Citigroup (NYSE:C) is trading at 0.55 times tangible book value. In my view, this is a great buying opportunity. For the past decade, the trading playbook at Citi has always been to buy at a deep discount to the physical book (~0.5-0.6x) and sell at or only slightly 1x tangible book at the top.
Citi wasn’t a long-term hold as it was bound to slip on a banana peel somewhere in the world, and frankly its business model was flawed and much weaker than peers like JPMorgan (JPM) and Bank of America (BAC).
That has changed with new CEO Jane Fraser and the refreshed strategy.
The key points of the previous business model
I’ve been writing about these topics for several years, but to recap the main topics are:
- Citi as a US G-SIB bank has been a disadvantaged owner of so many consumer banks worldwide. In a global consumer bank, synergies are limited to non-existent, it delivers mediocre returns, 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.
- Pressured to deliver near-term returns (e.g., 12% ROE) as promised, Citi management has been forced to cut back on investments in controls and technology while the company starves out much-needed investments.
- Citi’s US consumer bank is predominantly card-heavy (and therefore riskier) and not as diversified as JPM and BAC. Most importantly, it doesn’t benefit from the low financing costs that its competitors enjoy.
Jane fixed it (mostly).
The refreshed strategy under the new CEO is very sensible. Citi is selling all of its consumer banks worldwide and reverting to a wealth management business model primarily focused on Asia and the US, which are very attractive regions.
This strategy has several advantages. First, Citi frees up capital (about $15 billion) and most of its divestitures are being sold at or above book value. The sizable Mexican franchise is expected to sell at a premium of approximately twice tangible equity.
Let me remind you that Citi is currently trading at 0.55 times tangible equity.
Second, the divestitures also support reduced capital requirements across the Citi franchise. The incremental capital requirements for Citi are driven by annual CCAR (aka Stress Capital Buffer (“SCB”)) results and the G-SIB score. A simplified Citi supports the reduction of both.
For example, Citi’s capital requirements are currently being increased from 11.5% to 13%. This is due to higher SCB and G-SIB scores. As a result, Citi was forced to pause its share buybacks and raise capital instead.
In the medium term, supported by these disposals, management expects capital requirements to fall to between 11.5% and 12%. By the end of 2023, Citi will likely be in a position with significant excess capital.
Second, Citi is finally investing in the franchise, and doing it big. Citi is modernizing and digitizing its infrastructure and controls. An upfront investment is required, but it will pay off in the medium term. Citi’s CFO highlighted an example from Citi’s finance function at a recent Barclays financial services conference:
Thinking about my finance organization each quarter, as we close our books and feel good, I feel good that those numbers are essentially accurate and timely when they are produced. As I lead this process, I have thousands of people working on tuning along the way to ensure these numbers meet that standard. I have thousands of people working to make sure we have proper controls that are in place. As we roll out new systems, improve operations, streamline processes, we don’t need such an inefficient approach to achieve that quality output and that will do a few things. It will allow us to get this information much faster and it will allow us, if you will, to rationalize the number of resources we have for this type of thing.
These transformations and job-related costs will ultimately drive efficiencies across the organization.
Combine those investments with anticipated divestitures and I don’t think Citi is too large and/or complex to manage anymore.
The macro environment and interest rates
Interest rates are a tremendous tailwind for Citi’s strategy. Citi expects an additional $2.5 billion in net interest income (“NII”) for a parallel 100 basis point interest rate shift. This is already reflected in the quarterly results and will be even stronger in the coming quarters:
As seen above, Citi’s ex-markets NII is up about $1.5 billion year over year and is expected to continue rising in the quarters to come.
This tailwind should not be underestimated.
Citi also anticipates strong credit growth for cards in the second half of 2022, which is a very positive sign. While credit losses are at levels 50% below expectations throughout the cycle.
While the outlook contains many uncertainties, Citi is conservatively cautious and built some reserves in the second quarter and expects to build modest reserves in the third quarter.
What are the risks?
The main risk is a deep recession characterized by massive job losses in the economy (e.g. an unemployment rate well above 6%). Citi may have to absorb additional credit losses in such a scenario.
More importantly, the Fed may cut interest rates back to 0% and stay there for a very long time. This will affect the profitability of all banks. A zero interest rate environment isn’t a good environment for banks, but even then I expect Citi to earn above its cost of capital.
However, the Fed’s overnight rate of 2% to 4% is goldilocks for the banks. While I don’t have a crystal ball on the medium-term direction of interest rates, I see a slim chance that the economy will return to ZIRP.
I now use a barbell approach in my portfolio, where I hold banks but have also recently opened a position in long-dated bonds (TLT) as well as other long-dated assets.
For now, this is an exceptionally positive macro environment for banks with a strong tailwind from interest rates. The market fears a deep recession scenario. Tactically, I think it’s a good time to allocate to banks. My baseline scenario is that we live in an inflationary economy of friction, particularly as supply chains are rewired and critical industries are moved offshore.
Citi offers a compelling risk/reward trade-off on a relative and absolute basis at 0.55 times tangible book value. It’s no longer as risky as some might think due to recency bias. Managing Citi is no longer too complex. I like the management team’s new strategy and early indications are that execution is robust. Second quarter results were exceptional, particularly in the Institutional Client Group (“ICG”).
In my next article, I’ll dive deep into ICG’s strategy and explain why it’s Citi’s crown jewel and a much underappreciated asset.