How do you know when a business is poorly run? When the U.S. government pumps $20 billion in it just to keep it going.

That, in a nutshell, explains why legions of investors will never, ever invest in Citigroup (NYSE: C). 
 
[block:block=16] That’s a shame, because Citigroup these days is a far better bank than before, taking on fewer risks and pursuing more sound growth strategies. For investors willing to move beyond the whole banking bailout mess (in which Uncle Sam still profited anyway), then they need to give the sector — and Citigroup in particular — a fresh look. 
 
I’ve been watching Citigroup for almost two years. And though the banking giant is far from a picture of health, it is on a much better trajectory. The bank just reported another challenging quarter, yet it also appears that the stage is set for a slow and steady rebound in quarterly results. A year or two from now, investors may be stunned to see a company that is boosting profits at a sharp pace.

I’m adding Citigroup to my $100,000 Real-Money Portfolio now, because I want to profit from the coming change of sentiment — before it happens.

The cart before the horse
Citigroup’s CEO, Vikram Pandit, laid out a fairly impressive turnaround strategy nearly two years ago: Unload underperforming divisions and assets, and redirect funds to the most promising opportunities. Broadly speaking, he wanted to de-emphasize the mega-bank’s exposure to the troubled U.S. consumer while boosting Citigroup’s presence in the most dynamic regions, such as Asia and Latin America.

That’s a wise long-term plan, but Pandit put the proverbial cart before the horse, neglecting to put Citigroup in lean shape before pressing ahead. Planned asset sales are taking longer to materialize, and the bank has had a still-bloated cost structure in the United States. Meanwhile, costs also rose quickly in foreign regions in a bid to quickly establish a major presence. So during the past year, shares have muddled along in the face of too-high expenses and weak quarterly reports.

 

Here’s the good news: Citigroup is tackling its cost-structure more aggressively. The better news: Citigroup’s revenue streams have found a floor, and slowly rebounding revenue should pair up well with falling expenses. The best news: Struggling European banks are so fixated on the troubles in their home markets that they’ll represent minimal competition for Citigroup as its pushes further into international markets.

With all of these items taken together, Citigroup has the makings of a surge in earnings that few are talking about right now.

Let’s take a closer look…

On the matter of expenses, Pandit had expected U.S. operations to look stronger by now, led by rising investment banking fees and a moderate rebound in commercial and consumer lending. So he was loath to keep cutting after Citigroup’s radical downsizing in 2009. The bank’s overhead expenses shrank from $31 billion in 2008 to $25 billion in 2009, where they’ve stayed ever since. The bank has generated more than $10 billion in net income in 2010 and 2011, but that still pales in comparison to the $21 billion to $24 billion that Citigroup made in the middle of the last decade. Pandit now understands that 2012 may represent another year of subpar growth, so his $2 billion of recently-announced cost cuts should help boost profits in the near-term.

Indeed, for the remainder of 2012, investors may get more excited about Citigroup’s balance sheet than its income statement. The bank finished 2011 with 11.8% in Tier 1 Capital, which is core equity divided by risk-weighted assets (i.e. loans and investments in other entities). Regulators like to see this figure above 8%, and Citigroup has been so focused on boosting its score that it now arguably has too much capital. That’s why Wall Street says Citigroup will look to deliver dividends and stock buybacks in 2012. (Citigroup offers a tiny quarterly one-cent dividend now, but some say it could go to $0.10 this year and perhaps $0.20 by 2013).

Looked at another way, investors are finally realizing that Citigroup’s balance sheet is so strong, and its operations are now so stable, that fears of another 2008-style meltdown should be a diminishing concern. As a result, Citigroup’s stock should slowly work its way back to tangible book value, or from a current $32 up to $48. That’s a 50% gain right there, just on the book value angle alone.

More importantly, Citigroup is sufficiently healthy, despite subpar revenue growth, that net profits are likely to stay above $10 billion each year. This means book value would climb into the low to mid-$50s by the end of this year and nearly $60 by late 2013 or sometime in 2014. Simply moving up to that book value in the next 12-18 months would help this stock nearly double.

Risks to Consider: There’s an event on the near-time horizon you’ll need to monitor. In mid-March, Citigroup will have reviewed its capital base, internally stress-testing its operations to be sure there are enough funds to handle any future global economic shocks. Any excess capital will likely be put to work by management, probably in the area of dividends and buybacks as noted above. If the results are a shock, then these plans might be delayed.

The Downside Protection –> Trading so far below tangible book value, shares are unlikely to pull back much from current levels unless the European economic crisis spirals out of control. A move to hike the dividend or institute a stock buyback (which could absorb almost 10% of the current share count) would be weapons to defend the stock if it comes under deep pressure as it did last summer.

Upside Triggers –> The stock simply moving up to tangible book value is the clearest path to upside for the next 12-18 months. Yet during that time frame, the “new Citigroup,” which is emerging as a major player in Asia and Latin America, will come into focus. Few are talking about growth for Citigroup right now, but emerging economies continue to build strength, and the U.S. economy — especially housing — will likely start to look a bit better in 2013 and beyond. As a result, the stage is set for Citigroup to become a profit powerhouse in coming years.

Analysts say earnings per share (EPS) will rise around 10% this year to around $4.10, and forecast low-teens growth in EPS to around $4.70 by 2013. With just a few small breaks, Citigroup’s EPS could quickly work up to $6 by 2014 or 2015. That’s a pretty far time horizon, but worth thinking about for a stock that trades in the low $30s. One day, whether it’s 12 months from now, 24 months from now or 36 months from now, this stock could well trade up to 10 times that mid-cycle profit forecast. That again implies a $60 price target, nearly double where it sits now, supported by that rising book figure analysis.

Action to Take –> 48 hours after you read this, I will buy 300 shares of Citigroup (worth roughly $10,000) in my real-money portfolio. It’s a bold investment, rivaled only by Ford (NYSE: F) in size in my portfolio. This reflects my conviction that Citigroup’s toughest sledding has already passed, along with the risk associated with shares, and that slowly brightening skies lie ahead.

[Note: My last real-money portfolio pick, Exide Technologies, was down sharply on Monday, Jan. 30, the day I wrote about it. As always, I give readers two days’ notice before I actually make a purchase. On Wednesday, Feb. 1, the stock went on a tear, gaining 11% from when I originally wrote about it. This means if you bought in when I first wrote about Exide, then you’re already sitting on a double-digit gain, and your gain is likely even bigger than mine. And this isn’t the first time that’s happened. I don’t know how long the streak can continue, but it’s just another reason why I absolutely urge you to sign up and have these articles delivered to your inbox as soon as they’re published. Go here to sign up.]