The third quarter results of Citigroup Inc. (NYSE: C) provide comfort that 2014 will see significant levels of capital return. The July-September quarter is important in that it is the starting point for the Fed's Comprehensive Capital Analysis and Review (CCAR).
CCAR seems likely to remain the key driver of capital deployment. The Fed is expected to release this year's guidelines in November. This year will include an additional 11 banks for a total of 29 (all banks with more than $50 billion in assets).
Under Basel 3, capital cushion seems likely to be less given lower starting points compared to Basel 1 for most banks and risk weighted assets (RWAs) under Basel 3 can increase in a stressed environment.
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On balance sheet metrics, Q3 was a remarkably strong quarter for Citi. Basel III common equity tier 1 ratio rose to 10.4 percent from 10.0 percent, the supplementary leverage ratio rose to 5.1 percent from 4.9 percent and allowance as a percentage of non-performing assets stands at 211 percent. With this kind of balance sheet position, Citi is well positioned to ask for, and receive, permission to increase capital return.
"Our forecast incorporates a $0.25 quarterly dividend starting in Q2 2014 and permission for up to $6 bn of annual share buyback," UBS analyst Derek De Vries wrote in a note to clients.
It is also worth highlighting that Citi came through the 2013 CCAR process in a reasonably strong position. More specifically, Citi was the strongest money center bank with a common equity tier 1 ratio 200 bps above JP Morgan (NYSE:JPM) and 150 bps above Bank of America (NYSE:BAC).
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Let's assume that Citi starts paying a 25 cent dividend from the second quarter of 2014. For the four quarters starting Q2 2014 that would represent a pay-out ratio of roughly 20 percent. Comparatively, Bank of America has a payout ratio of 9 percent, and JPMorgan 23 percent.
Citigroup may need to operate with a 10 percent common equity tier 1 ratio under fully phased in Basel III rules.
"Our investment case focuses on the fact that, assuming capital equal to 10% of Basel III risk weighted assets, Citicorp is generating a 17-18% return on regulatory capital. By year-end 2014 we expect Citi will have a 10.8% ratio, equaling $9.7 bn of excess capital," DeVries noted.
Over time, as deferred tax assets are utilized and Citi holdings is run down, this 17-18 percent return on regulatory capital in Citicorp will become the group return on tangible book value. While it may take a decade for the 2014 estimated 9 percent return to move to the 17-18 percent level, with Citi trading on 0.9 times tangible book value the downside risks seem limited.
As of the second quarter, Citigroup had $54.5 billion of deferred tax assets (DTAs), of which $41 billion is disallowed from a regulatory capital perspective. As Citi utilizes its DTAs, by posting earnings, the DTAs become capital. In essence, pre-tax earnings in certain jurisdictions become eligible for distribution to shareholders.
"To capture the value of these DTAs, we have assumed Citi can realize $4 bn of DTA each year starting in 2015 (after realizing a small amount in 2014) and we include the net present value in our valuation," DeVries said.
C is trading 0.9 times tangible book and 9 times its 2014 EPS forecast. By comparison, the US bank universe trades on 1.5 times tangible book value and 10.4 times 2014 EPS.
If all goes well, it's time for income investors to keep an eye on Citigroup as it is taking steps towards normalization by resuming capital return in 2014.