Citigroup: Does a Breakup Make Sense?

A number of analysts have opined recently that Citigroup (NYSE:C) is worth more broken up than as a going concern. Specifically, several analysts argue that C should be selling business lines piecemeal in order to enhance "shareholder value," short hand for boosting the near-term stock price.  Aside from being self serving, these arguments seem to ignore some significant business model differences between C and banking industry peers, at least those peers based on market capitalization.

When you speak to inhabitants of the Buy Side, the peer group selection for C usually includes names such as JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC) and Wachovia Bank (NYSE:WB). Trouble is, none of these institutions is a particularly good business model peer for C.  Thus the question: Do arguments about C's performance relative to market cap peers such as JPM or BAC hold water?  If you review the Basel II metrics for these institutions generated by the IRA Bank Monitor, using data from the FDIC, the disparity becomes clear.

HOLDING COMPANY	Total Assets (000)	Defaults	LGD	M	EAD	EC to Tier 1 RBC
BANK OF AMERICA	$1,353,389,310	56.6	75.10%	7.34	173.50%	1.703
JPMORGAN CHASE & CO.	$1,252,868,764	59.4	77.30%	3.1	210.80%	5.337
CITIGROUP INC.	$1,149,628,884	88.4	72.30%	1.63	246.80%	3.15
WACHOVIA CORP	$521,355,328	15.2	55.90%	5.84	77.90%	2.057
WELLS FARGO & CO	$427,593,917	35.2	72.70%	2.99	63.20%	0.64
HSBC HOLDINGS PLC	$168,902,842	80.3	74.90%	2.81	272.50%	3.44

Sources: IRA Bank Monitor/FDIC (9/30/06)

The first thing to notice in the table above is the low Weighted Average Maturity or "M" for C compared with JPM and BAC.  With a M of < 2 years for all of the group's banking units, C has a maturity profile closer to a credit card specialization bank than a commercial bank.  Indeed, only institutions such as Wells Fargo (NYSE:WFC) and HSBC Holdings (NYSE:HBC) evidence M that is even close to the short duration profile of C. 

Notice too the relatively high Exposure at Default or "EAD" for C, JPM and HBC, an illustration of the large percentage of unused credit lines in each institution.  In the case of C and HBC, this is mostly a function of a large consumer lending book, while for JPM it is a combination of retail and wholesale exposure.  Indeed, note the fact that the ratio of Economic Capital to Tier 1 Risk Based Capital generated by the IRA Bank Monitor's Basel II simulation is 5.337:1 for JPM is  vs. just 3.15 for C and 1.7 for BAC, a reflection of the former's massive trading book exposure.

While you can argue that JPM is a good peer for C on the institutional side of the business, it is pretty clear from the table above that neither BAC nor WB belongs in the same peer group as C or HBC.  Notice the huge duration risk on the balance sheet of BAC, more than seven years, a profile it shares with WB, albeit to a lesser degree.  Yet both BAC and WB are relatively conservative institutions in terms of the low EAD and, in the case of WB, the excellent Loss Given Default rate of just 55%. 

Look too at the default rate for C -- 88.4bp for the first nine months of 2006 -- a rate only approached by HBC in this group of banks.   The relatively high default rates and the likewise high gross loan spread or yield are key business model indicators that can help more discerning analysts distinguish between different bank business models.  Question for break-up proponents: If WB has fewer defaults in a year than C has in a single quarter, can these two banks be good business model peers?

HOLDING COMPANY	ROA	ROE	Lending Spread (bp)	P/E
BANK OF AMERICA	1.57%	13.61%	704	12.4
JPMORGAN CHASE & CO.	0.86%	9.31%	717	13.9
CITIGROUP INC.	1.43%	15.70%	737	12.4
WACHOVIA CORP	1.23%	11.92%	653	12.7
WELLS FARGO & CO	1.65%	17.11%	768	14.9
HSBC HOLDINGS PLC	0.99%	12.22%	609	11.9

Sources: IRA Bank Monitor/FDIC (9/30/06)

Of course, many of the critics of C who want to see the bank broken up measure valuation in terms of short-term stock price appreciation, not financial performance.  These are, generally speaking, the same folks who support the use of market cap weighted indices to determine portfolio allocations and benchmark the broad market, both bad ideas in our book.  But if you compare the "bank only" financial performance of C to the market cap peers like JPM or BAC, the former's performance actually is pretty good.  Note too that C's P/E ratio is in the same neighborhood as the market cap peers, but below banking industry leaders such as WFC and US Bancorp (NYSE:USB).  

Looking at the financial performance of C, you have to really wonder why the critics are so unhappy.  Perhaps the stock performance of C has lagged the market cap peers like BAC and especially JPM, which is up around 20% LTM, but it seems hard to make the argument that C deserves a higher P/E multiple that these market cap peers.  One of the legacies of the Sandy Weill (and Warren Buffet) era was to move C toward a focus on sub-prime and unsecured consumer lending, and away from areas like commercial real estate and derivatives.  Was it just a coincidence that C, after helping to invent the OTC derivatives market in the late 1980s, let JPM race ahead in terms of market share? 

C does have the largest C&I loan portfolio of any US bank, but at $147 billion as of June 30, 2006, that's just 10% of total banking assets.  To us, the real story of C is told by the short portfolio duration and the high loan yields of some of the group's consumer banking units.  When you see loan yields in the 1,800-2,000bp range and default rates above 300bp annually, that is sub-prime territory.  While the numbers may look more benign on the consolidated, bank-only roll up basis shown above, to us C is a high risk franchise that is probably pretty well-valued at current levels.  That is, the market is right again.

If you want to be critical of C, in our view, the place to start is the management suite, not the balance sheet.  CEO Chuck Prince is a skillful lawyer who was given the top job during a crisis in order to get C out of the penalty box with US regulators, this after the Enron fiasco and other operational risk mishaps.  Now that C hopefully has put these issues behind it, the board of directors and Prince himself should be thinking about a replacement to lead the organization forward.  There is no criticism for Prince in this observation; he did the job and cleaned up the legal and regulatory mess left by Mr. Weill et al.  But Prince's weak performances in face-to-face meetings with investors make it clear, to us at least, that he is not the man to sell C's story to the Buy Side. 

Bottom line: Arguments that C should be broken-up seem wide of the mark, but the organization should definitely be in the market for a road-show ready CEO.

Comments

[FIG trader_:]

To quote the master, the market is a voting machine in the short term, and a weighing machine over the long term. So any attempt to extrapolate from recent performance how well the company is doing and/or whether it should be split up is just watercooler talk. As noted in previous posts, the company outperformed its "peers" substantially over the ten year period, and the stock is only underperforming in the most recent 5 year stretch (though it is catching up fast). The gentleman uses IRA Bank monitor data for comparison purposes, but those figures conflict with reported numbers at 9/30 (for ex C reported a 18.9 ROE for the quarter) and one should be suspect of the inference that portfolio quality reflects mostly subprime (mostly from Associates acquisition) based on the supposed duration of 1.6 (seems like a misprint if you ask me). Default rates of 300 basis points is not sub-prime. In fact, the ongoing rate for most consumer credit card businesses (including COF, MBNA, Discover, AXP ) has consistently been somewhere between 250 and 400 basis points for several years now. I'm not sure where the author is going with all this, since reporting methods change so dramatically over the course of the years, and economic and interest rate cycles, and most companies purposely attempt to obfuscate and hide problems anyways. From investors standpoint, its ROE, ROE, ROE and institutional investors (who do no better at figuring it out than anybody else) seek the business with the best chance of sustaining the current high ROEs at the lowest risk. To try to reduce the size of the industry buckets in which these companies are thrown in more than is already done by S&amp;P in its sector ratings would be a waste of time. For one who has been through the excercise numerous times, its easy to reach the conclusion that PM's are just managing around their core benchmark holdings anyway. Its the safe way to play..............unti... its not.

2007 Jan 02 06:44 PM