Citigroup Is Still Too Cheap To Ignore

Summary

• I see Citigroup as a good trading position going into the banking earnings season.
• There are multiple tailwinds in play.
• It is still a good time to own the financials.
• Citi is not as exposed to interest rates as other banks yet still benefits from a steepening yield curve.
• At this point in time, Citi is too cheap to ignore.

Photo by Andy Feng/iStock Editorial via Getty Images

I am bullish on Citigroup (NYSE:C) as a short-term trade prior to the earnings report on the 15th of April.

Citi still trades below tangible book value and is substantially cheaper on a relative basis to peers. I also believe that its tangible book is somewhat understated which is not fully appreciated by the market.

The short-term tailwinds are ample and include the followings:

1) Loan loss provisions releases;

2) Buoyant investment banking and trading markets;

3) The steepening yield curve;

4) The potential for buybacks and dividend increases; and

5) Strategic repivoting by the new management team.

Given the above, I see an attractive entry point prior to earning release date on the 15th of April.

In this article, I will discuss in detail the above factors as well as reflect on Citi's current valuation.

Loan loss provisions

Citi, like many other banks, has booked significant provisions in respect of expected pandemic-related delinquencies. In reality, given the generous monetary and fiscal support offered, these are hardly needed.

At the end of 2020, Citi's reserves are extremely conservative especially given the recent outlook for the economy:

As gleaned from the above slide, the economic assumptions in current reserving stipulate a GDP growth of 3.7% and an unemployment rate of 6.5% for 2021. The current outlook is much brighter with GDP growth in the U.S. expected to be north of 6 percent.

As such, 2021 will likely be the year of reversals and I expect billions of reserves to be released over the next few quarters. This has the impact of increasing capital ratios, flattering EPS as well as adding to tangible book value. This is a key reason why I argue that book value is understated somewhat.

In fact, at the February Credit Suisse Financial Services Forum, the CFO provided the following update for the upcoming quarter:

I think we're likely to see a release in the quarter, and it could very well exceed the release that we saw in the way of reserves in the last quarter of the year, in the fourth quarter of 2020. And that's going to be driven again mainly by those improved macro variables but also the seasonality in the card balances, right? So they're generally higher in the fourth quarter than in the first. So obviously, it's early. There's still uncertainty there, but that's kind of the current view.

Based on the above, I would expect the releases of provisions to be in the order of $2 billion or so.

Investment Banking & Trading

The first quarter of 2021 has been a buoyant quarter for the industry, especially so considering the strong Q1'2020 comparables. Deutsche Bank (DB), for example, has guided for a 20 percent growth year on year.

As Bloomberg reported recently, junk bond issuances are at an all-time record.

These are good times for the industry and Citi has so far avoided some of the pitfalls such as the Archegos Capital fiasco. Citi's CFO provided guidance in the Credit Suisse conference:

I think we're off to a very good start to the year when I look at our performance thus far. The quarter is not over. But if I look at markets, broad-based client engagement, if I look at our fixed income and equities trading activity off of a strong quarter last year, I expect that we would be down kind of mid-single-digit range, if you will. If I look at Investment Banking, continued strength, good momentum in equity capital markets, I'd expect to be up in the high teens, call it, low 20s year-over-year.

Note that Citi's CFO usually tends to be conservative when providing mid-quarter guidance. As such, I would expect a somewhat better print when it reports.

The steepening yield curve

The steepening of the yield curve has been a bonanza for banks especially the likes of Bank of America (BAC) who are exceptionally sensitive to rates.

Citi on the other hands is much less sensitive to rates and is concentrated at the short end as revealed by its disclosure in the latest 10-K:

Important to note that the above is a static balance sheet sensitivity analysis and does not incorporate any opportunistic management actions.

The opportunity for Citi is to start deploying liquidity pools (so-called "dry powder") in longer duration assets as alluded to by the CFO in the above-mentioned CS conference:

And having kept that powder dry, that creates an opportunity as we see the steepening of the yield curve. We do tend to be more sensitive to the short end. But having this liquidity and dry powder does create an opportunity that we'll look at kind of going forward. But net-net, we're holding to our NIR guidance, notwithstanding some of those moving variables, including the stimulus and the like. ......We're always looking at the opportunities to put that to work first with our clients and then just to optimize the balance sheet if we have that excess liquidity. And as you mentioned, we are seeing a steepening there, and we're looking closely at it.

The steepening yield curve should certainly assist in offsetting some of the net interest margin ("NIM") pressures due to low short-term interest rates.

Dividends and buybacks

As reported in Seeking Alpha, the Fed has now removed the pandemic-era limits on dividends and buybacks. From the third quarter, I expect Citi to massively increase capital returns to shareholders. Given that the stock trades below tangible book with a respectable dividend yield of 2.8%, I expect the capital returns to lean heavily towards buybacks.

I expect Citi's common equity tier 1 ("CET1") ratio to be around 12 percent at the end of the second quarter. This translates to excess capital of approximately 0.5 percent compared with its management target of 11.5 percent. This leaves Citi with plenty of capacity to return capital to shareholders over the 2021/2022 CCAR cycle. In fact, I expect Citi to return 100% or more of its earnings which should also include further monetization of its deferred tax assets.

The strategy

Citi's new CEO is now in the box seat and has been busy in recent months carrying out a "dispassionate" strategic review of its operations.

The market is not really pricing in a major shift in strategy. Any announcements, such as intent to sell parts of the global consumer bank or progress on the wealth management strategy (including numbers) may move the dial on the stock.

Another important item to bear in mind is progress on addressing deficiencies identified by the Fed's consent orders. Currently, the market has limited visibility on progress or costs to achieve. Clarity on these items should allay the market's legitimate concerns regarding this key regulatory issue.

The valuation

Citi is the cheapest of them all as measured by the standard price to tangible book value metric. Even if one adjusts for respective RoTCE, Mr. Market is clearly very skeptical when it comes to Citigroup.

Additionally, as shown by the below chart, Citi is the only large bank that is still trading below tangible book value.

Data by YCharts

Citi is currently trading at a forward P/E ratio of only 10.5 and I believe that consensus earnings are substantially understated due to the tailwinds highlighted above. As such, I believe that the "real" forward P/E ratio is materially lower.

Final thoughts

In my view, Citi is too cheap to ignore. Especially so, given where we are in the economic cycle and the multiple tailwinds listed above.

Having said that, I see Citi as a trading position only and not necessarily a long-term hold. In my view, Citi's business model of operating a global consumer bank is fundamentally flawed and Mr. Market is right to attribute a valuation discount compared to peers.

However, given the limited opportunity set in the market, in my view, Citi is an attractive opportunity for a shorter-term trading opportunity.

Analyst’s Disclosure: I am/we are long C, BAC. 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.