It has been a long road to redemption for Citigroup (NYSE:C). It was deeply scarred by the 2008/2009 financial crisis and required a massive government bailout. It then failed CCAR in 2012 as well as 2014 - whereas its business model was significantly handicapped by the post-crisis regulatory paradigm, anemic global growth and an extremely dovish Fed (secular stagnation anyone?).
Against this background, Mr. Corbat has performed a very credible job. Despite an initial CCAR setback in 2014, he went on to position the firm strongly for the future - some of the key achievements are highlighted below:
- Reduction in the footprint significantly by selling or unwinding big parts of the Global Consumer Bank (GCB)
- Reduction in the size of Citi Holdings to the verge of collapsing it back into the firm
- Started to chip at the $50 billion Deferred Tax Assets (DTA)
- Largely met financial targets set in the beginning of 2013 (ROA of 90-110 basis point, mid-50s efficiency ratio and RoTCE of 10%)
- The firm (excluding DTA) earned above its cost of capital on a 2015 FY basis
Make no mistake about this - these are not insignificant achievements and the management team deserves much credit for achieving that, in what has proven to be an extremely challenging external environment for global banks.
The last step for redemption is CCAR
Whilst Citi passed the CCAR process in 2015 - the capital ask was a rather modest one and represented mid-30s payout ratio. This is not a satisfactory for a firm that generates around $20 billion of regulatory capital a year.
Wells Fargo (NYSE:WFC) and JP Morgan (NYSE:JPM) payout ratio is in the 70% range. Citi has to achieve that, especially given its unique ability, through DTA consumption, to generate large amount of capital above and beyond its net earnings. That excess capital simply sits on its balance sheet and dilutes its return on equity (otherwise known as the "denominator problem").
To rejoin the family of "normal banks" and warrant similar valuation to its banking peers - Citi needs to demonstrate that the earnings and capital it generates is not trapped capital.
My favorite valuation metric (i.e. price to tangible book value) says it all really:
C Price to Tangible Book Value data by YCharts
Why am I bullish on Citi's capital submission for 2016?
I covered the topic at length in this article.
Bottom line, my expectations are for a total capital ask of $12-$15 billion in 2016 (which equates to over 10% of the market value of the firm!).
Beyond the quantitative analysis that I provided in the above-mentioned article - the rhetoric has changed somewhat as well.
In the 2015 CCAR cycle, Mr. Corbat described the CCAR submission as "credible" and as "beginning to return meaningful capital over time" - in relation to the 2016 CCAR submission, Mr. Corbat simply describes it as a "strong submission". There is a clear upgrade in the language utilized - I read that to mean a substantial increase on the 2015 ask. The successful pass of the Resolution Plan by Citi (the only bank to manage achieving this milestone) provides further credence to the credibility of the submission. At least in the eyes of the Fed, Citi is well on its way for redemption.
I am sure there will be plenty of dissents in the readers' comments and of course we will all find out shortly whether my optimism is misplaced or not - but what if I am right, what does it mean for the stock's valuation?
Buyback a dollar for 70 cents?
The above sub-heading is a little misleading. Many bank investors repeat the mantra about trading below tangible book as gospel and a key reason for investing in a particular banking stock. The underlying presumption is that this is the theoretical liquidation value of the stock, hence if it trades below book there is a potential arbitrage there - this is of course completely misguided.
Take Citi as an example, it trades below 0.7x tangible book currently - to suggest that Citi could liquidate its institutional assets and recover $75 billion or so of capital is plainly ridiculous. In other words, one needs to think about going-concern returns on net assets as opposed to unrealistic assumptions around theoretical liquidation scenarios expected to be in line with GAAP assets' valuation. Realistically, if Citi (or any other major bank) ever needs to liquidate its assets - it will be hugely capital destroying.
So what are sustainable going-concern returns for Citigroup?
Citi's management believes a reasonable RoTCE through the cycle is ~15%. The math is simple - GCB is capable of delivering 20+% RoTCE, the institutional business delivers ~14% and factor in some drag on returns from the Corporate center. In that context, normal means the Fed's short term rates at ~200 basis points or higher and the economy GDP growth is closer to 3% than 2%.
Are these unrealistic presumptions for the new normal?
Perhaps so, especially if you subscribe to Larry Summer's secular stagnation narrative. In any case, Citi still earns above its cost of capital (excluding the non-productive DTA capital) even in this mediocre macro environment - as such, if it able to demonstrate that it can, in fact return excess capital to shareholders - it is really analogous to buying a dollar for 70 cents (or less).
Citi at $43 per share is a clear bargain - especially if you factor in the upcoming CCAR catalyst. If you are a long-term investor - do not be overly concerned about the potential temporary downside from a Brexit. If the stock moves down sharply, it simply means Citi could buy back shares at a greater discount.
A large part of the investment thesis in Citigroup is the capital return narrative. The key of course is for Citi to deliver on CCAR 2016 - Mr. Corbat cannot afford another mediocre CCAR submission and let another year to pass by.
Shareholders (including myself) are growing increasingly impatient.
I will be covering the CCAR results for all the large U.S. banks - if of interest, do subscribe as a "real-time follower" at the top of this page.
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Disclosure: I am/we are long C.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.