More Bad News for Citigroup

The S&P 500 and the narrower Dow Jones Industrial Average were up 0.19% and 0.21%, respectively as of 10:25 a.m. EDT. In today's headlines, in another reverberation of Citigroup's  capital return plan rebuff by the Federal Reserve, analysts project the banking group will be unable to meet its own target of a 10% return on tangible common equity in 2015. Shares of Citigroup have fallen 5% since the Fed announced the final results of its annual stress tests last week, underperforming the KBW Bank Index by nearly 6%.

The Federal Reserve detonated a figurative bomb at Citigroup's headquarters when it rejected the bank's proposed capital return program; Citi had requested authorization for an increase in its share repurchase program from $1.2 billion to $6.4 billion and a raise in its quarterly dividend from $0.01 to $0.05. The news was an unpleasant surprise for Citi executives, and was particularly embarrassing for CEO Michael Corbat -- Citigroup was the only major bank that earned an outright rejection from the Fed.

The Fed's decision placed Citigroup in an undesirable spotlight, as the central bank cited "qualitative concerns," including inadequacies in Citi's controls and in its ability to estimate revenue and losses in a downturn. With the bank now facing stringent limits on the amount of capital it can return to shareholders via dividends and buybacks, the decision has a direct impact on its ability to meet its return on tangible equity target. Indeed, retained earnings bolster shareholders' equity (good for balance sheet strength), but make it more difficult to hit return on equity targets (bad for common equity investors, all other things being equal).

Citigroup's return on tangible common equity was 8.2% in 2013. The 10% target for 2015 was laid out by Corbat in what the Financial Times called a "role-defining speech" in March 2013 -- roughly five months after he was named to the top role. Failing to meet that target is also significant in that analysts often use 10% as a benchmark for large banks' cost of equity -- an inability to achieve a 10% return on equity then suggests the bank isn't earning an economic profit. Indeed, the assumption that Citigroup isn't earning its cost of equity is reflected in the fact that its shares continue to trade at a discount to their book value and their tangible book value.

I'm going to take a contrarian stance here: While Citi's shares don't look like a screaming bargain, they look cheap relative to the broad market -- I think long-term investors will be adequately compensated from current levels. Meanwhile, Corbat has his work cut out for him in boosting profitability, as well as Citigroup's perception among investors.

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Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool owns shares of Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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