Citigroup: The Opportunity, If You Are Patient

Summary

• Citigroup's share price is impacted by short-term headwinds.
• The strategic transformation makes excellent sense.
• The operational transformation should make it a simpler, safer, and more efficient bank.
• I believe that in the next 2 to 3 years, Citigroup will close the returns gap with peers.
• In the interim, Citigroup is buying back shares like there is no tomorrow.

Andy Feng/iStock Editorial via Getty Images

In prior years, Citigroup (NYSE:C) was simply a trading position for the savvy investor who enjoyed taking advantage of the volatility in the stock. When the global economy merely sneezed, Citigroup seemed to have developed full-blown flu.

It happened in January 2016, December 2018, and more recently during the COVID19 pandemic. All of these were good opportunities for a quick double within a short few months. At these times, Citigroup ended up trading as low as 0.5-0.6x tangible book value ("TBV") which is really too cheap to ignore until it reverted to trading in its usual range of 0.9x to 1.1x TBV.

The trick with Citigroup was to buy at a low multiple of TBV (say at 0.6x TBV) and sell as it approaches tangible book value.

This time is different. Citigroup is going through a strategic as well as an operational transformation. It is time to play the long game.

The thesis

Citigroup's new CEO, Jane Fraser, is not trying to drive the share price up in the short term. The management is (finally) properly investing in the franchise for the long-term as opposed to trying to meet short-term financial goals. But I mostly like the strategic clarity.

In several years from now, Citigroup should look very different by:

1. Building a global wealth management business and a powerhouse in Asia.
2. Enhancing its position as a top tier corporate and investment bank.
3. Becoming a scale player in the U.S. domestic consumer market through a combination of partnerships, digital capabilities, and inorganic acquisitions.

This strategic transformation is also underpinned by a multi-year operational transformation project where the bank will modernize and digitize its dated infrastructure. This will serve to reduce risks but also drive cost efficiency.

Phase one of the strategy involves the disposal of 13 consumer banking franchises in Asia and pivoting to a wealth management business model.

Citigroup is also heavily investing in its leading corporate and investment bank (otherwise known as the Institutional Client Group or "ICG").

Putting this all together, Citigroup should be able to deliver returns on equity of mid to high teens and bridge the gap to its peers. Citigroup currently trades at ~0.9x tangible book value. Opportunistically, Citigroup is also buying back shares aggressively, and I expect it to buy as much as 20% of its market cap. Excess capital currently comprises ~$4 billion (excess above minimum), ~$7 billion expected to be released from the disposal of Asian consumer operations, deferred tax assets monetization, and earnings.

The refreshed strategy makes sense on several fronts. It really plays to the strength of the firm including its unique Asian footprint as well as its global product capabilities.

The valuation discount and flawed business model

Mr. Market applies a seemingly perennial discount on Citigroup's valuation. This is plainly evident by the chart below comparing the price to TBV with its peers.

Data by YCharts

The main culprit is a flawed business model in the Consumer segment.

Currently, Citigroup's Global Consumer Bank ("GCB") is a collection of mostly sub-scale operations (outside of the Americas). These currently deliver mediocre returns on equity with the exception of Banamex Mexico. They simply lack the scale to compete with local and regional players and carry the cost burden of large U.S. gold standards of capital adequacy and regulations.

Whereas in North America, Citigroup is predominantly a credit card issuer. In recent years, the cards space, with its high-yielding loan assets, has seen increased competition from the incumbents who are trying to wrestle away market share by offering exceptionally generous rewards programs and cashback.

More recently, though, it is very much about the disruptors such as Buy Now Pay Later and FinTechs such as LendingClub (LC) (which I have written a number of articles on) that are also looking to eat Citigroup's lunch. The value of Citigroup's franchise, easily the largest credit card issuer in the world, is slowly eroding away.

As a point of comparison, JPMorgan (JPM) and Bank of America (BAC) hold a scale and multi-product presence in the domestic U.S. consumer markets which allows them to deepen client relationships and cross-sell products. Importantly, their scale and branch footprint allows them to benefit from an exceptionally low cost of funds, which is a significant competitive advantage. Consequently, the returns on equity for these businesses are in the 20+ range. Mr. Market likes the relative stability of the consumer businesses and therefore attributes higher valuation compared with their more "volatile" distant cousins in the investment banking space.

Fixing Citigroup

Citigroup's new CEO gets it. The disposal of the Asian consumer businesses is absolutely the right strategy. Citigroup is a disadvantaged owner of these assets.

The pivot to wealth management also makes a lot of strategic sense. Importantly, Citigroup's banking licenses and presence in Singapore, Hong Kong, UAE, and London is a strong competitive advantage. For example, its HK wealth management center can serve high-net-worth clients in China, HK, Taiwan, Korea, etc. Similarly, the Singapore bank can serve wealthy clients from Indonesia, Malaysia, Thailand, and Vietnam. Given the vast wealth, political uncertainties in some of these locations and Citigroup's brand, this is exactly the right go-to-market approach. These clients prefer offshore banking services precisely due to political uncertainties in their home countries as well as the product offerings available in established financial centers such as HK, Singapore, UAE, and London.

Importantly though, the wealth management business is run as a global product as opposed to stand-alone country operations. The IT systems, products, management, compliance, research are going to be leveraged across those four locations. This is very different from having mass-market sub-scale, inefficient stand-alone banking operations across Asia.

There is little doubt that Citigroup has the client base, brand, and products for this strategy to succeed. The market multiples of such a business, especially if it is delivering growth, should be a multiple of equity invested (see Morgan Stanley's (MS) valuation ascribed to its large wealth management business).

How about the investment bank?

Citigroup's ICG division is in good shape and already delivering a steady mid-teens return on equity. The Treasury and Trade Solutions ("TTS") division is the crown jewel, that is truly unique with a closed-loop banking system across ~100 territories. Citigroup is committed to investing in preserving its competitive advantage as well as strongly growing the TTS business. Citigroup's other ICG businesses include fixed income trading, debt, and equity underwriting, M&A advisory, and security services are also all top tiers.

The only obvious weakness is Citigroup's Equities trading business which is substantially lagging behind its peers. Given Citigroup's client base, balance sheet, and geographic presence, it should really perform much better. There were some encouraging signs in recent quarters and revenues seem to be ticking up materially, especially so in prime services. If Citigroup can bridge the gap with peers in respect of the Equities business, it could sustainably deliver high teens returns on equity overall for ICG. It appears that the new management is committed to investing where it sees high returns.

Management perspective

The management team is determined and there are no shortcuts being taken. Citigroup is cutting off the less desired businesses and invests in the high returning ones. As noted in a recent financial services conference, Citigroup's management is having a "whatever it takes" attitude to closing the return gap with peers:

But what I will say is, as you know, we're going to do whatever we need to do, whatever it takes to close the return gap as much as possible, full stop, right? And the work that we've been talking about is directly aligned with that objective, that work around our strategy, that work around the transformation, that work around talent.

Final thoughts

There are a number of short-term headwinds impacting the share price. These headwinds include:

1. normalisation of trading income in the investment bank (albeit at higher levels than 2019, and importantly, Equities is outperforming)
2. low-interest rates
3. low balances and high repayments in the Cards space
4. increased costs due to the transformation project
5. lack of guidance to the market on revenues and costs
6. the Fed's consent orders

All of these weigh heavily on the share price currently. Over 12 years since the financial crisis, Citigroup is still in a restructuring mode.

However, that is also the opportunity. Most of these headwinds are short-term in nature. Citigroup is opportunistically (and massively) buying back shares at well below the tangible book and my view of intrinsic value. In three to four years' time, Citigroup could reduce its share count by 30 to 40 percent, whereas the value of the franchise should increase materially.

I "remain bullish".

Analyst’s Disclosure: I/we have a beneficial long position in the shares of C, LC, JPM, BAC either through stock ownership, options, or other derivatives. 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.