There are plenty of reasons to be wary of 
Citigroup C . Over the past few decades, the bank has teetered on the edge more than once, taking massive losses on emerging-markets loans in the 1980s, commercial real estate in the early 1990s and subprime-related securities in the 2000s. Citigroup has made progress over the past five years by raising capital, shedding assets and bulking up its board of directors and management team. However, with operations spanning several continents, the bank in many ways still embodies the "too big to fail" concept.
For the final quarter of 2013, Citigroup reported net income of $2.7 billion, or $0.85 per diluted share, bringing full-year income to $13.9 billion, or $4.42 per share (all figures are in U.S. dollars). The results were slightly less than we expected, but the difference was based primarily on the rate of provisioning. We therefore don't expect to alter our $45 per share fair value estimate for the narrow-moat bank, and we believe potential upside is limited at the current stock price.
Among large U.S. banks, Citigroup's claim to fame is its international consumer exposure. Over the long run, we think exposure to credit growth overseas will be a key advantage, but investors should not anticipate a smooth ride. In fact, Asian revenue actually fell slightly during both the quarter and the year--driven mostly by regulatory and other changes in Korea--and average international deposits did not grow at all during the year. We don't expect such blips to alter the long-term outlook for the bank's international business, and we might view further weakness as buying opportunities in future quarters.
Though we don't view legal and repositioning costs as true one-time items, as the large U.S. banks have been experiencing such costs for years, it's encouraging to see core operating expenses totalling less than $11 billion during the fourth quarter, and management expects similar levels in the coming year. However, without help from a more favourable interest rate and investment banking environment, the company's efficiency goals may be tough to meet, as adjusted revenue actually fell slightly during the year.
Outside of the core business, Citi Holdings continued to take a toll, though the segment now accounts for only 6% of assets at only $117 billion, most of which are North American mortgages. Citi Holdings was still responsible for a $422 million loss, however. Obviously, this earnings headwind should subside over the next several years, allowing the bank's core earnings power to shine through.
Other areas of Citigroup's balance sheet also continued to improve in 2013. The bank increased corporate loans by 11% during the year. We don't expect this rate of growth to continue, as this has become an area of intense competition among banks in recent quarters. Citigroup has also built a sturdier balance sheet in recent quarters. Its Basel III Tier 1 common ratio now stands at 10.5%, up more than 50% since the beginning of 2012. Unfortunately, earnings don't necessarily support a share price approaching the company's reported tangible book value per share of about $55, in our view. In fact, management is targeting a 10% return on tangible common equity by 2015. Because such results are both hypothetical and almost two years in the future, we think a modest discount to tangible book value -- as our fair value estimate implies -- is justified.
In the company's Securities and Banking segment, investment banking revenue rose 3% during the year as increases in equity and advisory revenue offset a decline in debt underwriting fees, thanks in part to a rising stock market. Similarly, equity-markets revenue rose while fixed-income revenue fell. We don't have any unique insights into near-term activity, but we note that the combination of Fed tapering and current stock prices -- the Morningstar market price/fair value ratio now stands at 105% -- might bode poorly for future market-related revenue.
Citigroup emphasizes international markets and bottom-line improvement
With a large portion of revenue coming from Latin America and Asia, Citigroup is poised to ride the growth of these economies over the coming decade. The bank should remain a bank of choice for global corporations thanks to its ability to provide a variety of services across borders. Developing economies offer an attractive combination of high margins and rapid credit growth -- especially in comparison with the low rates and declining leverage we expect will persist in the U.S. and other Western economies for the next few years. At the same time, investors should prepare for volatile results out of emerging economies, where governments and economic systems have generally not stood the test of time to the same extent as developed markets.
Since its bailout, Citigroup does not appear to be chasing growth at any cost. Instead, management is attempting to scale back operations and cut expenses -- a proven plan for turning around troubled banks. Citigroup is consolidating back-office functions and reducing consumer operations in far-flung geographies like Pakistan and Paraguay and concentrating its branch network in key international markets, including Brazil and Hong Kong. We think investors should view further announcements along these lines with relief rather than disappointment, and focus on improvements in the bottom line more so than growth in the top line.
Our fair value estimate is $45 per share
Our fair value estimate is $45 per share, equivalent to 1 times tangible book value per share and 10 times our 2014 earnings per share estimate. In our base-case valuation, we think assets will remain flat during the next five years with the continued runoff of Citi Holdings' assets offset by the growth of loans outside the U.S. We think the net interest margin will average 2.8% during the next five years, improving slowly to approximately 3% by 2016 as nonperforming assets fall and interest rates normalize somewhat. We forecast noninterest income to increase by approximately 10% cumulatively during the next five years, as capital-markets revenue normalizes. We expect net charge-offs to slowly decline during our forecast period, averaging 1.7% in the long run. We expect the efficiency ratio to average 63% over the next five years. Our valuation reflects a middling level of profitability, with return on assets reaching 0.8% by the end of our forecast period. We assign Citigroup a 12% cost of equity based on the volatility of the company's post-provision revenue, the moderate level of operating leverage inherent to the business, and the bank's high level of financial leverage relative to the rest of our coverage universe.
International presence helps secure a narrow moat
Citigroup's advantages are not the strongest among the financial services companies we cover, but the bank's massive scale in consumer lending and the global reach of its institutional clients group endow the company with a narrow moat. Although consumer lending is essentially a commodity business, few competitors can spread the associated operating costs over such a large asset base, providing a significant cost advantage to the company. On the institutional side of the business, Citigroup's presence in dozens of countries allows it to provide a wider range of products and services than local competitors can. This may produce a modest network effect, as each additional market the company services adds value for global corporate customers.
Bank moat trends are driven primarily by changes in a firm's cost position or changes in the regulatory environment. Citigroup's moat trend is stable. A sustained reduction in operating costs--we currently expect the efficiency ratio to decline to an acceptable 61% over our forecast period--and a resulting increase in Citigroup's return on assets could persuade us to upgrade our moat trend rating. We think the net interest margin will expand to 3% as bad assets run off the balance sheet and the performance of high-yielding emerging-markets consumer loans shines through. Conversely, we'd see any further underwriting missteps as evidence of lax risk management. Substantial credit losses and a weakening of the firm's cost position would therefore result in a downgrade of the company's moat trend.
We hope to see management cut expenses and return capital
We view Citigroup's recent stewardship of shareholder capital as standard. In our view, an analysis of Citigroup's management must start with the board of directors, which has improved dramatically during the past five years. Chairman Michael O'Neill turned around Bank of Hawaii during his time as CEO of the island institution, making shareholders multiples of their initial investments. Board member Robert Joss enjoyed similar success during his time at Westpac WBK. Other members of the board boast experience at premier financial services companies, including American Express AXP, RenaissanceRe and PIMCO, while others served as regulators. We think the board is well-positioned to oversee continued improvements at Citigroup.
We also think new CEO Michael Corbat's experience will serve Citigroup shareholders well. In contrast to Vikram Pandit, who brought investment banking and hedge fund experience to the CEO role, Corbat has served in a variety of basic banking roles around the world during his time at Citigroup. We like that he appears to be focused on scaling back the bank's operations, announcing cost cuts and branch closures in his first major move as CEO.
In our view, management should be evaluated over the near term on its ability to cut expenses and return capital to shareholders. In addition to the amount of capital returned, we're interested to see how management balances dividends and repurchases. While the restoration of the company's dividend is a plus, we would look favourably upon repurchases as well. A substantial buyback program seems a good fit for the earnings volatility possible thanks to Citigroup's investment bank and international consumer book.
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