2023-05-16 17:41:50 ET
Summary
- Higher rates and wider spreads will help Citigroup raise its interest income.
- Sale of assets in Mexico will help improve capital ratios.
- Stock buybacks at this cheap valuation should put a floor on the stock price.
Overview
I believe Citigroup (C) is the deepest value play in financials. The current macro environment is helping rather than hurting Citigroup in my view, as higher rates, wider credit spreads, and a yield curve that will eventually have to steepen will all help increase interest income. Along with that, it has the lowest valuations of any major bank and upcoming stock buybacks will only help.
The Macro Environment Helps Citigroup
I have a bearish view of the macro environment, as I believe that rate hikes will continue with the possibility of 50 basis point hikes per quarter for the next year; along with that many regional banks are likely to continue to become insolvent. In my opinion, this will help rather than hurt all the big four banks (Bank of America (BAC), JPMorgan (JPM), Wells Fargo (WFC), and Citigroup).
The biggest reason failures in regional banks help Citigroup is that the deposits formerly at regionals will go to Citigroup and as the situation in the economy gets worse even more deposits should go to Citigroup. Because of this, I believe that a recession is a positive for Citigroup not a negative. Further, this provides Citigroup with potential asset acquisition opportunities that banks like JP Morgan and First Citizen's Bank have taken advantage of. JP Morgan acquired assets from First Republic Bank and First Citizen's Bank acquired assets from Silicon Valley Bank.
An area where I see large amounts of growth due to the Fed rate hiking cycle is in net interest income.
Below is the overview of the part of the income statement that shows interest income and expenses:
The above shows the interest revenue and expenses on a quarterly basis. As seen from September 2020 to now both interest income and interest expenses have gone up, but noticeably the spread between them has widened due to rate differentials widening. In my opinion, there are two major spreads that will widen significantly as we head into a recession. The first is the credit spread; banks will take deposits which are at a lower risk and rate and lend them out at a higher risk and rate. As we head into a recession higher-risk assets like C&I loans will be seen as risky and rates will adjust higher on them as a reaction to that; at the same time though low-risk assets like AAA bonds will be in higher demand as there is a flight to safety. This will itself cause the credit spread to widen and on top of that in a recession, it is likely that the Fed has large cuts causing rates to be paid on deposits to go down while rates on loans will continue to stay high due to a tight credit market. This widening in the credit spread will allow Citigroup to borrow cheaply and lend pricey.
On top of this, I see duration risk expanding. As of now, duration risk is negative due to an inverted yield curve, so banks have a tougher time lending long and borrowing short, but I believe that will change as we head into a recession. Prior to a recession, the yield curve is inverted and during a recession itself, the yield curve actually tends to get extremely steep. An extremely steep yield curve will easily allow Citigroup to borrow short and lend long.
During a recession, if the overnight rate were to get cut down to 0-0.25% as it was in 2020, but rates on corporate credit were to continue to stay high due to tight credit conditions making it so that corporate borrowers are willing to pay high rates, we could easily see $27 billion per quarter of net interest income. I get to the $27 billion figure by taking the current interest income the bank is getting (around $29 billion), and subtracting interest expense that they would pay on deposits if rates were lower (around $2 billion).
We had seen something similar to the above-highlighted scenario in March 2020. Below is a chart of ICE BofA US High Yield Index Effective Yield:
As can be seen in the above chart during the equity and credit market crash in March 2020 bond yields spiked while the overnight rate went to zero. This quickly reversed as the Fed stepped into the market, but if they hadn't this credit spread blowout would've stayed for a long time. This time around with high inflation I believe that the Fed is less likely to step into the market and buy junk debt, and high inflation has also led to a contractionary fiscal policy; this means that if the credit spread blows out, the spread is a lot more likely to stay wide. A good example would be to look back to 2008 when the High Yield Index got up to a 23% yield.
The main risk in a recession of course is default risk and deposits leaving. I do believe that since Citigroup is in the big four banks rather than deposits leaving they will instead come in droves. The default risk of the bond portfolio is what I would be more worried about. While this is a potential risk if the situation gets bad enough, I do expect that since Citigroup is a "too big to fail" bank that well before such a situation would happen there would be a government backstop. On top of this, most of the investment securities owned by Citigroup are low-risk corporate debt (A or better), so default risk is highly unlikely in my view.
Mexico Sale
Citigroup is in the process of selling its Mexican operation, Banamex. I find the purchase price to be around a billion dollars below what most of the market expected, but in the long run, this is likely the right move for Citigroup as it looks to simplify its business.
This sale will reduce the risk for the firm and improve its tier-one capital ratio.
Return of Capital to Shareholders
Citigroup trades at an insanely low P/B of just 0.48. Along with this, the forward P/E is around 5.5. This low P/E and low P/B is a great valuation to buy back stock. Over the next year, I believe Citigroup could buy back as much as 20% of the outstanding shares. Stock buybacks will help Citigroup directly grow EPS and increase book value per share, which I think market participants will positively recognize as they already have the lowest P/E and P/B of all major banks. Stock buybacks can also potentially act as a floor on the stock price.
Takeaway
The takeaway here is simple. Citigroup is the cheapest of all the major banks from a P/E and P/B perspectives, and stock buybacks will only make it even cheaper. On top of this, I believe that most are underestimating how much credit spreads will widen and how the yield curve will eventually steepen, causing net interest income to go up astronomically. The sale of Banamex will reduce risk and improve capital ratios.
For further details see:
Citigroup: Low Valuation With Great Macro Backdrop