Citigroup: Compelling Risk/Reward Opportunity at 0.55x Pound (NYSE:C)
Citigroup (NYSE:C) is trading at 0.55x the tangible pound. In my opinion, this is an excellent buying opportunity. Over the past decade, the trading playbook with Citi has always been to buy at a steep discount to the tangible book (~0.5-0.6x) and sell at or just slightly above 1x tangible book.
Citi was not a long term hold as it would be doomed to slip on a banana peel somewhere in the world and frankly its business model was flawed and much weaker than its peers such as JPMorgan (JPM) and Bank of America (BAC).
That all changed with new CEO Jane Fraser and the updated strategy.
The main problems of the previous economic model
I have written about these questions for many years, but to recap the key questions are:
- Citi, as an American G-SIB bank, was a disadvantaged owner of so many mainstream banks around the world. There are few to no synergies in a global consumer bank, it offers poor ROE, Citi cannot compete effectively in local markets, and most importantly, it increases Citi’s overall capital requirements. In other words, it makes absolutely no sense.
- Citi management was under pressure to deliver promised short-term returns (e.g. 12% ROE), and so they were forced to reduce investments in controls and technology while depriving the company of much-needed investments.
- Citi’s US consumer bank is primarily card-based (and therefore riskier) and not as diverse as JPM and BAC. More importantly, it does not benefit from the low cost of funds enjoyed by its peers.
Jane fixed it (mostly)
The updated strategy under the new CEO makes a lot of sense. Citi sells all of its consumer banks globally and adopts a wealth management business model primarily focused on Asia and the United States, which are very attractive geographies.
There are several advantages to this strategy. First, Citi frees up capital (~$15 billion) and most divestments are sold at or above book value. The large Mexican franchise is expected to be sold at a premium of around 2 times tangible equity.
I remind you that Citi is currently trading at 0.55 times tangible equity.
Second, the divestitures also support lower capital requirements for the entire Citi franchise. Citi’s additional capital requirements are determined by annual CCAR results (also known as the Stress Capital Buffer (“SCB”) and the G-SIB score. A simplified Citi supports the reduction of both.
For example, Citi’s capital requirements are currently raised to 13% from 11.5%. This is due to higher SCB and G-SIB scores. Consequently, Citi was forced to suspend its share buybacks and raise capital instead.
In the medium term, management expects equity requirements to fall to 11.5% to 12% supported by these disposals. By the end of 2023, Citi is expected to be in a position of substantial excess capital.
Second, Citi is finally investing in the franchise and in a big way. Citi is modernizing and digitizing its infrastructure and controls. This is an initial investment but will pay off in the medium term. Citi’s chief financial officer pointed to an example in Citi’s finance function at a recent Barclays financial services conference:
If I think about my financial organization each quarter we close our books and feel comfortable, I am confident that these numbers are materially accurate and timely as they are produced. As part of that process, I have thousands of people working on reconciliation along the way to make sure those numbers meet that standard. I have thousands of people making sure we have proper controls. As we introduce new systems, improve operations, streamline processes, we won’t need to have such an inefficient approach to get that quality result and it will do several things. It will allow us to get that information much faster, and it will allow us to rationalize, if you will, the number of resources we have for these kinds of things.
These transformations and the expense of consent orders will ultimately drive efficiencies across the business.
Combining these investments with the expected divestments, in my view, Citi is no longer too big and/or complex to manage.
The Macro-Environment and Interest Rates
Interest rates are a huge tailwind for Citi’s strategy. Citi is heading for a $2.5 billion increase in net interest income (“NII”) with a parallel 100 basis point change in rates. This is already playing out in quarterly results and will be accelerated in the coming quarters:
As can be seen above, Citi’s out-of-market NII has increased by approximately $1.5 billion year-on-year and is expected to continue to rise over the coming quarters.
This tailwind should not be underestimated.
Citi also expects strong card loan growth in the second half of 2022, which is a very positive sign. While loan losses are at levels 50% lower than expected throughout the cycle.
Although there is a lot of uncertainty in the outlook, Citi is cautious and built reserves in Q2 and expects modest reserves to build in Q3.
What are the risks ?
The main risk is a deep recession characterized by massive job losses in the economy (say an unemployment rate well above 6%). Citi may have to absorb additional loan losses in such a scenario.
More importantly, the Fed could drop interest rates to 0% and stay there for a very long time. This will have an impact on the profitability of all banks. A zero interest rate environment is not a good environment for banks, but even then I expect Citi to earn above its cost of capital.
That said, the Fed’s overnight rate, which is between 2% and 4%, is a golden loop for banks. While I don’t have a crystal ball in terms of the direction of medium-term rates, I see a low probability of the economy returning to ZIRP.
In my portfolio, I now use a barbell approach in which I hold banks, but have also recently opened a position in long-term bonds (TLTs) as well as other long-term assets.
Currently, this is an exceptionally positive macro picture for banks benefiting from strong interest rate tailwinds. The market fears the scenario of a deep recession. Tactically, I think it’s a good time to allocate to the banks. My base case scenario is that we live in a frictional inflationary economy, especially for supply chains to be rewired and critical industries to be offshored.
Citi presents a compelling risk/reward ratio on a relative and absolute basis at 0.55x the tangible pound. It is no longer as risky as some perceive due to recency bias. Citi is no longer too complex to manage. I like the management team’s new strategy and the early signs are that the execution is strong. Second quarter results were exceptional, particularly in the institutional client group (“ICG”).
In my next article, I’ll take a deep dive into ICG’s strategy and explain why it’s Citi’s crown jewel and a very underrated asset.