A stock that has been on my radar for some time has been Citigroup (C), primarily because of its once thriving Latin American franchise, which brought it into direct competition with many of the Latin American banks that I regularly review. Like its U.S. peer Bank of America (BAC), it was a key contributor to the creation of the subprime crisis, which left it as a shadow of its former self. However, since then the bank has strengthened its financial position and appears to be well positioned on the road to recovery. But at the time of writing, Citigroup is still trading at a significant discount of almost 68% to its book value per share. This has seen a number of market pundits claim that Citigroup now represents a compelling deep value investment.
In this article, I am going to take a closer look at Citigroup, with a focus on uncovering the bank's true value and ascertaining whether its sharp discount to its book value creates a deep value opportunity for investors. Citigroup is a particularly complex institution to analyze and is composed of a multitude of moving parts, covering all aspects of the banking and finance spectrum. These extend from retail and commercial banking, to investment banking and wealth management. But I believe the first step to conducting this analysis is to examine the bank's financial health, and in particular its financial performance for the last quarter.
Financial performance continues to decline
Despite Citigroup seeing a significant improvement in revenue since the financial crisis, over the last year its revenue and net income has been trending downward, as is illustrated in the chart below.
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The company has seen reported revenue for the third quarter 2012 in comparison to the same period in 2011 (YoY) fall by 33% to almost $14 billion and in comparison to the second quarter 2012 (QoQ), fall by 25%. Net income YoY has fallen by 88% and QoQ by 84% to $470 million. But while Citigroup's financial performance has declined, the U.S economy has grown over the same period by 2.3% YoY and QoQ by 2%.
The fall in third quarter revenue can, in part, be attributed to the bank's sale of a portion of its holding in the Morgan Smith Barney business and the winding down of its legacy assets. The fall in net income can be primarily attributed to a one-off $3 billion impairment charge, related to the carrying value of Citigroup's remaining 35% investment in the Morgan Stanley Smith Barney joint venture. The bank also reported a credit value adjustment (CVA) of $776 million, which along with the impairment charge, contributed to the substantial fall in revenue.
When allowing for these amounts on an adjusted revenue basis, Citigroup reported revenue of $19.4 billion, which represents a 7% YoY and 4% QoQ increase in revenue. But in contrast to declining reported revenue, Citigroup has continued to grow the value of its loan portfolio since the end of 2010, with it rising by 3% to $658 billion as the chart below illustrates.
This rate of growth is lower than JP Morgan (JPM) and Wells Fargo (WFC), both of which saw their loan portfolios grow by around 4% for the same period, but it is superior to Bank of America, which saw its loan portfolio shrink by 5%. While this is not the most spectacular rate of growth in the bank's core business of lending, it is commensurate with its peers and pleasing to see given the difficult economic environment and growing uncertainty.
Since the end of 2010, Citigroup's deposits have also grown by around 10% to $944.6 billion, as the chart below shows.
This rate of growth is double Bank of America's 5%, marginally lower than Wells Fargo's 14% and less than half of JP Morgan's 23%. But while the rate of growth is not as high as I would like, it does clearly show that Citigroup's deposit base is growing at a faster rate than its loan portfolio. This demonstrates that the deleveraging process is continuing and bringing the benefit of increased increasing liquidity.
Ongoing deleveraging program is improving the funding mix and increasing liquidity
Citigroup's ongoing deleveraging program has made significant inroads into reducing the bank's long-term debt, which is down by almost 19% YoY as the chart below shows.
By continuing to aggressively pursue this deleveraging process, Citigroup is improving its funding mix and reducing its dependence on wholesale and short-term credit markets. This is illustrated by the chart below, which shows how significantly the bank's long-term debt to equity ratio has fallen over the last year.
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Reducing the bank's dependence on debt improves its profitability by reducing the costs associated with funding its assets (loans), while reducing the impact of short-term interest rate movements and improving liquidity.
In fact, the change in funding mix and focus on deleveraging has seen Citigroup significantly improve its liquidity, with its loan-to-deposit ratio falling by almost 4% since the first quarter 2011, to around 70% as the chart illustrates.
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This loan-to-deposit ratio is one of the lowest of the bank's major U.S. domiciled peers. While it is well below what is generally seen as the optimal loan-to-deposit ratio of 95% to 105%, this in my view is a positive because the priority for the bank since the subprime crisis has been to reestablish its financial health and stabilize its balance sheet. A higher level of liquidity also leaves the bank better equipped to deal with any further financial shocks and as a means of improving investor and customer confidence.
Growing capital adequacy indicates a greater awareness of risk
Since the subprime crisis, Citigroup has been focused on increasing its capital adequacy as part of the deleveraging process. This has also been in response to Federal Reserve capital requirements resulted in Citigroup failing the stress tests conducted earlier this year because it had inadequate capital. It was this capital deficiency, which led the Federal Reserve to put the kibosh on Citigroup's plans to increase its dividend earlier in 2012.
The bank is also preparing to meet the additional capital requirements set out by U.S. market risk rules and Basel III requirements, which were scheduled for commencement on 1st January 2013, but have now been delayed. Finally, by increasing its capital adequacy, it gives a clear indication to investors that the bank is strengthening its balance sheet, giving reason for renewed investor confidence. As a result, the bank has been working towards boosting its capital adequacy in order to meet the various regulatory requirements, and to allow it to increase its dividend. The bank has increased its tier one capital ratio by 0.4% YoY to 13.9% and its tier one common capital ratio for the same period by 1% to 12.7%, as the chart below illustrates.
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Source: Citigroup Third Quarter 2012 Earnings Review.
It is important to note that the bank's tier one common capital ratio is lower than its tier one capital ratio because it excludes preferred stock, trust preferred securities, hybrid securities and minority interest. Citigroup has the highest tier one common capital ratio of the four major banks at 12.7%, as illustrated by the chart below.
Source data: Citigroup Financial Statements, Bank of America, JP Morgan, Wells Fargo, First Quarter 2011 to Third Quarter 2012.
Clearly, Citigroup is well on its way to meeting the capital adequacy requirements set by the Federal Reserve in order to not only comply with the Basel III requirements, but also to give it the opportunity to increase its dividend.
These measures also show that Citigroup is strengthening its balance sheet and reducing risk by boosting capital adequacy and liquidity while reducing debt. This approach has seen all of Citigroup's key risk measures improve considerably and now be well within acceptable parameters.
Evidently, I do not believe that it is Citigroup's funding mix, liquidity or capital adequacy, that are causing the bank to continue trading at a considerable discount to its book value. Nor does it explain the continued negative investors' sentiment towards Citigroup, which is obviously a key driver of its current share price. This leaves asset quality as the next major indicator to be examined in order to ascertain why the bank continues to underperform.
Asset quality continues to improve considerably
One of the key reasons for Citigroup's near collapse was its poor asset quality and over-exposure to substandard loans. Asset quality, as represented by the bank's non-performing loan ratio at the end of the third quarter was high, with the bank having an NPL ratio of 1.9%, representing an improvement of 50 bps YoY.
Citigroup's NPL ratio is well within acceptable parameters, being almost a third of the 5% marker, which is considered to be the point at which a loan portfolio's quality becomes questionable. It is almost half of the U.S. national average at the end of the third quarter of 3.7%, and comparable to both Wells Fargo's and JP Morgan's NPL ratios.
A further indicator of Citigroup's improving asset quality is that loan-loss provisions have continued to fall, being reported as $2.5 billion as the chart below illustrates, which represents an 18% fall YoY.
Any significant and continued fall in provisions is particularly important for a bank's profitability, because provisions come with an economic cost. This arises because not only must the bank incur a cost for holdings the funds on its balance sheet, but they also cannot be used for revenue generating activities.
Another indicator of the decreasing risk in the bank's loan portfolio is its high NPL coverage ratio, which at 203% is the second highest of the four major banks as set out in the chart below.
The coverage ratio is representative of the degree of risk within a bank and in the case of Citigroup, the high coverage ratio indicates that the bank has wound down its level of risk. The coverage ratio is also well within acceptable parameters, and indicates that the level of risk regarding its portfolio is low. However, by keeping its coverage ratio high, particularly in comparison to its peers, Citigroup is increasing the economic cost associated with both its loan-loss provisions and the non-performing loans, which is affecting profitability.
Efficiency and profitability continue to remain poor but should start to improve in the short to medium term
Even though Citigroup's risk, capital adequacy and liquidity indicators are all within acceptable parameters, the bank continues to trade at a substantial discount to its book value per share. At the time of writing, Citigroup is trading at a 77% discount to its book value per share of $63.59, but this falls to a 32% discount when compared to its tangible book value per share of $52.70. This indicates that market sentiment towards the bank is currently poor, and most likely a reflection of the real and perceived risks affecting its profitability.
One of the key issues regarding Citigroup's performance is its poor efficiency ratio, which at almost 88% is the worst of the four major banks as the chart below illustrates.
However, prior to the third quarter 2012, Citigroup was delivering a more respectable efficiency ratio of around 65%, which is in line with U.S. bank industry expectations. Essentially, the efficiency ratio is a measure of how efficiently a bank is generating revenue and in the case of Citigroup, at the end of the third quarter, it was spending almost 88 cents for every dollar of revenue generated. Generally the higher the ratio, the less efficient a bank is and the lower its profitability. But higher margin, more cost intensive and qualitative focused businesses, such as investment banking and wealth management, have lower levels of efficiency than commercial and retail banking and have the potential to deliver greater profitability.
Like Bank of America, Citigroup is continuing to incur additional costs for managing a large book of subprime loans, non-accrual loans, CDOs and other legacy assets that have been quarantined from its balance sheet. The ongoing management of these assets comes with a considerable economic cost, because not only are accounting and administration costs incurred, but the bank is unable to redirect those funds to activities that are likely to produce revenue and enhance profitability.
It is this large pool of legacy assets totaling around $171 billion held in Citi Holdings which is having a significant impact on the bank's efficiency. More specifically, it was the third quarter impairment charge for the Morgan Stanley Smith Barney joint venture that had a significant impact on the bank's efficiency ratio. Over the last year, the bank has incurred around $17 billion in costs for managing these assets.
However, what is promising is that the Citigroup's legacy assets are continuing to fall in value as they are gradually wound down. As the chart below shows, the total pool of legacy assets have fallen by 31% over the last year.
(click to enlarge)Source: Citigroup Third Quarter 2012 Earnings Review.
The value of the bank's legacy assets should continue to fall, which will obviously have a positive impact on the efficiency, and flow on to improved profitability. The chart below gives evidence of this, showing that as legacy assets have fallen in value over the last year, legal and operational costs for managing those assets have also fallen by 21% over the last year to $1.2 billion.
Source: Citigroup Third Quarter 2012 Earnings Review.
This indicates that the overall trend for the bank's operational costs is improving, and I would expect to see its efficiency ratio improve considerably over the next four quarters.
The bank's net-interest-margin remains poor
An important measure of profitability for banks is the net-interest-margin (NIM). This essentially measures how successfully a bank makes, and executes, investment decisions using the money it obtains by way of deposits or loans to lend or invest. It is essentially the key measure of lending profitability, and it is affected by a range of factors.
The key factors are, firstly, the economic environment, because official interest rates and market interest rates cap the interest rate a bank is able to charge. Secondly, the ability to manage risk and in particular credit risk, because loan-loss provisions and other costs associated with poor quality loans, carry significant real and economic costs. Finally, operational efficiency, as represented by the efficiency ratio, has a direct impact on the margins, with lower efficiency indicating higher operational costs.
Citigroup's profitability is being affected by its low NIM, although this is an industry-wide problem with the industry-wide average NIM for all U.S. banks at the end of the second quarter 2012 being 3.4%. While Citigroup's NIM is lower than the industry average at around 3%, it is the second-highest of the four majors as shown by the chart below.
The bank's low NIM can primarily be attributed to the low interest rate environment in the U.S. at this time, with the official rate set at a historic low of 0.25%. This is forcing banks to take a volume based approach with an increased focus on controlling costs in order to maintain margins. It is unlikely that this will change for the foreseeable future, meaning that for Citigroup to improve its NIM and therefore profitability, the bank will need to continue focusing on improving its operational efficiency and the size of its loan portfolio. But with the bank actively winding down its legacy assets, while focusing on costs and improving the quality of its loan portfolio, I expect its NIM to marginally improve over the short to medium term, which should boost profitability.
Profitability continues to be poor but should improve
Clearly, the bank's operational efficiency and low NIM are having a direct impact on its profitability as measured by its return-on-equity. For the third quarter, Citigroup reported a return-on-equity of 1%, which is a 5% fall from the previous quarter as the chart below shows.
Source data: Citigroup Financial Statements, Bank of America, JP Morgan, Wells Fargo, First Quarter 2011 to Third Quarter 2012.
This return-on-equity as the chart shows is the second lowest of the four major banks, but again this can be attributed to the impairment charge against the bank's interest in the Morgan Stanley Smith Barney joint venture. The impact of this charge also highlights the direct linkage between costs and the bank's efficiency ratio and its profitability.
Accordingly, Citigroup's return-on-equity should improve as the value of and the costs associated with managing its legacy assets fall. Obviously, this will be dependent on how many further impairment charges that Citigroup will have to make against its legacy assets. But over the long term (five years plus), I expect to see the bank's return-on-equity being with its major peers such as Wells Fargo and JP Morgan.
Calculating Citigroup's indicative fair value
It is clear that Citigroup still has its share of problems, which affect its operational efficiency, profitability and financial performance. These, in combination with overall poor market sentiment towards the banking industry in general are, I believe, causing the market to unfairly value Citigroup. Accordingly, I have set out to value Citigroup using an excess return valuation based upon the bank's tangible book value as the starting point and then using a range of assumptions based on the data presented above to calculate an indicative fair value.
The bank's tangible book value was calculated by deducting goodwill and intangible assets from the bank's total common equity. This gives a tangible book value of around $155 billion, which equates to a tangible book value per share of almost $53. With Citigroup trading at around $36 at the time of writing, it is trading at a 32% discount to its tangible book value per share. I have then used this tangible book value to calculate Citigroup's retained earnings over a ten-year period and then into perpetuity, using the following assumptions:
- Profitability and therefore Citigroup's return-on-equity will continue to grow over the valuation period, increasing to 10% in the final year.
- A return-on-equity in perpetuity of 8% has been used to calculate the terminal value of retained earnings.
- A discount rate of 7% has been applied to all future retained earnings, which was derived from the weighted average cost of capital (GM:WACC) calculated for Citigroup.
- Applied a conservative rate of economic growth of 2.5%, which is lower than the U.S historical average of 3.4%, because it takes into account the long-term impact of the current global headwinds. It is also higher than the rate of growth used in the same methodology for valuing Bank of America, because of Citigroup's higher exposure to faster growing emerging markets.
- I have calculated, using the capital asset pricing model, a cost of equity of 7% for the valuation.
- The dividend will continue to grow over the valuation period and therefore the payout ratio has been increased conservatively, initially to 10% for the next three years.
Using this data and assumptions, I have calculated an indicative fair value per share of $59 as set out in the chart below.
At the time of writing, Citigroup is trading at around $34, which means that this indicative valuation represents a 74% upside, giving investors a considerable margin of safety. While there are many working parts to any valuation of Citigroup, because of the depth and breadth of the institution, as well as some way to go before the market regains confidence in the bank, indicates the bank is a deep value investment opportunity for the patient risk tolerant investor.
Other matters for consideration
There are a number of other matters that investors should consider when making an investment in Citigroup. The key positive considerations that should help to boost profitability and ultimately market confidence and the bank's share price are:
- The recent replacement of Vikram Pandit as CEO with Michael Corbat a veteran banker. This I believe should lead to an improved relationship with regulators and increased confidence among the bank's key stakeholders.
- I am also expecting Citigroup to moderately increase its dividend in 2013, now that its capital adequacy has improved, and significant inroads have been made into winding down its legacy assets. In the valuation model I have allowed for a modest increase in the dividend to around 25 cents per share, representing a payout ratio of 10% of trailing twelve months net income. It is important to note that any increase in the dividend is subject to regulatory approval and at the amount of the increase is unknown.
- Growing signs of a U.S. housing recovery, which would deliver considerable revenue growth to Citigroup as one of the largest mortgage originators.
- Citigroup continues to have considerable exposure to a number of emerging markets in Latin America and Asia, which will help to enhance growth.
There are also a number of risks that investors should consider before investing in Citigroup that have the potential to significantly and negatively impact on the bank's financial performance including:
- The bank still holds a considerable amount of legacy assets, which will see further impairment charges and credit valuation adjustments.
- There is still considerable litigation and regulatory risk related to the legacy assets, particularly those composed of toxic residential mortgages, which makes up $95 billion of the total legacy asset pool.
- The bank is continuing to incur considerable legal costs predominantly because of its legacy assets. For the third quarter alone these totaled $529 million or almost 4% of the reported revenue.
- Citigroup holds around $21 billion in gross funded credit exposure to the European sovereign debt crisis and the five worst affected sovereigns Portugal, Ireland, Italy, Greece and Spain.
- There is growing regulatory risk, with broad based regulatory changes on the agenda, which will increase regulatory costs, reduce opportunities for revenue generation and increase the economic cost of capital. All of which, will place further pressure on profitability. Banks are also seeing growing regulatory uncertainty with the Federal Reserve recently announcing that the introduction of the Basel III reforms will be delayed.
While it is difficult to judge the exact impact of these risks, I believe that any impact will be mitigated by the bank's continued efforts to reduce risk in the business and increase the quality of its assets.
Citigroup has made significant progress in rebuilding its shattered business, which has seen it build a strong balance sheet with improved asset quality, increased capital adequacy and higher liquidity. This has also been enhanced by an aggressive deleveraging process that has allowed the bank to reduce risk and improve its funding mix. While the winding down of legacy assets is continuing to reduce costs and helping to enhance efficiency. All of which over the long-term can only serve to enhance Citigroup's profitability.
However, despite this, there are still considerable headwinds and risks for the bank, which will not only impact on profitability but also continue to impact on its reputation and undermine the confidence of key stakeholders and the market. This explains why the bank, continues to trade at a considerable discount to its book value. But even after taking into account these risks, I believe that with a 74% margin of safety, Citigroup represents a deep value opportunity for the patient risk tolerant investor.