Citigroup Inc (C)

[Enterprising Investor]

Citi Earnings: Finding Keys to Unlock Trapped Capital (4/15/16)

A 27% drop in quarterly net profit masks major progress elsewhere in the bank

By Aaron Back

Citigroup has often been derided as the bank that couldn’t shoot straight. Its aim is getting better.

Fresh off a regulatory victory this week, Citigroup posted first-quarter net profit that fell 27% from a year earlier. But the bank beat expectations. More importantly, a yearslong, slow-motion restructuring is starting to bear fruit.

Investor views of the bank, and its valuation, should better reflect the changes.

After the financial crisis, Citigroup’s worst assets were grouped in what it dubbed Citi Holdings, akin to a “bad bank” to be wound down or sold off. Reporting these assets separately, and trying to direct investors to the performance of the rest of the firm had no real economic effect. Investors could only buy the whole Citigroup.

But reducing the size of Citi Holdings has an impact. These assets tend to carry high-risk weightings for purposes of calculating capital needs. That forces it to hold more capital.

At the end of the first quarter, assets in Citi Holdings were equal to just 4% of total assets, but 10% of risk-weighted assets. And Citi Holdings required about 8% of the firm’s tangible common equity.

So reducing Citi Holdings frees capital that can be reinvested or eventually returned to shareholders. In this regard, the first quarter marked a turning point: Citigroup said assets in the division had fallen to $73 billion, versus $130 billion a year earlier, and a further $10 billion in asset sales are coming. And, after this year, it will stop breaking out Citi Holdings.

Another key unlocking trapped capital is for Citigroup to keep consuming deferred tax assets. These are credits against future tax bills built up due to Citigroup’s huge losses during the crisis; they were about $48 billion at the end of 2015.

While included in equity for accounting purposes, the assets are largely excluded from measures of regulatory capital. And investors give Citigroup varying degrees of credit for them, meaning shares can appear far more expensive than suggested by a beaten-down valuation of just 62% of book value.

The only way to work off these assets is to keep posting profits. And while first-quarter net income of $4.7 billion was down year-over-year, the bank still managed to use $1.6 billion of tax assets.

It will take Citigroup years to wipe out these assets at the current profits pace, underscoring the need to bolster returns. At just 6.4% in the first quarter, these were still subpar.

But Citigroup is walking in the right direction. And the gradual rundown in these two stores of trapped capital raises the prospect of greater capital returns.

Citigroup still needs the Federal Reserve’s permission to boost dividends and share buybacks, so annual stress tests remain crucial. And given Citigroup’s previous stumbles on that front, news this week that it was the only major bank to get a nod from regulators for its “living will” raises hopes it is getting its house in order.

Granted, Citigroup has plenty of challenges. It faces the same headwinds as all big banks, from suppressed interest rates to moribund trading activity. Among big U.S. banks, it also has the biggest total exposure to the faltering energy sector, at $60 billion, and to emerging markets.

Even so, Citigroup’s stock deserves more credit for the progress it has made.

http://www.wsj.com/articles/citi-earnings-finding-keys-to-unlock-trapped-capital-1460744340