Citigroup: cheap or hopeless? | Financial Times

Good morning We have the makings of an agreement on the US debt ceiling, but negotiations will continue as the deal is pushed past the outer wings of both parties in Congress. However, even assuming that a default is avoided, it is not entirely clear how markets will or should react. A first relief rally in share prices and long bonds would make sense. But as the debt ceiling interlude fades, the main themes of the market opera – inflation, interest rates, asset valuations – will regain prominence. Investors may notice that economic data, such as the April personal spending report, has been positive. that real GDP for the quarter is trending at 2 percent; and that the yield on two-year bonds is rising. The idea of ​​another Federal Reserve rate hike, if not in June then later, is no longer ridiculous. Could the rally be short? If you do, for heaven's sake, email me at: [email protected].

Citigroup has reconsidered

Four years ago, I wrote a lengthy article about Citigroup, arguing that the bank's business model wasn't working and needed to change. Almost everyone I spoke to—former bank executives, investors, analysts, high-level insiders—privately admitted that a new approach was needed. The banks' low return on equity, the underperformance of the stock market and the low valuation made this point irrefutable, although the leadership could not say so 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 say she was inspired by my work, brilliant as it was. As I said earlier: everyone knew what to do). Most notably, she set out to divest Citi of much of its global consumer banking business, which had no synergy with its best businesses, namely transaction banking, credit cards, and fixed income markets. Those divestitures culminated last week with news that Citi would seek an IPO for its Mexican retail operations. It had been hoped that it would be sold to another bank, but at least the separation process is progressing.

Fraser and Citigroup haven't been rewarded for doing the right things. The stock has continued to underperform the other large, diversified US banks and its valuation remains sleepy. Here's the price to tangible book value ratio compared to JPMorgan Chase and major regional bank Comerica:

Not surprisingly, Citi's valuation lags behind that of JPMorgan Chase, the bank with the best balance of retail, wealth management, commercial banking, investment banking, and trading businesses. What's surprising is that it lags behind even a regional bank with the characteristics that are currently troubling investors (lots of uninsured deposits and a large securities portfolio).

What is the problem? In a way, the answer is simple: Citi is a show-me story, and the bank hasn't yet shown it can improve its returns. Citi's return on tangible equity (8.9 percent last year) is lower than in 2019, and the gap with its major (mid-teens) peers hasn't narrowed. Retail divestments and other reforms have not yet achieved anything. The undersized retail banking business in the US (a major source of revenue at Bank of America and JPMorgan) continues to weigh on the cards and transaction banking businesses. An overhaul of the bank's core risk and compliance systems has kept expenses ahead of revenue growth become. Fraser has yet to move mountains.

With that in mind, there's a temptation to write off Citi. If a bank has a price-to-book ratio well below 1, my simple-minded interpretation is that the market has concluded that its return on equity is lower than its cost of equity (“book value” means “equity value”). I imagine a bank or any other company in this situation destroying shareholder value even if it reports profits on the income statement. Given the uncertainty of when and if Fraser's restructuring will bear fruit, why own a bank that does?

Maybe I was too dismissive. New York University valuations expert Aswath Damodaran has made strong arguments for owning Citi. He does so despite being aware of the bank's weaknesses and the challenges the industry is facing:

Citi has clearly lost the battle not only against JPMorgan Chase but also against most other major US banks. The company experienced low growth and below-average profitability. . .

Almost all aspects of banking [as an industry] is under stress as deposits become less sticky, competition for lending from fintechs and other disruptive factors increases, and risks of contagion and crisis increase. . . I believe that the long-term trends for the [industry] are negative.

Banks are difficult to value because free cash flow, the critical input to most valuation models, is difficult to measure in a business composed entirely of financial assets and liabilities. In a bank, there is always an open question as to whether cash is profit or working capital. 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 unique risks of banking.

Damodaran notes that Citi had ample regulatory capital and grew its fortunes slowly but steadily, suggesting net income will increase over time. To assess the bank's exposure, he looks at the net interest margin, regulatory capital ratios, dividend yield, return on equity, deposit growth, and securities portfolio accounting at the 25 largest US banks. On the first three of those six metrics, Citi is above the median — the best performer among banks trading at a price-to-book discount. He summarizes:

[Citi’s] The weakest link is the return on equity. . . lower than the median for US banks, and while that would suggest a below-median price-to-book ratio, Citi's discount exceeds that expectation. Although Citi's banking business is growing slowly, it remains lucrative in this sample due to higher interest margins. I will add Citi to my portfolio. . . It's a slow-growing, unwieldy bank that appears to have been priced on the assumption that it will make it. . . Never get an ROE anywhere near the cost of equity, and that makes it a good investment.

I find Damodaran's argument for Citi analytically compelling, but I have two concerns. First, the argument is purely quantitative, and I wonder if it ignores the structural factors that are keeping the bank's profitability low — most notably its small retail banking business in the U.S. — and how difficult those problems might be to fix . Second, and this is a lot less rational, people have been betting that Citi is too cheap for at least 20 years, and they've lost that bet. Are things really different this time?

If there are Citi investors, both on the long and short side, I'd really appreciate your message.

A good read

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