This Undervalued Brexit Winner Just Tripled Its Dividend

Joseph Hogue's picture

Tuesday, July 12, 2016 - 12:30pm

by Joseph Hogue

Markets have recovered their post-Brexit selloff, but that doesn't mean the United Kingdom's decision to leave the European Union won't have some big effects on corporate profits. 

While the actual process to leave the EU could take years, corporations will be positioning ahead of the new environment and clear winners will emerge before the separation is final. 

One group will be looking to capitalize on the power shift in the global financial market -- U.S. banks. Not only will this group benefit as UK and EU competitors struggle with uncertainty, but its own government may be getting out of the way as well, something that's weighed on the industry since 2009.

One company in particular looks poised to benefit from the new scenario, and it's just tripled its dividend in victory.

London's Pain Is The New World's Gain
As London sees its power as a major financial hub weaken one of the few winners of the Brexit vote could be U.S.-based banks. At risk are the current privileges enjoyed by UK-based firms to easily move staff around the European Union. EU leaders are saying "no" to trade negotiations without immigration concessions by the Britons, which could hold up a new trade deal for a very long time.

London has always been an important trading center, but growth in international trade and benefits from EU passport laws have helped the city become a major currency trading and financial hub. A survey by the Institute of Directors of 1,000 businesses found a fifth of those businesses reporting considerations to move some operations out of the UK. Whether the UK goes ahead with a years-long plan to formally exit or not, the uncertainty will be enough to move jobs out of London and to weaken the city as a financial powerhouse.

U.S.-based banks, which are facing less staffing and political uncertainty, could step into the void created by the move out of London. The uncertainty and transition in a post-Brexit UK could benefit U.S.-based banks, which could choose to move jobs back to New York or to offices in the European Union. Citigroup (NYSE: C) and JP Morgan (NYSE: JPM) hold the top two spots in currency trading by market activity. Both have offices in London but should benefit as uncertainty weighs on UK-based firms. 

Beyond the concern over Brexit, another recent development has cleared the way for U.S. banks: All 31 banks tested in the second phase of the Fed's stress test were found to have enough capital to withstand a severe economic downturn. Citigroup got the cleanest approval among the largest banks. The news comes a year after Citigroup failed the 2015 stress test. Since then the bank has spent more than $180 million in improving its systems and processes.

Low interest rates and pressure on the net interest margin has weighed on the financial industry. The sector trades for 12.6 times expected earnings, just 6% above the 10-year average multiple. That premium pales in comparison to S&P 500 trading at 16.5 times forward earnings, more than 15% above its 14.3 multiple over the last ten years.

The cheaper valuation may not last long as the banks get back to making money without the constant burden of the Fed on operations. If there is one thing I've learned about banks, it's they will always find a way to make money... as long as the government gets out of the way. 

The recent stress test results look like the government is taking its focus off of banks, signing off on capital plans and acknowledging the industry has moved on from the financial crisis. While some rules around Dodd-Frank are yet to be written, regulatory pressure seems to be easing on the largest banks.

A 26% Discount To Peers And A 30% Upside
After passing the stress test, Citigroup announced it would increase its dividend more than threefold to $0.16 per quarter. Shares still trade on the stigma of the bailout for 8.2 times earnings, well below the 11.1 average multiple for the banking industry and at a 42% discount to Citigroup's average multiple of 14.1 times over the last five years.

Beyond the increase in its dividend, which brings the yield to 1.5%, the company has announced an $8.6 billion repurchase program for the year starting in the third quarter 2016. The repurchase plan could reduce the share count by 7% and boost earnings per share.

Second quarter results are expected out on July 15, with the potential for an earnings surprise on higher trading volume around the recent market volatility. Analysts expect earnings at $1.16 per share, down sharply from $1.26 per share estimates just 90 days ago. Citigroup has beaten estimates in all of the last four quarters by an average of 6.5% and could have positive guidance around the company's progress from the 2008 crisis.

I expect full-year earnings to come in well above analyst estimates of $4.59 per share, closer to $4.90 per share on the repurchase along with stronger results in Asia and North America. Even on the industry multiple of 11.1 times, that yields a target of $54 per share and a 30% upside.

Risks To Consider: Regulatory burden around Dodd-Frank and Basel III is still not fully developed and presents headline risks to the entire sector.

Action To Take: Citigroup's progress since the 2008 crisis is underappreciated, and the shares could pop when sentiment realizes it. Take advantage of one of the most attractive valuations and the potential for market share gains after the Brexit vote with a long position.

Editor's Note: It turns out that the fallout from Brexit is the least of our worries... The right thinks Democrats will sink this country's economy. The left thinks Republicans will bring economic destruction. Truth is: They're both right. It doesn't matter who takes office in January, because history says the market could drop up to 58%. But these three investments are a shoo-in for double and triple-digit returns no matter what happens.

Joseph Hogue 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.