2023-03-24 10:53:37 ET
Summary
- Citigroup’s financials could appear not on the strong side, as the gain in the client base could be offset by the net interest spread compression.
- Citigroup is taking the right steps for reorganization and improvement of business efficiency amid the uncertainty that is amplified by the Fed's move.
- Citigroup Inc. stock is trading on relatively undervalued multiples but beware of P/B.
Despite heightened risks, the positive long-term outlook on the U.S. banking sector remains intact. I believe that the U.S. economy still has a margin of safety and will be able to avoid a serious downturn. Against this background, Citigroup Inc. ( C ) should continue to feel relatively well, although the financials in 2023 could turn out not the strongest. Citigroup shares provide a superior dividend yield and trade at a prominent discount to peers, and I expect the bank's reorganization and business efficiency measures to boost its valuation multiples up.
Outlook
Obviously, the main event of this week for market participants was the results of the Fed meeting. High volatility at the short end of the US Treasury yield curve in recent weeks indicated a high level of uncertainty about the regulator's decision. The Fed came up with a +25bps rate hike to a range of 4.75-5%, and once again pointed out the importance of fighting inflation and confirmed its intention to bring inflation down to the target level of 2%. Also, general market expectations include the achievement of another +25bps, where the probability of this scenario is 43.5%.
The bankruptcy of SVB Financial Group (SIVB), the largest since 2008, which specialized in financing tech start-ups, would most likely have remained a local story at another time. However, it has not only seriously alarmed the markets, but also required emergency decisions from regulators in order to avoid contagion and the emergence of a systematic financial crisis. And if the strongest always survive, this also applies to the financial sector, where Citigroup benefited from the depositors shift to the largest U.S. banks.
The near-term outlook for the financial sector appears clouded. However, despite heightened macro and other risks, the long-term prospects remain positive thanks to strong consumer and business spending, and I stick to the following thesis from my piece on KBE :
I believe that the US economy still has a margin of safety and prospects to avoid a serious and prolonged downturn. In my view, the banking sector will continue to perform well, although the financials in H1 may not be on the strongest side.
The reorganization of the retail division will allow Citi to increase targeted investments in those lines of business in which its competitive advantages and opportunities are most prominent. As a result, the strong brand, solid positions in a number of segments, as well as ongoing efforts to optimize operations, should allow Citigroup to get through the current difficult period with sufficient confidence and return to profit growth subsequently.
Financials
Citigroup's financial results for Q4 2022 were mixed. Net income sank 20.8% YoY to $2.5 billion, or $1.16 a share, and missed the analysts' average estimate by 4 cents. The bank's quarterly revenue climbed 5.8% to $18 billion, and was superficially above the consensus.
Earnings were significantly pressured by a sharp increase in credit risk costs, while capital adequacy ratios improved over the year and are at quite comfortable levels. The CET-1 ratio increased by 75bps over the year, up to 13%, exceeding the minimum regulatory requirement by 1%.
Looking at the U.S. banks, unrealized losses are high, but much of this is in Held-to-Maturity. Citi is carrying $268.9 billion HTM debt securities at amortized cost, with $25.3 billion of such losses. Big? Not really compared to the 148.9 billion of CET-1. Still, if realized, this would reduce the CET-1 ratio to around 10.8%, lower than the 12% regulatory minimum. With the latter expected to increase this year, along with the persistent rate hikes, this gap could widen further. The point is that Citi is a well-capitalized bank, with well-diversified deposit liabilities and is unlikely to have to realize these losses.
Citi has up to $1.16 trillion of uninsured deposits, implying 85% of the total deposit base. However, the bank has ample liquidity in cash, deposits with banks and Available-for-Sale debt securities, which adds up to $591 billion or 51% of total uninsured deposits without resorting to Held-to-Maturity bonds.
The Fed has recognized the risk of a systemic financial crisis and took measures to stop it at an early stage with the Bank Term Funding Program , offering loans to banks against collateral. Sounds like a QE program. The banks can now post Treasures (or other qualifying securities) worth 80% (for instance) to the Fed and collect funding at 100% (par value) of the bond. In case the deposit basis is fleeing, this could play out for banks and ensure their liquidity position. However, the BTFR is not a QE, as it lends money against collateral for up to one year, meaning that it doesn't remove the duration risk. In case of QE, the bonds are taken away from the banks for an indefinite time, hence the duration risk as well. This means that the Fed is not trying to put out the fire, but only to limit its spread. Still, Citi is well-capitalized, with a strong moat from that fire.
Looking forward, higher interest rates will continue to positively affect the interest-bearing business of the bank, particularly in Treasury and trade solutions and Cards. Securities services should underpin the positive performance thanks to significant client wins, evidenced by the onboarded $1.2 trillion of assets under custody and administration, and the positive outlook for new deals. Personal banking will continue to benefit from a recovery in borrowing, underpinned by growth of revolving balances. In addition, the increase in e-commerce spending combined with the digitalization push will drive more card payments.
On the downside, legacy franchises will continue to weight on the overall performance until the wind down of the remaining exit markets will take place. However, simplification of the organization and management structure, and continued investments in transformation could materialize through improvement of the synergy efficiencies. The situation in the investment banking and wealth division is likely to persist unfavorable in the coming quarters. However, inflation is weakening , and I believe that by the end of the year, the Fed will be able to move on to a gradual easing of monetary policy. This allows counting on the normalization of the financial markets in the medium term and increase in the number of placements and M&A transactions. Although fears of a global recession and high geopolitical risks are likely to remain deterrents.
Valuation
The executives gave their full year 2023 revenue target in the $78-79 billion range , and committed to achieving the 11-12% RoTCE medium-term target, which at current stock price levels implies a P/E of just 4.8x, significantly below the historical multiples. However, I addressed the valuation of Citi with the same model I used for JPM or by comparison with the peer group by forward dividend yield and P/E ratio.
In the fourth quarter, Citigroup returned $1 billion to the shareholders through dividend payments, and I expect C to maintain its annual payout of $2.04 per share in FY2023. From the comp table, we could spot the dividend yield on C's shares (4.67%) is the highest among leading U.S. banks and peer group overall. The calculation also incorporates the consensus analysts' forecast of EPS of $5.76 for 2023, which represents an 18.9% decline YoY and is consistent with the deposit repricing, which in turn could put pressure on the net interest margin. With the equal weight in between, the implied MCap should be $212.5 billion, or $54.8 per share, which represents a 26.5% upside potential from current levels.
Looking at the P/B comparison, Citigroup is currently trading at a 0.46x multiple, compared to the 0.90x median P/B in the peer group. This might imply an almost two-fold upside potential for C's share price, but it doesn't. Let's examine the following chart.
ROE and P/B scatter (author's estimates)
We can find Citigroup's spot below the trendline. However, taking into account that the bank has a relatively low ROE of 7.50% compared to the peer group median of 9.85%, it obviously doesn't imply 2x potential. The calculations show that in order to bring Citigroup up to the trendline, the P/B ratio should increase up to 0.69x. From this point of view, the upside potential is roughly 50%, which still puts merely the upside risk to my target price. Applying the same logic, JPMorgan Chase & Co. (JPM) and Bank of America Corporation (BAC) are not that expensive, while trading at superior valuation multiples to the peer group.
Risk Factors
Citigroup's business, like the banking sector as a whole, is highly dependent on economic and market conditions. In the event of further significant deterioration, we can expect a decrease in customer activity and demand for the bank's products and services, losses from the revaluation of investment portfolios, and a negative impact on capital adequacy ratios.
Conclusion
I expect that as the plans for reorganization and improvement of business efficiency are implemented, Citigroup Inc.'s valuation ratios will increase. I am for a Buy on Citigroup stock, as the positive factors that we stressed earlier are gearing momentum, making the bank an attractive investment opportunity. The near-term outlook appears clouded, where the depositors, seeking to exploit the elevated interest rates through more profitable alternatives, put pressure on the interest-bearing business of the bank. However, Citigroup has significant liquidity in place and, moreover, turns a preferred place for the accounts of the most risk-averse clients. In addition, Citigroup Inc. is well-capitalized, with the CET1 ratio comfortably above the target level. This gives Citigroup a reasonable assurance to maintain the dividend distributions to shareholders.
For further details see:
Citigroup: Cheap, Relatively Safe, And That Dividend