The biggest surprise in the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) results announcement this Wednesday, March 26, was the regulator’s decision to reject Citigroup’s (NYSE:C) capital plan for 2014. ((Federal Reserve releases results of Comprehensive Capital Analysis and Review (CCAR), Federal Reserve Website, Mar 26 2014)) As a consequence, the globally diversified banking group earned the ignominy of being the only bank holding company to have its capital plan rejected on two of the four occasions the tests have been conducted. This was unexpected because of two primary reasons: Citigroup is currently the best capitalized U.S. bank in terms of Basel III readiness (something we pointed out as a part of our recent article U.S. Banks Took Big Strides Towards Basel III Compliance In 2013), and also because the bank performed better than its peers JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), Morgan Stanley (NYSE:MS) as well as Goldman Sachs (NYSE:GS) in the stress tests (see Fed Stress Test For Banks: Rationale, Results & Implications). So what prompted this move by the Federal Reserve? After all, there were no hiccups in Citigroup’s plans last year as the Fed cleared its request to repurchase $1.2 billion worth of shares and to also redeem trust preferred securities (TruPS) worth about $3 billion (see The Fed’s Stress Test & Citi: $3B TruPS Redemption Bolsters $1.2B Stock Buyback Plan).
We explore the reasons for the rejection below. We are currently in the process of updating our $56 price estimate for Citigroup’s stock to factor in the impact of a much lower than expected increase in capital payout this year.
Citigroup was known for handing out handsome dividends in the pre-2008 era, with total dividends of more than $9 billion each year between 2005 and 2007. Dividends were slashed in 2008 and were completely stopped until Q1 2011, after which they were increased to the token figure of a penny per share each quarter, and they have remained at that level since then.
The table below summarizes Citigroup’s capital return figures for each year since 2005 and has been compiled using figures reported in annual reports. In a statement released Wednesday, Citigroup detailed the capital plan it had submitted to the Fed – a five-fold increase in quarterly dividends to $0.05 per share, and a $6.4 billion common stock repurchase program. ((Citi Statement on 2014 CCAR Results, Citigroup Press Releases, Mar 26 2014)) Considering the fact that Citigroup has a little over 3 billion outstanding shares, the total dividend payout works out to about $600 million – implying a plan to return a total of $7 billion to investors. The figures for 2014 in the table below are what Citigroup proposed to the Fed as a part of the stress test.
|(in $ mil)||2005||2006||2007||2008||2009||2010||2011||2012||2013||2014(P)|
|Common Stock Dividends||9,120||9,762||10,742||5,794||249||-||81||117||126||600|
Notably, Citigroup initiated a share repurchase program in 2013 for the first time since the economic downturn – a move that was triggered by the substantial discount at which its shares were trading to its book value then. With the price-to-book ratio remaining around 75% now, a large share repurchase plan seemed the logical next step for Citigroup in 2014. That explains the $6.4 billion proposed share repurchase. Also, the bank sought to increase its dividends meaningfully from 4 cents a year to 20 cents, but clearly the Fed was not crazy about such a high payout from Citigroup.
Ironically, the primary reason for the Fed’s rejection of Citigroup’s capital plan has to do with one of the banking group’s biggest strengths – its considerable geographical diversification. The regulator noted that Citigroup was unable to project revenues and losses for “material parts of the firm’s global operations” under an adverse scenario, and that the bank could also not “develop scenarios … that adequately reflect and stress its full range of business activities and exposures.” ((Comprehensive Capital Analysis and Review 2014: Assessment Framework and Results, Federal Reserve Website, Mar 26 2014)) Apparently the issue had been already pointed out by the Fed to Citigroup last year, but there had been no noteworthy action on the bank’s part to make up for this shortcoming.
So what does this mean for investors? And what can we expect from Citigroup over the coming months?
While the Federal Reserve threw Citigroup’s $7 billion capital return proposal out the window, the bank can stick to its current payout of $1.3 billion for 2014. That is, investors can be assured of at least $1.3 billion in capital returns this year. How much the bank actually returns will depend on whether its revised capital plan to be submitted in the near future is approved by the Fed. But considering the fact that Citigroup moved quickly Thursday, March 27, to announce a plan to redeem $2 billion worth of TruPS in April, this does not leave the bank with much room to boost share repurchases for the year in the updated capital plan.  On the brighter side, as the TruPS paid out an interest rate of between 6-6.35%, their redemption will save the bank roughly $120 million in annual interest expenses – not a bad deal in an environment where net interest margins at banks are already under considerable pressure.
We estimated that the bank would return around $4 billion in capital in 2014 – something that we represent in our analysis of Citigroup in the form of an adjusted dividend payout rate shown in the chart below. Note that as this payout rate was not meaningful in 2008 and 2009, we represent it in the chart as 0%. You can understand how a change in Citigroup’s adjusted payout ratio affects its share value by making changes to the chart below.Notes:
- Citigroup Announces $2 Billion Redemption of Trust Preferred Securities, Citigroup Press Releases, Mar 27 2014 [↩]