- Citi is quite often seen as a trading position and not a long-term holding.
- The current crisis may change this perception.
- The key metric to pay attention to is Citi's capital ratios.
- Citi is poised to deliver a strong Q2 in the investment bank.
- In this article, I consider the near-term outlook and risks.
Some punters on Seeking Alpha (such as my colleague Jeff Anderson) at times view Citigroup (NYSE:C) as a trading stock and not as a core long-term holding. The trading strategy is to buy at a deep discount to tangible book value and sell at or slightly above tangible book. To be fair, in the last 8 years or so, that has been quite a profitable strategy. No argument there. It seems like every time the global economy sneezes, the banking industry catches a cold and Citi stock ends up with the flu!
Fortunately, it generally recovers quickly as well - we saw it in January 2016, December 2018 and most recently in the recent COVID-19 crisis.
My personal view, though, is that Citi is on the cusp of a new paradigm. It will earn its stripes navigating through this crisis and investors will reprice its cost of capital - earning it higher multiples and lower beta. It is clear that in the current regulatory framework, the risks of a large bank imploding is materially lower than pre-2008 and its business model and earnings are sustainable. It makes no sense to apply the same cost of capital like its pre-2008.
However, to reach that conclusion, Mr. Market needs to see this bank navigating successfully through a deep crisis - COVID-19 might just be that opportunity.
I intend to cover the quality and sustainability of the business model and earnings in my next article - but in this article, I want to focus on the near term outlook and risks.
Capital ratio is the key
The key number to watch is Citi's common equity tier 1 (CET1) ratio. As of Q1'2020, CET1 declined to 11.2 percent compared with a management target of 11.5 percent and minimum regulatory requirements of 10 percent.
In a crisis like this, the CET1 ratio comes under pressure on multiple fronts. The first and foremost impact is due to loan loss provisions (Citi has taken a total of $4.9 billion provision in Q1). Other headwinds include drawdown of revolvers and unrelenting hunger for liquidity from clients during times of crisis. Whilst the increased activity in the capital markets also led to increased utilization of RWA, especially in the Markets division. Finally the quarterly dividend also reduces the CET1 ratio.
It was somewhat offset by the cancellation of the buyback program (conserving capital) mid-way through the quarter and overall positive earnings for Q1 driven by $2.5 billion incremental revenue in the Markets division.
Having said that, the key risk for Citi remains a low CET1 print that has the potential to scare the market - in my view, if CET1 begins to flirt with a 10.x digit, concerns will slowly rise. These concerns will first manifest in chatter around cancellation of dividends to preserve capital and at a later stage, if the CET1 print gets worse, the specter of a capital raise will be in the air.
Important to note though, there is nothing in the regulatory rules that prescribes this eventuality. The regulatory rules only begin to restrict distributions on a progressive basis (such as dividends and buybacks) once CET1 falls below the minimum requirement (10% in Citi's case) and eats into the additional layer of capital buffer (the so-called capital conservation buffer).
It is beyond the scope of this article to fully explain the operation of the capital rules - suffice to note though, that no Banking CEO wants the markets to be concerned with a capital adequacy issue. Once rumors begin, it is a self-fulfilling prophecy and before you even realize it, capital conservation actions must be taken. After all, large banks have greater societal role to play and shareholders returns are secondary.
Therefore, the trajectory of the CET1 ratio is an absolutely key metric to focus on. And I have no doubts in my mind, that Mr. Corbat and Mr. Mason are intensely focused on this.
Loan loss provisions outlook under CECL
2020 is the first year that U.S. banks operate under the new Current Expected Credit Losses (CECL) accounting standard. The key difference to the prior standard (incurred losses), is that CECL effectively front-loads the impact of loan losses. Management is required, at each reporting period, to estimate the future credit losses based on projections incorporating expected economic conditions as of that date.
The net impact is that banks typically recognize losses earlier than before and depending on the economic data trajectory (e.g. unemployment and GDP primarily) will update (write-back or increase) the provisions on each reporting date. CECL also appears to be pro-cyclical as it is likely to exert pressure on banks' capital ratio just as you enter a crisis and exactly at the point where governments want the banks to be there supporting the economy. So perhaps not such a great idea. Also note that there is a modest transitional relief in place from inclusion in the capital ratios that equates to 25% of year-to-date provision.
If anyone interested in knowing more, I can respond in the comments section below.
The other important point to note on CECL, is that it is very hard to compare between peer banks. Each bank has their own propriety models, forecasts and assumptions about economic conditions. As I noted in my previous article, JPMorgan (JPM) seemed to have taken a more conservative view on credit provisions compared with Citigroup (C) in Q1'2020.
Expect another large provision taken by Citigroup on the consumer-side. This will likely be higher than the one taken in Q1'2020. The increase in provisions reflects deteriorating macroeconomic conditions since the prior reporting date (primarily due to a ~20 percent unemployment rate in the U.S.).
The recovery in the oil price should be a positive for the corporate segments but perhaps too early to result in a provision write-back. As always, there are elevated risks of single name credits imploding in times of crisis.
On the (very) bullish side though, the capital markets have had an exceptionally busy time in April and May with record bond issuances and high secondary trading volumes. Mr. Corbat described the Markets division results to date as "very strong". JPMorgan's Daniel Pinto, noted that expectations are for year-on-year growth of 50% in the Markets division and within that FICC has outperformed equities by a large margin.
This bodes well for Citi - especially so, as its Markets business is heavily slanted to FICC. This could well be one of the biggest quarters ever for Citi's investment bank.
So how does it all impact the capital ratios?
It is looking quite positive.
As mentioned, the loan loss provisions will be quite high on the consumer side (higher than Q1). However, the substantial uptick in the IB revenue will offset a large part of that, and therefore Citi is likely to be sufficiently profitable to cover the dividend multiple times over.
Given that the capital markets have been open for business for both investment grade and high yield names - this should reduce the capital and liquidity pressures on the large banks. In other words, less reliance on the banks' balance sheet. This should translate to lower RWA consumption and capital requirements.
Putting this all together, I expect Citi's CET1 ratio to remain stable or up somewhat in Q2 compared with the 11.2 percent print in Q1. The higher the ratio, the more bullish it is for the stock.
In times of crisis, the single most important data point (aside from a liquidity run) is the bank's CET1 ratio. Where we sit today, it is of no concern.
The diversified business model of corporate and consumer bank is paying dividends. The investment bank is firing in all cylinders just as Mr. Corbat needs to account for large losses on the consumer side.
Whilst Citi's loan losses are front-loaded compared with prior crisis due to new accounting standards - the CET1 ratio trajectory still remains healthy.
Citi is now going through a real stress test as opposed to CCAR stress test - and the early read is that they are doing much better than expected (even when you factor in a 20 percent unemployment rate).
The tail risk of course remains a full blown depression-like conditions where loan losses completely overwhelm Citi's earnings power whilst the investment bank faces the 'bad' kind of volatility where market participant sit on the sidelines.
Despite the recent run up in the last few days - Citi is still trading well-below tangible book and there is definitely space to run up further. My 12 months valuation is $70 and longer term is 100+)
In my next article, I will cover the sustainability of earnings in the "new normal" post-COVID-19.
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Analyst’s Disclosure: I am/we are long C, JPM. 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.
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