2023-05-16 09:08:53 ET
Summary
- Citigroup is making concrete moves to streamline its business and become more profit-centric.
- Financials are healthy, the valuation is attractive, and margins are improving.
- C stock pays an attractive 4.5% yield and has lots of excess capital to return to shareholders in the form of buybacks.
- Instead of purchasing a stock outright, selling put options is the best way to generate a yield from the underlying operations while mitigating downside risk.
While Citigroup ( C ) hasn't been known historically for its flawless business execution or operational outperformance (covered here and here ), we believe that the bank has turned the corner on its strategic transformation. Now, with healthy revenues and cash flows, a streamlined operating structure, an attractive valuation, a sticky deposit base (as a result of its TBTF designation), and incredible capital return potential, we think it's time to begin getting involved in this storied financial institution.
Additionally, the company's shares exhibit a relatively low level of volatility compared to its industry, especially of late. Not only is this a testament to the scope of Citigroup's stable and profitable businesses, but it also serves as an opportunity for more cautious investors to generate tremendous yield and further mitigate risk by selling at-the-money put options. This strategy would provide a good chance of being assigned the shares at a discount, or generating a very healthy cash-on-cash return.
Financial Results
Let's take a look at Citigroup's recent results.
Financials show a stable, promising picture:
Revenue grew YoY, which was driven primarily by strong execution in Citi's TTS and securities services divisions, along with modest improvements in branded cards and personal banking.
EBT also grew YoY, although the bulk of these earnings came from the Institutional Clients group, as Personal Banking and Wealth Management took a hit as a result of higher funding rates and credit losses.
While it's easy to worry about fluctuations like this, it's important to remember that inter-division revenue and earnings rotations are common among large and diversified financial institutions.
These diverse business lines often provide natural hedges as well. During tightening cycles, NIMs rise while trading activity falls. In easing cycles, trading picks up along with M&A, while NIMs get hurt. Credit businesses fluctuate with macroeconomic health, and wealth management usually makes up the rest as a secular business in almost all markets.
Taken in full, Citi's earnings are stable, improving, and very much what you might expect to see from an institution of Citigroup's size.
Valuation
Earnings and profits are healthy, but the valuation is really what has us interested.
Seeking Alpha's quant scoring system pegs the valuation at an "A-", which we agree with wholeheartedly:
On almost every metric, Citigroup is trading at a discount to its sector, as well as to its own historical averages.
Many will argue that Citi's sub-par margins are at the heart of the company's chronic undervaluation (an argument we will examine shortly), but taking a broader capital allocation perspective, getting a stable, profitable, global banking business for only 6.2x net income seems like a steal. Doubly so when the company pays a solid 4.5% dividend yield and is poised to buy back shares with excess capital it has accrued recently above its mandated 12% CET ratio.
Margins
On the margins comment; they are improving, if somewhat slightly.
Citigroup achieved a 23% net income margin in its most recent quarter, which is better than the 21% it averaged in 2022. We expect that this margin expansion should continue, as Citi continues to sell off remaining legacy assets and retrain focus on its ICB and its North American PBWM divisions.
While margins are improving, they still lag other profitability metrics amongst like-sized competitors: ( BAC , JPM , WFC ).
It's true that many analysts over the years have speculated that Citigroup's margins would mean-revert higher to industry averages.
However, as a result of the concrete moves the company is making around asset sales, we believe that progress is actually being made towards these goals and that recent margin improvements could only be the beginning.
Transformation
Financial results are important to the future of Citi, but the bigger issue at play here is the reduction of overseas/legacy businesses which have made the company's structure overly complicated and byzantine in the past.
This, in turn, has complicated strategy, increased regulatory burden, and created other operational issues that have plagued the company.
This should all be coming to an end soon, as a result of the company's continued efforts to streamline the business and become more capital light and profit-centric:
Of the 9 divestitures the Citi wanted to make, 7 have been signed and 3 have been closed as of the most recent earnings report, and the company has made progress with respect to the other idiosyncratic situations like Russia:
The progress on these sales and situations has been a long time coming, and it finally appears as though Citi will be able to unlock more value for shareholders.
As the legacy businesses wind down or are sold, management will be able to spend time focusing on accentuating the strengths found within Citi's 'golden goose' TTS franchise, as well as finding ways of improving the company's other offerings to increase competitiveness.
There's no structural reason Citi can't achieve industry average margins or better.
The Trade
Now that we've laid out our investment case for Citi, let's dive into our preferred strategy for taking advantage of the healthy financials, attractive valuation, and improved operational performance: selling put options on the stock.
For those unfamiliar, selling put options involves taking on the obligation to buy Citi stock, at a certain price, by a certain point in the future, in return for cash premiums.
In this case, because we are quite bullish on Citi, we think selling the $45 strike, June 30th contracts has the most attractive risk/reward. In return for trading these puts, sellers can collect $1.37 per SHARE in premium over the next 46 days. This nets out to $137 per contract:
Given that each contract only requires $4,500 in margin to sell, the $137 cash premium translates into a massive ~3.1% return per share and annualizes to a very healthy 24% return on capital.
If Citi stock finishes June 30th trading above $45 per share, then sellers would get to keep the cash as income.
If Citi stock finishes under $45 a share on June 30th, put sellers get to keep the premium AND purchase the underlying stock at $45, which, as we've already discussed, seems attractive.
Risks
While the trade idea presents a high probability of success, it's crucial to be aware of the potential risks associated with the trade. Some of the key risks to consider include:
Business Execution : If Citi slows the pace of divestitures, experiences other mishaps (like the erroneous bond payment ), or otherwise sees its business become less profitable or competitive, then the current valuation is justified and put sellers would likely see losses as the stock adjusts.
Option Execution : While it is unlikely to occur in the next 46 days, if Citigroup stock goes to zero, then option sellers would be forced to purchase the stock at $46 per share anyway, which would lead to big losses. Functionally, this is the same risk as owning the stock outright, but it's something to keep track of, nonetheless.
Macro : Citi is subject to broader macroeconomic risks, including interest rate fluctuations, economic downturns, and changes in government policies that could impact the banking sector.
Technical Sentiment : Citi's stock has been technically weak over the last 24 months, and there's always a risk that negative sentiment or continued downward momentum could persist longer than anticipated, impacting the trade idea's success.
Summary
In short, Citi is poised to be an excellent investment over the next few quarters as the market begins to see results from the company's strategic transformation. Trading at a great value, with improving profit margins and excess capital to return to shareholders, there's a lot to like with this setup. We think selling at-the-money puts is the best way to capitalize on the underlying stock and reduce risk while generating a healthy chunk of income.
For further details see:
Citigroup: Quiet Potential For High Total Returns