Citigroup: cheap or hopeless?

Good morning. We have the makings of a US debt ceiling deal, though negotiations will continue as the pact is pushed past the outer wings of both parties in Congress. Even assuming default is avoided, however, it is not perfectly clear how markets will, or should, react. An initial relief rally in equity prices and long bonds would make sense. But as the debt ceiling intermezzo fades, the main themes of the market opera — inflation, interest rates, asset valuations — will reassert themselves. Investors might notice that the economic data, for example April’s personal consumption expenditures report, have been coming in warm; that real GDP for the quarter is trending at 2 per cent; and that the two-year bond yield is rising. The idea of another Federal Reserve rate increase, if not in June then later, is no longer risible. Might the relief rally be brief? If you know, for goodness’ sake email me: robert.armstrong@ft.com. 

Citigroup reconsidered

Four years ago I wrote a long reported piece about Citigroup, which made the case that the bank’s business model did not work and needed changing. Almost everyone I spoke to — former leaders of the bank, investors in it, analysts, senior insiders — acknowledged privately that a new approach was required. The banks’ low return on equity, stock market underperformance and low valuation made the point irrefutable, even if its leadership could not say it out loud.

A year or so later Citi appointed a new chief executive, Jane Fraser, who has proceeded to initiate many of the changes discussed in my piece (I can’t claim she was inspired by my work, brilliant though it was. As I said, everyone knew what needed doing). Most importantly, she set about divesting Citi of much of its global consumer banking franchise, which had no synergies with its best businesses, which are transaction banking, credit cards, and fixed-income markets. These divestments culminated last week with news that Citi would pursue an IPO of its Mexican retail operations. A sale to another bank had been hoped for, but at least the separation process is proceeding.

Fraser and Citigroup have not been rewarded for doing the right things. The stock has continued to underperform the other big diversified US banks and its valuation remains somnolent. Here is its price to tangible book value ratio, compared with those of JPMorgan Chase and the large regional bank Comerica:

It is not surprising that Citi’s valuation should lag behind JPMorgan Chase, the bank with the best balance of retail, wealth management, commercial banking, investment banking and trading businesses. What is surprising is that it trails even a regional bank with the characteristics that are currently giving investors the heebie-jeebies (plenty of uninsured deposits and a biggish securities portfolio).

What is the problem? In one sense, the answer is simple: Citi is a show-me story, and the bank has not yet shown that it can improve its returns. Citi’s return on tangible common equity (8.9 per cent last year) is lower than in 2019, and the gap with its big peers (in the mid-teens) has not narrowed. The retail divestments and other reforms have not yet moved the needle. The undersized US retail banking operation (a big source of returns at Bank of America and JPMorgan) continues to be a drag on the card and transaction banking businesses. An overhaul of the bank’s core risk and compliance systems has kept expenses running ahead of revenue growth. Fraser has mountains left to move.

Given this, the temptation is to write Citi off. When a bank has a price/tangible book ratio well below 1, my simple-minded interpretation is that the market has concluded that return on equity is lower than its cost of equity (“book value” means “equity value”). I think of a bank or indeed any company in this situation as destroying shareholder value, even if it shows profits on its income statement. Given the uncertainty about when and if Fraser’s restructuring will bear fruit, why own a bank that does that? 

I may have been too dismissive. The valuation wizard Aswath Damodaran of New York University has made a strong case for owning Citi. He does so despite being clear-eyed about the bank’s weaknesses and the challenges facing the industry:

Citi has clearly lost the battle not only against JPMorgan Chase, but against most of the other big US banks. It has delivered low growth and subpar profitability . . . 

Almost every aspect of banking [as an industry] is under stress, with deposits becoming less sticky, increased competition for the loan business from fintech and other disrupters and increased risks of contagion and crisis . . . I believe that the long-term trends for the [industry] are negative.

Banks are hard to value because free cash flow, the crucial input to most valuation models, is hard to measure in a business that consists solely of financial assets and liabilities. At a bank, whether cash is profit or working capital is always an open question. Damodaran solves this problem by using future net income as a proxy for future cash flows, adjusting it for net contributions to regulatory capital, and discounting it at a rate reflective of banking’s special risks.

Citi, Damodaran notes, had ample regulatory capital and has been growing assets slowly but steadily, suggesting that net income will grow over time. In order to assess the riskiness of the bank, he looks at net interest margin, regulatory capital ratios, dividend yield, return on equity, deposit growth and securities portfolio accounting at the 25 largest US banks. Citi scores above the median on the first three of these six measures — the best performance among banks that trade at a price/book discount. He sums up:

[Citi’s] weakest link is a return on equity . . . lower than the median for US banks, and while that would suggest a lower than median price to book ratio, the discount at Citi exceeds that expectation. Citi’s banking business, though slow-growing, remains lucrative with the higher interest rate spread in this sample. I will be adding Citi to my portfolio . . . It is a slow-growth, stodgy bank that seems to be priced on the presumption that it will . . . never earn a ROE even close to its cost of equity, and that makes it a good investment.

I find Damodaran’s case for Citi analytically compelling, but I have two worries. First, the argument is purely quantitative, and I wonder if it ignores the structural factors that keep the bank’s return low — most notably its small US retail banking franchise — and how hard those problems might be to fix. Second, and much less rationally, people have been betting that Citi is too cheap, and losing that bet, for at least 20 years. Are things really different this time?

If there are any Citi investors out there, on the long and short side, I’d be very keen to hear from you.

One good read

Something has gone wrong at the volatility laundromat.