2023-11-02 10:00:00 ET
Summary
- Citigroup is a large financial services holding company subjected to increased regulatory supervision as a global systemically important bank.
- The bank's negative historical reputation and lower returns on equity have contributed to its undervaluation in the market.
- Despite its past issues, Citigroup is currently less risky and cheaper than ever before, making it an attractive investment opportunity with a large margin of safety.
The following segment was excerpted from this fund letter.
Citigroup ( C )
Citigroup (“Citi”) is a large-capitalization global diversified financial services holding company that primarily serves multinational institutional and high net worth consumer clients. Citi is one of three large American banks to be designated in “bucket 3 or 4” of the “global systemically important bank” (“G-SIB”) framework by The Basel Committee on Banking Supervision. The other banks in this group are J.P. Morgan and Bank of America.
As a G-SIB, Citi is subjected to increased regulatory supervision by global bank regulators and central banks. Enhanced regulatory supervision was an important post-crisis reform to strengthen the global financial system by increasing bank capital ratios, transparency, and decreasing risk-taking. These reforms resulted in the largest G-SIBs moving away from risk-oriented banking activities such as advisory, high-yield lending, and trading, towards lower-risk activities. Indeed, Citi’s most valuable, high-growth segment, Treasury and Trade Solutions, is in lower-risk and entrenched activities such as liquidity and cash management, payments, trade solutions, and automated receivables processing. In our view, somewhat unintuitively, Citi’s increased regulatory supervision contributes to the company’s less risky banking business model, and thus its attractiveness as a downside-oriented investment opportunity.
Citi’s market perception suffers from the bank’s negative historical reputation. In 2008 during the Great Financial Crisis, Citi received the most TARP funding (the largest “bailout”) of the U.S. banks. TARP funding was provided by the U.S. government to forestall a liquidity problem that threatened to become a solvency problem. More recently, Citi mistakenly used its own capital to pay lenders when acting as Revlon’s loan agent, resulting in a $400M fine by the Federal Reserve and orders to resolve internal controls (which Citi fulfilled). Citi’s large global consumer bank was assembled by prior management in the early 2000s to attract and service high-end global consumers. Unfortunately, this pivot was costly and ill-timed in the context of increasingly complex multi-jurisdictional regulation to prevent money laundering and tax evasion. The global consumer bank has been a drag on Citi’s overall performance.
We believe the market dislikes Citi for these historical reasons and because Citi earns lower returns on equity (“ROE”) than its peers. In 2023, Citi has so far earned an ROE of ~7%, compared with peers that earn 10%+ ROEs. Recognizing that Citi is less valuable than its peers because it is a lower performance bank, we would argue that Citi’s valuation is still far too low. We believe the market is over-discounting Citi at its current valuation of ~0.48x tangible book value (“TBV”).
In our view, today Citi is:
- Less risky than it ever has been.
- Cheaper than it has ever been, even when we burden our estimate of intrinsic value to account for the bank’s lower returns on equity.
Citi’s CET1 ratio, a risk-sensitive measure of capital adequacy, increased from 10.6% to 13.5% over the past ten years. Citi’s increased capital adequacy underscores the regulatory transformation that has resulted in large G-SIB banks being less risky. While increased capital adequacy does burden a bank’s ROE, Citi is more resilient today than any other point in recent history. At the end of the third quarter, Citi’s balance sheet had $2.4T of assets, including $649B of loans (net of loss reserves), compared to $166B of tangible common equity (“TCE”).
In the following downside scenarios, Citi’s current market capitalization compares favorably to adjusted TCE. Also, this math does not include offsets for Citi’s earnings power over a prolonged period where losses would occur, nor the tax efficiency of those losses, making these comparisons even more conservative:
- If the Federal Reserve’s “severely adverse scenario” (the “Fed Stress Test”) materialized, Citi’s loans would see 5.9% loss rates, resulting in $39B of credit losses. Therefore, Citi’s TCE would shrink to $145B versus today’s $80B market cap, resulting in an adjusted ~0.56x TBV valuation.
- If we assume 2x the credit losses that Citi predicted during peak COVID fear, when the global economy stopped, locked down, and unemployment skyrocketed, Citi’s loan book would see 7.9% loss rates, resulting in $53B of credit losses. Therefore, Citi’s TCE would shrink to $131B versus today’s $80B market cap, resulting in an adjusted ~0.61x TBV valuation.
In the below table, we show that Citi’s G-SIB peers are valued at more than 2x Citi’s valuation though they do not feature operating performance commensurate with such a large dispersion.
Citi is cheap on an absolute basis and compared to peers. Citi has large margin of safety and earnings power to absorb unforeseen loan losses (even if substantial). The bank is protected from typical bank risks such as bank runs given its G-SIB status and the structure of its deposits. At the end of the third quarter, Citi’s P/E was ~6.8x 2023E earnings. We believe Citi’s shares are significantly undervalued. In our base case underwriting, Citi’s shares are worth more than $68 (~0.8x tangible book value).
We also note that Citi is in the middle of a corporate transformation which could provide additional upside in excess of our base case underwriting assumption. Management’s promised transformation includes simplifying and shrinking the company, divesting the global consumer bank, and investing in higher growth business activities with premium ROEs. If the corporate transformation is achieved, Citi would deserve a higher valuation more in line with its peers. In an “upside case,” we estimate Citi is worth more than $85 per share, or double the company’s share price at the end of the third quarter. Management’s transformation would also free up substantial regulatory capital, enabling accelerated capital returns to shareholders through share repurchases at today’s accretive stock prices.
Important DisclosuresSilver Beech Capital Management, LLC (“Silver Beech”) is a New York limited liability company that serves as the investment manager to Silver Beech Capital, LP (the “Fund”), a Delaware limited partnership. The principals of Silver Beech are James Hollier, who serves as the portfolio manager and managing partner of the Fund, and James Kovacs, who serves as the managing partner of the Fund. All performance results presented herein refers to the performance of an unrestricted investor in the Fund since its inception. Net performance is presented net of the highest performance allocation in effect at the time (20%) above a 6% hurdle rate, the highest actual management fees (1.0%) charged at the time, and net of other expenses, and includes the reinvestment of all dividends, interest, and capital gains. Performance for investors who subscribed on different dates, or who pay different fees would necessarily be different from the performance presented herein. The rate of return is calculated on a “time weighted” rate of return basis, which minimizes the effect of cash flows on the investment performance of the Fund. All monthly performance data presented herein reflects unaudited data, unless otherwise specified, and as such its accuracy cannot be guaranteed. Past performance is not necessarily indicative of future results. All securities transactions involve substantial risk of loss. The material presented is compiled from sources thought to be reliable, including in certain instances, from outside sources, but accuracy and completeness cannot be guaranteed. Any opinions expressed herein reflect the judgment of Silver Beech and are subject to change. The information in this letter is for discussion purposes only. Nothing contained herein should be construed as an offer to sell, or a solicitation of an offer to buy or sell any security or investment strategy or a recommendation as to the advisability of investing in, purchasing or selling any security or investment strategy, which may only be made in the Fund’s confidential offering memorandum and operative documents (collectively, the “Offering Documents”). Before making an investment decision with respect to the Fund, prospective investors are advised to read the Offering Documents carefully, which contain important information, including a description of the Fund’s risks, investment program, fees, expenses, redemption and withdrawal limitations, standard of care and exculpation, etc. Prospective investors should also consult with their tax and financial advisors as well as legal counsel. The Offering Documents are the sole documents on which a potential investor is entitled to rely in evaluating an investment in the Fund. The information in this letter does not take into account the particular investment objectives, restrictions, or financial, legal or tax situation of any specific prospective investor, and an investment in the Fund may not be suitable for many prospective investors. This letter is not intended to be, nor should it be construed or used as, investment, tax or legal advice. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. |
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Silver Beech Capital - Citigroup: Cheaper Than It Has Ever Been