Citigroup: Cheap or Hopeless? | Financial Times

Good morning. We have the makings of a US debt ceiling Deal, although negotiations will continue as the pact is pushed past the outer wings of both sides in Congress. Even assuming that the default is avoided, however, it is not entirely clear how markets will or should react. An initial relief rally in equity prices and long bonds would make sense. But as the interlude of the debt ceiling wears off, the main themes of market play – inflation, interest rates, asset valuations – will reassert themselves. Investors might notice economic data, such as personal consumption expenditures for April relationship, they came to the heat; to which real GDP tends for the quarter 2 percent; and that the two-year bond yield is rising. The idea of ​​another rate hike by the Federal Reserve, if not in June then later, is no longer ridiculous. Could the relief rally be short? If you know, please write to me: robert.armstrong@ft.com.

Citigroup reconsidered

Four years ago I wrote a long report piece on Citigroup, which argued that the bank’s business model was not working and needed to be changed. Almost everyone I’ve spoken to—former bank executives, investors in it, analysts, senior insiders—privately acknowledged that a new approach was needed. The banks’ low return on equity, stock market underperformance and low valuation made the point irrefutable, even if its leadership couldn’t say it out loud.

About a year later Citi appointed a new CEO, Jane Fraser, who initiated many of the changes discussed in my article (I can’t claim she was inspired by my work, however brilliant. Like I said, everyone knew what needed to be done ). More importantly, she decided to divest Citi of a large portion of its global consumer banking franchise, which lacked synergies with its core businesses, which are transaction banking, credit card, and fixed-income markets. These divestments culminated last week with news that Citi would pursue an IPO of its Mexican retail operations. A transfer to another bank had been hoped for, but at least the separation process is proceeding.

Fraser and Citigroup have not been rewarded for doing the right things. The stock has continued to underperform other large diversified US banks and its valuation remains sleepy. Here is its price-to-tangible book value, compared to that of JPMorgan Chase and major regional bank Comerica:

Unsurprisingly, Citi’s valuation lags JPMorgan Chase, the bank with the best balance of retail, wealth management, commercial banking, investment banking and trading businesses. What is surprising is that it is also trailing a regional bank with the characteristics they are currently giving to investors heebie-jeebies (abundant uninsured deposits and a large portfolio of securities).

What’s the problem? In one sense, the answer is simple: Citi is a show story, and the bank has yet to demonstrate that it can improve its returns. Citi’s return on tangible common stock (8.9% last year) is lower than it was in 2019, and the gap to its large peers (in the mid-teens) hasn’t narrowed. Retail divestments and other reforms haven’t moved the needle yet. Underpowered US retail banking operations (a big source of returns for Bank of America and JPMorgan) continue to be a drag on card and transaction banking. An overhaul of the bank’s key risk and compliance systems kept expenses ahead of revenue growth. Fraser still has mountains to move.

That said, the temptation is to cancel Citi. When a bank has a price to tangible book value well below 1, my simplistic interpretation is that the market has concluded that the return on equity is less than its cost of equity (“book value” means “value equity capital”). I think a bank or indeed any company in this situation destroys shareholder value, even if it shows profits on the income statement. Given the uncertainty about when and if the Fraser restructuring will pay off, why own a bank that does?

Maybe I was too dismissive. Assessment whiz Aswath Damodaran of New York University has crafted a strong case to own Citi. He does so despite his clear eyes about the bank’s weaknesses and the challenges facing the sector:

Citi has clearly lost the battle against not only JPMorgan Chase, but also most other major US banks. It has produced low growth and poor profitability. . .

Almost every aspect of banking [as an industry] it is under stress, with deposits becoming less sticky, increased competition for lending from fintechs and other game-changers, and increased risk of contagion and crisis. . . I think the long-term trends for the [industry] they are negative.

Banks are difficult to value because free cash flow, the crucial input to most valuation models, is difficult to measure in a business that consists solely of financial assets and financial liabilities. In a bank, whether cash is profit or working capital is always an open question. Damodaran solves this problem by using future net income as a proxy for future cash flows, adjusting it for net contributions to regulatory capital, and discounting it at a rate that reflects the banking sector’s special risks.

Citi, Damodaran notes, had ample regulatory capital and has been growing assets slowly but steadily, suggesting that net income will grow over time. To assess the bank’s riskiness, it examines net interest margin, regulatory capital ratios, dividend yield, return on equity, deposit growth and securities portfolio accounting at the 25 largest US banks. Citi scores above the median on the first three of these six metrics—the best performer among banks that trade at a price/book discount. He summarizes:

[Citi’s] the weakest link is the return on equity. . . below the median for US banks, and while that would suggest a below median price-to-book ratio, Citi’s discount exceeds that expectation. Citi’s banking business, while slow growing, remains profitable with the highest interest rate spread in this sample. I will be adding Citi to my portfolio. . . It’s a robust, slow-growing bank that seems to take a price on the assumption that it will. . . it never earns a ROE even close to its cost of equity, making it a good investment.

I find Damodaran’s case for Citi analytically compelling, but I have two concerns. First, the argument is purely quantitative, and I’m wondering if you ignore the structural factors that keep the bank’s yields low – especially its small US retail banking franchise – and how difficult these problems might be to fix? . Secondly, and far less rationally, people have bet that Citi is too cheap and have been losing that bet for at least 20 years. Are things really different this time?

If there are any Citi investors out there, on the long and short side, I’d be very eager to hear from you.

A good read

Something has ended badly to volatility laundromat.