Citigroup (C) was gaining ground again Tuesday, following its Monday rally on better-than-expected first-quarter earnings, thanks to an upgrade from Sanford Bernstein.
Analyst John McDonald and his team upped their rating on the stock to Outperform from Market Perform, and increased their target price by $5 to $57. They write that the move comes as they have increased confidence in Citi's ability to improve core efficiency and get on track to achieve a 0.9% return on assets—and on their belief that the firm has addressed the Fed's concerns, which puts it on the path to increasing the amount of cash it returns to shareholders.
They note that investors will need some patience to see all this happen, but see downside limited by growing book value and the company’s modest valuation. They applaud Citi's upbeat first-quarter, which they believe demonstrated "progress on core expense controls, largely stable credit (ex-known items in Mexico), and continued growth in capital levels and book value per share."
Read more highlights from the note below:
Credit costs decline sequentially on lower losses and steady reserve release. Citigroup’s provision declined by ~$100m q/q to $1.97b due to a decline in net charge-offs by roughly the same amount, as reserve release remained flattish to slightly up vs. last quarter. Adjusting for charges in 1Q related to the PEMEX Mexico supplier fraud and a 4Q change in loss treatments at CitiFinancial and Mortgage, NCOs declined 4% q/q to $2.28b mostly on improved mortgage losses in Holdings, while Citicorp losses increased slightly on LatAm portfolio growth and seasoning. Consolidated net reserve releases of $646m remained steady q/q, with Citicorp’s net reserve release of $320m coming in bigger than expected on a ~$200m release from N.A. consumer (card). Looking ahead, we model some additional room for consolidated NCOs to fall further, driven by US mortgages, partially offset by seasoning in International consumer. However, we model all-in provision expense to increase modestly ahead as reserve releases in US card and mortgage tail off. We have total reserve release shrinking from $646m in 1Q to $422m in 2Q and down to $179m by 4Q14.
Continuing to build capital and book value, and consume DTA. The company’s Basel III capital grew 30bps sequentially to 10.4%, as a $6.3b build in Basel III capital more than offset $27b of RWA growth. Citi reduced its DTA by ~$1.1b in the quarter, providing further proof that this asset can consistently help build regulatory capital. The company also reported strong growth in its Basel III supplemental leverage ratio, which was up 20bps sequentially to 5.6%, well above the 5.0% proposed regulatory minimum for 2018. Management estimates that the adoption of the Fed’s recently announced SLR rules would have a flat to modestly positive impact on the 5.6% ratio. Citi’s TBV grew ~2% in the quarter from $55.31 to $56.40 and we model tangible book value to end 2014 at $60.50 and 2015 at $66.52.
Management declares CCAR issues fixable, and sets its sights on 2015 return. Management indicated, based on its initial discussions with the Fed, that the regulator’s rejection of Citi’s 2014 capital plan is neither a reflection of a problem with its business model nor its ability to generate capital, but relates more to deficiencies in Citi’s models and processes around stress testing. As expected, the company could not comment further on the precise details of what it needs to fix, as it has not received the detailed written feedback from the Fed explaining its rejection and it is currently engaged in an ongoing confidential dialogue with its regulators. That being said, management did note that it is focusing 100% of its attention on getting the right people, processes and models in place to create a permanent, “industrial strength” solution that will lay the groundwork for many years of capital return, beginning with its 2015 submission. We continue to model for the company to maintain its current $0.01 per quarter dividend and its annual buyback run-rate of $1.2b through CCAR year 2014 (i.e. until 1Q15) and then ramp up capital return to $6b in share repurchases and a $0.12 per quarter dividend in CCAR year 2015, representing a ~9% dividend payout ratio and a ~40% total payout ratio.
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