after the financial crisis began. 

Regulators expressed concern that Citigroup's business model was too unwieldy and not yet capable of weathering another deep financial crisis. They told the bank to further strengthen its capital base and reduce risk in key areas. It was like the investment world's equivalent of being told to clean your room before you get a snack. 

Corbat told investors, "Citigroup must prove we can manage ourselves." And a lot is riding on the next CCAR, at least as far as investors are concerned. 

"When asked what investors thought was the biggest catalyst for the stock to rerate, not surprisingly, the majority of those polled (67%) viewed a successful submission in the CCAR stress test as the most important catalyst," wrote Merrill Lynch's analysts in a recent note to clients.

The difference between last year's CCAR and the next one: Citigroup has strengthened its balance sheet even further thanks to solid cash flow, and the bank is reducing risk by exiting certain emerging markets. 

What happens if Citi's CCAR gets the thumbs up? 

First off, the dividend will get a badly needed boost. Citigroup currently pays out a token $0.04 a year, yet is on pace to earn more than $5 a share next year. Though initial payouts may be modest, Citigroup's annual dividend could approach $3 or $4 a share in a few years, as earnings rise in a firming economy and the company targets a more robust payout ratio.

For now, the greater focus may be on buybacks. That's because Citigroup sports $67 a share in book value, a figure that is set to rise to $74 by the end of 2015, according to analysts at Merrill Lynch. Shares currently trade near $54. As bankers like Corbat know, buying back stock at below book value prices is a great use of shareholder funds. 

Meanwhile, a positive outcome in the next CCAR should help narrow a major valuation gap between Citigroup and its peers, which as a group trade at a slight premium to book value. 

Assuming shares of Citigroup trade up to current book value, they have roughly 25% upside. 

It's unclear when the Fed will release the results of the next CCAR. We only know that it will be some time after Jan. 5. But when that day arrives, the longstanding discount for this "penalty box" stock is likely to evaporate. 

By the end of the first quarter of 2015, when the CCAR results are in, book value is likely to rise to $70 a share based on the current trajectory. Look for shares to appreciate to that level by then.

In addition to the near-term CCAR catalyst, there is a pair of powerful longer-term tailwinds for Citigroup that could boost EPS and book value much higher over the next few years. 

First, as interest rates normalize, Citigroup's net interest margins (the difference between its cost of capital and interest income) are bound to expand back to historical levels. 

Second, Citigroup remains strongly focused on U.S. mortgage lending, and a housing rebound would lead to a spike in mortgage origination fees. 

Bottom line: This is a bank that is getting healthier in a still-tough macro backdrop, and it is poised to flourish when the economy -- and the Fed -- is back on an even keel. 

Recommended Trade Setup:

-- Buy C at the market price
-- Set stop-loss at $48
-- Set initial price target at $70 for a potential 30% gain by end of Q1 2015

This article originally appeared on ProfitableTrading.com: Bank Stock Could Soar 30% After It Exits the Penalty Box

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.