2023-10-27 16:08:00 ET
Summary
- Citigroup is focused on simplifying its financial services portfolio to improve profitability and competitiveness in the long run.
- The bank's turnaround strategy, led by CEO Jane Fraser, aims to divest unprofitable units and cut costs.
- Citigroup's financial performance has been lagging behind its peers, but its improving liquidity and increasing dividend payout indicate positive progress.
- I believe shares may be intrinsically undervalued by almost 50%.
- Strong Buy rating issued.
Investment Thesis
Citigroup ( C ) is one of the " big four " commercial banks. The firm has an extensive portfolio of products which is primarily focused on commercial banking and wealth management with the bank also operating a slightly smaller set of retail banking services.
Recent divestitures and an objective to simplify the bank's product portfolio to enable it to focus on the more profitable ICG and wealth management businesses should see Citi become more profitable and competitive in the long run.
However, a lackluster FY23 so far combined with a difficult macroeconomic backdrop for banks has resulted in a massive drop in investor confidence with a huge selloff in Citi shares ensuing.
I believe this leaves shares materially undervalued by almost 50% which could present a real deep value opportunity for patient, long-term investors.
Strong Buy rating issued.
Company Background
Citigroup is one of the "big four" banks based in the U.S. ranking fourth in terms of market capitalization behind JPMorgan Chase ( JPM ), Bank of America ( BAC ) and Wells Fargo ( WFC ).
The bank has a significant presence within the U.S. domestic retail and personal banking industry, the wealth management sector as well as in international commercial banking.
Citi remains engaged in a significant turnaround strategy as the bank aims to significantly cut costs while continuing to grow revenues at an elevated rate. Given the highly diversified portfolio of products offered to customers by Citi, the bank is aiming to divest some of their consumer services in order to better focus their resources on the international commercial banking and wealth management sector.
While this strategy appears sensible and should place the bank in a better competitive position in the long term, this turnaround will take many years and currently is weighing down on both profitability and investor patience.
Jane Fraser took over as CEO of Citigroup back in 2021 from outgoing Michael Corbat. Fraser has significant experience both within Citigroup and within the banking industry as a whole. I believe her time running wealth management and mortgage units within Citi should allow her to guide the bank in the right direction thanks to her acute knowledge of what works and doesn't work in the industry.
She has already emphasized the importance of divesting unprofitable banking units while simultaneously scaling back costs to ensure the bank's margins and earnings outpace its cost of capital.
Nonetheless, Citi is most definitely a special situation in my view, with their turnaround only starting to show signs of positive outcomes.
Economic Moat - In Depth Analysis
Citi may have an incredibly diversified portfolio of services and financial products, but I believe the firm harbors a narrow economic moat at best.
The bank operates three distinct business segments consisting of their ICG services, Personal Banking and Wealth Management (PBWM) and Legacy Franchises.
The ICG segment provides Treasury and Trade solutions (TTS), securities services, equity markets, fixed income markets, commercial banking and investment banking products to its clients. Citi has a massive global presence thanks to their geographically diversified ICG segment.
While the ICG business segment is the largest revenue stream for Citi, it is also the most resource intensive unit operated by the bank. Therefore, historic margins have been quite low for the segment compared to Citi's other two smaller operational units.
Nonetheless, the diverse set of services offered within the ICG unit benefit from a synergistic networking effect whereby clients are more likely to engage in other services offered by Citi once they are already benefitting from another.
Therefore, I believe that the ICG unit helps generate a narrow economic moat for Citi. While the services offered within the business segment are not entirely unique and ultimately similar to offerings from Bank of America, JPMorgan Chase and Wells Fargo, I do believe Citi has enough geographic spread to derive some moatiness from this operation.
Citi also operates a PBWM service with the firm issuing a large number of credit cards and offering a relatively extensive network of retail banking services across the U.S. Citi has a limited retail branch network especially compared to competitors such as Bank of America and has chosen to close many branches in favor of moving towards a digitalized business model.
While I do see this transition away from physical locations as cost effective, I believe it does little to create tangible switching costs for consumers. A cost advantage could be derived from this transition in the long run, but even this is highly speculative.
Perhaps the most relevant aspect of Citi's retail banking business is the large number of credit cards issued by the firm. About 70% of the cards issued by Citi are branded cards and 33% are retail service cards.
While many of Citi's branded cards have attractive perks and interest rates for consumers, little tangible switching costs exist to drive a tangible moat.
Citi FY23 Q1 Presentation
Citi is relatively well protected with regard to the quality of credit being issued by the firm's retail arm with 89% of their EOP loans being given to consumers with FICO scores of above 680. This means almost 80% of their U.S. card portfolio is Prime.
Ultimately the small nature of their retail banking segment is part of the reason Citi operates as a money center bank rather than a traditional commercial bank. Money center banks raise their funds through domestic and international money markets rather than depositors.
The Wealth Management element of their PBWM unit offers Wealth at Work management and private bank services. Citigold aims to offer a more dedicated and personal wealth management service to higher net-worth clients with tailored financial planning a key attraction to the service.
While the wealth management business undoubtedly has potential to become an industry-leading service for mid- to high-net-worth clients, I believe that Citi may struggle once more to differentiate their service from its competitors.
Citi's transition to even less retail branches conflicts with the desire to offer more personalized wealth management services which potentially could benefit from having face-to-face interactions with customers.
Overall, I believe Citi's PBWM segment currently has no moat but maintains that the wealth management business in particular could harbor a narrow economic moat if the firm can differentiate their product sufficiently and thus generating switching costs for consumers.
Finally, Citi's legacy franchises consist of their Asia consumer banking unit, Mexico consumer banking unit, and Legacy Holdings assets. The bank appears to currently be engaged in selling off their legacy business units in favor of focusing on their wealth management and ICG units.
Given that these units are intended to be divested from the Citi portfolio either through sale (as is planned for their remaining 8 Asia consumer banking businesses) or through IPO (as is planned for their Mexico banking business), I cannot assign any moatiness to Citi from these units.
Overall, it is clear to see that Citi is currently in a difficult situation regarding their business model and any ensuing economic moat. The transformative strategy pursued by Jane Fraser could see Citi generate substantial economic moatiness in the future from their ICG and wealth management units.
However, at present time Citi generates a very narrow economic moat at best thanks to their ICG unit.
Financial Situation
From an operating performance perspective, Citi lags all three of their "big four" peers across almost every single metric.
Citi's 5Y average net margin is 19.81% which while 1% ahead of Wells Fargo lags JPMorgan by over 10% and Bank of America by 8%. The bank's 5Y average ROA and ROE are 0.68% and 8.21% respectively which once again means Citi is beat by all three of its key rivals.
The bank had a financial leverage ratio of 13.26x in FY22 which is third lowest behind Wells Fargo and Bank of America but ahead of JPMorgan.
Even from these basic operational performance metrics we can see that Citi is performing relatively poorly compared to its competitors. While this is largely to be expected given the turnaround currently underway at Citi, their below average performance still affects the bank's profitability.
Citi has not been immune to the difficult conditions that affected the banking industry at the start of 2023. The turmoil witnessed within the banking sector in March, April and May of 2023 was due to widespread fears of deposit outflows resulting in banks having to sell assets at losses resulting in insolvency and widespread contagion across the globe.
However, the more robust measures taken to shore up the balance sheets of banks post-2008 appear to have soothed fears of this scenario occurring with market sentiment improving markedly as the year rolled into the summer.
Nonetheless, Citi's FY23 quarterly reports have been less than ideal and have done little to evidence substantial progress within their turnaround process.
Citi's Q1 results saw revenues grow 125 YoY to $21.4B with net income also growing 7% YoY to $4.6B. Of course, these figures include the sale of the India consumer business which when taken out of the equation resulted in revenue and net income growth of 6% and -19% respectively.
The bank's ROTCE dropped 0.8% to 9.3% (not with counting the divestiture of the India business segment) while the CET1 Capital ratio increased 2%.
Growth in revenues was driven by higher NII thanks to the higher interest rates witnessed across their businesses. NII increased 23% YoY and 1% QoQ to $13.35B while non-interest revenue fell 3% YoY to $8.1B.
The PBWM unit saw great YoY growth of 9% in revenues while ICG also witnessed growth at 1%.
Total expenses increased by 5% ex-divestiture impacts due to an increase in of 12% in total technology-related spending as a result of hiring 8k new staff.
Interestingly, NIM for Q1 increased by 0.36% from 2.05% in Q1 FY22 to over 2.41% in Q1 FY23. Average loans grew 1% YoY and average deposits increased 2% YoY.
Q2 saw Citi's revenue fall 1% YoY while net income dropped 36% YoY. The bank's ROTCE ratio dropped substantially by 4.6% to just 6.6% while their CET1 ratio continued to increase to 13.3%.
Citi FY23 Q2 Presentation
The second quarter was characterized by strong TTS revenues which were up 15% YoY driven by NII and NIR. The bank also ranked number 1 in TTS with large institutional clients. Cards revenues was also up 15% YoY with their wealth segment seeing a 5% YoY increase in client assets while the Citigold client base grew by 8% YoY.
NII for Q2 was up 16% YoY and 4% QoQ while non-interest revenue continued to fall by 32% QoQ or 28% YoY. Expenses also increased 9% YoY due to continued technology investments and volume-related expenses. Inflation and severance costs were also noted as impacting this significant increase in expenses.
Net income was down 36% YoY due to the muted NIR performance and overall increase in expenses. Strong performance by the bank's treasury and trade solutions were more than offset by a 13% drop in market revenues, 24% drop in investment banking revenues and a 20% drop in corporate lending all due to lower client demand and ensuring volumes.
While the increase in expenses is regrettable and does little to improve Citi's overall profitability and net income margin, the technology improvements achieved in Q2 have massively simplified their platform processes, improved client experiences through expanded digital offerings and improved the bank's ability to understand and manipulate data.
These investments are clearly being done to improve the long-term performance of the bank while sacrificing short-term profitability. Whether or not these improvements will work is at present, entirely speculative.
Q2 still managed to see Citi improve their NIM by another 0.07% QoQ to 2.48% which is definitely a positive step in the right direction. Average loans fell by 1% YoY and remained flat QoQ at $654. Average deposits increased 1% YoY and fell 2% QoQ which is understandable given the delayed impact rising rates have had on real disposable income with consumers.
Finally, Citi's most recent Q3 results were a little more positive than the previous two quarters. Revenues grew by 9% YoY due to growth in services, cards and markets while net income increased 2% YoY thanks to the overall growth in revenues outpacing expenses, NCLs, ACL Build and other credit costs.
The bank's TTS business saw revenues achieve record highs for the last decade while securities services revenue was up 16% YoY. Investment banking revenue was also up 34% YoY thanks to strong client demand.
This saw ROTCE increase 0.6% QoQ to 7.2% while their CET1 capital ratio continued to improve by 0.2% QoQ to 13.5%. ROE increased from 5.4% in Q2 to 6.7% in Q3.
Expenses for Q3 also fell 1% QoQ (up $6 YoY) thanks to a reduction in legacy expenses due to divestiture and an improvement in ICG and PBWM efficiencies.
NIM increased 0.01% QoQ to 2.49% while average loans grew by 1% YoY to $662B. Average deposits however continued to fall 2% QoQ to $1315B.
From a liquidity standpoint, at the end of Q3 Citi had a solid 117% liquidity coverage ratio with an average HQLA of 569. HTM securities did fall QoQ by about 1.1%.
Citi FY23 Q3 Presentation
The bank's CET1 capital ratio continued to improve thanks to the strong earnings witnessed in Q3 and capital distribution in the form of share repurchases and common dividends. The overall RWA also fell due to the divestiture of the Taiwan consumer business unit.
Overall, it is clear to see that Citi has been making slow yet steady progress throughout FY23. While results have not been phenomenal, they are relatively solid, especially given the difficult macroeconomic backdrop present in 2023.
While the mixed results particularly from an earnings perspective illustrate that Citi's turnaround is still far from being complete, I believe their solid and improving liquidity is excellent evidence that the simplification of their business operations will be beneficial to their bottom line.
Seeking Alpha's Quant calculates an " F " profitability rating for Citigroup which I believe to be a slightly pessimistic representation of their current situation. The relative grades assigned by the quant do not in my opinion effectively capture the underlying improvements being made at the bank.
Moody's credit ratings agency affirmed a reasonable "A3" credit rating for Citi's senior unsecured domestic notes and maintained their LT issuer rating also at an "A3". The outlook remains stable. Moody's classifies "A3" ratings as being of "high grade" investment quality.
Citi pays a healthy dividend with a current FWD dividend yield of 5.49%. The bank recently increased their quarterly payout from $0.51 to $0.53 which represented the first increase since 2019.
The firm's FWD annual payout is expected to be $2.12 with a payout ratio of 34.86%. The 5Y growth rate is 7.88% which is relatively positive. Of course, it must be considered that banks are sometimes quick to cut their dividend payments during recessionary economic periods which places the ultimate safety of Citi's dividend into question potentially.
Citi goes ex-dividend on the 11/03/2023 with the payout date being 11/22/2023.
I believe the increasing dividend paid out by Citi indicates that the bank is confident in their ability to reward shareholders more substantially moving into the future. This is most definitely positive news and suggests internal sentiment regarding their turnaround progress is positive.
Valuation
Seeking Alpha's Quant assigns Citi with an " A- " Valuation grade. I believe this is an accurate representation of the value currently present within Citi stock from a relative perspective in comparison to the current valuations of their peers.
The bank currently trades at a P/E GAAP FWD ratio of 6.33x. This represents a huge 29% decrease in the firm's P/E ratio compared to their running 5Y average.
Their FWD Price/Book of just 0.38x is attractive in my opinion, especially when also considering the bank's Price/Sales FWD of just 0.93x.
Warren Buffett famously only likes to purchase shares in banks once their P/B ratio is below 1.00 which illustrates quite clearly that Citi is fundamentally undervalued.
Considering these basic valuation metrics alone I believe Citi should already start to appear significantly undervalued given the stock's historic averages and low P/B.
From an absolute perspective, Citi shares are trading at a huge discount relative to previous valuations with current share prices of around $39.00 representing an almost eight-year low for the bank's stock.
When compared to the 12% growth seen in the S&P 500-tracking SPY index over the past nine years, Citi has been massively outperformed by the U.S. market index as a whole by over 142%.
This underperformance is of course largely due to the stagnating business model present at the bank along with the structural challenges Citi has faced which placed their ultimate returns, profitability and margins under pressure.
When mixed in with the turmoil witnessed within the U.S. banking industry earlier in 2023, it is understandable that many investors have decided to bet against the bank with short interest continuing to remain elevated.
While the relative valuation provided by simple metrics and ratios, along with the absolute comparison, allows for a basic understanding of the value present in Citi shares to be obtained, a quantitative approach to valuing the stock is essential.
The Value Corner
By utilizing The Value Corner's specially formulated Intrinsic Valuation Calculation, we can better understand what value exists in the company from a more objective perspective.
Using Citi's current share price of $39.34, an estimated 2024 EPS of $6.00, a realistic "r" value of 0.03 (3%) and the current Moody's Seasoned AAA Corporate Bond Yield ratio of 5.13x, I derive a base-case IV of $74.60. This represents a massive 47% undervaluation in shares.
When using a more pessimistic CAGR value for r of 0.01 (1%) to reflect a scenario where a globally spanning recession causes Citi to struggle to grow revenues, NII and NIM while expenses also fail to be reduced, shares are still valued at around $54.00 representing a 27% undervaluation in shares.
Considering the valuation metrics, absolute valuation and intrinsic value calculation, I believe that Citi is clearly an absolute deep value bargain.
In the short term (3-12 months), I find it difficult to say exactly what may happen to valuations. The general uncertainty regarding the future direction of both the U.S. and global markets as a whole means predicting the direction for most banks from a qualitative side is essentially impossible.
Tax harvesting could see further downward pressure exerted on Citi stock as investors seek to maximize the tax efficiency of their portfolios for 2023. The potential for credit swipe fee reforms and banking regulatory changes could also place some downward pressure on Citi's stock in the coming 12 months.
In the long-term (2-10 years), I see Citi's turnaround succeeding with the bank's focus on their wealth management and ICG businesses generating a modest economic moat with some competitive advantages.
However, it must be prefaced that predicting the time period in which Citi's turnaround begins to positively impact earnings, expenses and overall net margins is very difficult hence my 8-year timeframe.
Risks Facing Citi
Citigroup faces significant regulatory risk and a large amount of macroeconomic risk due to the nature of the global banking industry and Citi's particularly vulnerable state as of current.
Much like Bank of America and JPMorgan, Citi faces significant compliance costs to ensure their still incredibly wide set of products and services comply with the various regulatory requirements present. While Citi's simplification of their business structure by eliminating their legacy businesses should allow Citi to reduce exposure to this risk, the bank is still subject to a difficult regulatory environment.
The proposed changes coming to U.S. banks both from a capital requirements perspective and the potential for credit card swipe fees to be reduced could materially impact Citi's margins and profitability.
While this risk is present for essentially all U.S. banks, it is still important to consider when evaluating building a position in Citi stock.
Despite Citi's divestiture of many international commercial and retail banking units, the bank still has massive geographic exposure to a variety of different markets. I believe this diversity while essential for their ICG unit generates a substantial amount of risk due to the bank's revenues being subject to less stable international markets and consumers.
To compound matters, Citi is of course exposed to both the prevailing U.S. and global macroeconomic conditions with key factors such as average loans, deposits, NIM, HTM securities, and overall profitability being influenced by macro conditions. A recessionary period could see Citi struggle to reduce expenses all the while NIR and overall loans and deposits decrease.
Investing in Citi undoubtedly harbors more risk than what is associated with some of its other "big four" peers due to the turnaround generating more uncertainty with regards to the bank's ability to generate significant profits and ROTCE in the coming years.
From an ESG perspective, Citi faces no tangible threats that could place a strain on their reputation or fiscal situation.
The bank is actively playing a role in sustainable finance with by issuing loans and financing services to a wide range of sustainable activities. Citigroup has (much like Bank of America) set out to achieve net zero GHG emissions by 2050.
I believe the overall lack of major environmental, societal or governance concerns would make Citi an excellent pick for a more ESG-conscious investor.
Of course, opinions may vary and I implore you to conduct your own ESG and sustainability research before investing in Citi if these matters are of concern to you.
Summary
Citigroup is an interesting bank with huge amounts of history and reputation currently being marred by substandard performance and a turnaround strategy that has failed to generate meaningful results so far in 2023.
However, I believe that fundamentally Citi's turnaround objectives are sound with much of the bank's progress being masked by difficult macroeconomic conditions and persistent headwinds.
The slow improvement in results witnessed throughout FY23 suggests Citi is making progress towards becoming more profitable and competitive relative to its other three "big four" peers. However, to achieve a tangible economic moat Citi must create switching costs for consumers by improving the quality, availability and differentiated offerings present within their ICG and wealth management services.
Given the huge market selloff and recent underperformance relative to U.S. market indexes, Citi shares have become materially undervalued. I believe a potential 47% undervaluation could be present in Citi stock as of present.
Given this massive intrinsic undervaluation and despite some uncertainty regarding Citi's turnaround timeframe, I believe a real value opportunity exists in the bank. Warren Buffett appears to believe so too with the oracle from Omaha's Berkshire Hathaway (BRK.A) (BRK.B) holding a 0.80% stake in the company worth $2.54B.
Therefore, I rate Citigroup a Strong Buy.
For further details see:
Citigroup: Deep Dive Analysis Highlighting Its Turnaround Prospects