The recent drop in Citigroup’s (C) share price from low $50s to low $40s is mostly due to concerns arising from the Fed and OCC consent orders. The market is fearing a new era of heavy-handed regulatory intervention and oversight. Mr. Market is also struggling to quantify the impact on Citi’s operations and absolutely assumes the worst-case scenario. With interest rates on a path of lower for longer, there appear to be little reason to own financials generally and Citi specifically. The sentiments are as bad as I have seen since at least the 2008/2009 Great Financial Crisis.
This is exactly the reason why I am playing the long game here (and aggressively so). With Citi, the playbook has always been to buy at below tangible book (0.6x to 0.9x tangible book) and sell at 1.1x to 1.2x. Complemented by options trading strategies like selling puts and/or buying long-term call options. This has been my strategy throughout the last decade.
The Fed and OCC consent orders are much more than just a slap on the wrist and a $400 million fine to boot. Mr. Market is assuming a worst-case scenario including potential restrictions on capital distributions, assets/business caps (think Wells Fargo (WFC)) and a bottomless cost pit for many years to come.
Mr. Market is exaggerating the downsides and ignoring the fundamentals.
The upside is:
- Citi has over-provided on loan losses. There is a high probability that loan loss provisions will be written back somewhat in 2021.
- Interest rates are a headwind but to a lesser extent than investors imagine.
- Buybacks should recommence in 2021 and will be extremely accretive.
- Citi has a crown jewel of a business in the Institutional Client Group that is 2nd only to JPMorgan (JPM) in quality and consistency of earnings.
- Strategy and business model changes are on the cards with the new management team. If progressed, these have the potential to turbo-charge returns.
- Finally, Citi is too cheap to ignore on all relative and absolute metrics.
The Consent Orders
Citigroup has found itself in an unenviable position being forced to deliver a costly remediation programme addressing deficiencies identified by regulators.
These are substantial control, risk and operational issues that certainly caught shareholders by surprise. Mike Mayo summarised this well in the Q&A during the Q3 2020 earnings call:
“Speaking on behalf of investors, people I speak with, there’s collective sense of extreme disappointment with technology, the new regulatory order and tech, the route problems were not transparent to investors, but execution, (needing to) go fast enough. And you said this new tech fix will take time… So it’s just — you’re on a path and now all of a sudden we find out that the engine underneath, the company wasn’t as strong as it should be…”
It is quite clear why Mr. Corbat had to exit early. It appears that Citi was cutting corners and starved the firm of investments in key infrastructure areas. Thankfully, for shareholders, regulators were on the ball and forced the issue. Paradoxically, regulators are shareholders’ best friends as to the safety and soundness of the firm.
The long-term damage is very manageable
At the moment, the market is trying to come to grips with the medium- and longer-term implications. It was clear from analysts’ questions that concerns were focused on three key areas:
- Limitation of capital distributions (buybacks and dividends).
- Restrictions on business activities and assets caps (a la Wells Fargo).
- Scope and cost of the remediation programme.
The good news for shareholders is that impact of (1) and (2) appear largely overstated. Citi’s CFO noted the following in the earnings call:
“In terms of capital actions going forward, there’s nothing in the consent order that prevents us from making capital action decisions and taking capital action decisions going forward, and so we would expect that we’d be able to act similarly to our peers as we come out of this crisis.”
This is a key point for Citi. The ability to buy back shares is key for the investment case especially when trading at these distressed levels.
In respect of business activities and assets caps, Mr. Corbat suggested this is also unlikely as the consent orders relate to operational failures rather than fraud or harm inflicted on customers:
“Sure. So, I would say one very important part of that, Erika, is what we spoke about in terms of no widespread customer harm. The company did not profit from the activities, and you can kind of go on with that. I think the second piece is that around customer harm and around some of those things, there were not just Wells Fargo, but there were kind of widespread industry deep dives into sales practices and other pieces in here.”
As such, there is no reason to believe that business or assets’ caps are on the table.
In terms of the full cost of the remediation programme, it is early days and it will cost what it will cost. It is clear that Citi has much scope to offset some of these in its efficiency projects. Ultimately, this remediation programme is something that Citi had to do anyhow with associated ROI attached to it – the consent orders are simply accelerating the execution. It will, however, cost substantially more than if Citi self-addressed the matters earlier.
In any case, my view is that the cost question is not really the driver behind the share price action. The decline is mostly attributed to fears around business/assets limitations and/or capital actions constraints (in other words, dividends and buybacks). This is why the market is punishing Citigroup at the moment.
In one of the greatest downturns since the Great Depression, Citi has generated ~$7 billion of net income whilst absorbing upfront model-driven, lifetime forecasts of loan losses. That’s pretty impressive.
True, a big part of it is attributed to monetary and fiscal support underwriting capital markets as well as the U.S. consumer. In other words, this is an indirect bailout of the U.S. economy, make no mistake about it.
But it is also largely attributable to the ICG business that is a low-risk, diversified business delivering consistent and quality earnings throughout the business cycle. It is a business with significant moat across many businesses including accrual (such as TTS and Security Services) as well the trading businesses (e.g. FICC). ICG will print money, albeit with some volatility, come rain or shine.
Many punters would also point to lower interest rates as a key reason to avoid the banks. In other words, net interest margin (“NIM”) pressures really hurt the profitability of banks. In Citi’s case, however, the impact is not as material. Citi generates a large portion of income as fee income and its consumer businesses, by large, are less sensitive to interest rates (think about credit cards lending margins). Yes, lower interest rates hurt Citi’s profitability but the impact is somewhat offsetable by cost efficiency initiatives, volume growth as well as share buybacks.
In a nutshell, Citi’s earnings power should remain largely intact.
Another point of concern for analysts is the level of loan loss provisioning. Well, there is little to be concerned about. Over the last three quarters, Citi has built up significant loan loss buffers that are very conservative. It currently has $28.9 billion of allowances for loan losses. I expect a large chunk of this to be written back during 2021, as the economy normalizes. Any additional stimulus in 2021 will be a plus.
The strategic opportunity
There might be a blessing in disguise in these consent orders. The pressure is mounting on management to reexamine its strategy. On the earnings call, Citi’s CFO commented on this point:
“With every crisis, in some ways, comes a unique opportunity, and that is a unique opportunity to take a hard look at your business model. And you see corporations around the world having to think through that as they manage through this crisis. And similarly, we will – with the benefit of a new incoming CEO and as well as managing through this crisis, we’ll continue to look at our business model, continue to look at our strategy and see what makes sense as we come out of this and how we can best capture opportunities to serve our clients.”
I covered the strategic opportunities in this recent article. I recommend that you read this article about dismantling Citi’s Global Consumer Bank and utilizing proceeds to gain scale in the U.S. as well as turbo-charge accretive buybacks at below tangible book value. If executed properly, Citi could feasibly retire as much as 50% of its share count.
These are exactly the right times to buy Citi, at the bottom of the credit and interest-rates cycle when regulatory bad news is more than just reflected in the price and shares are valued at a fraction of tangible book value. It is important to keep a perspective on the value proposition. You are presented with an opportunity to buy a top-tier investment and commercial bank that has a significant moat and you essentially getting the consumer business for free (including the largest credit cards issuer in the world).
There are several catalysts that are likely to drive a change in sentiments:
- Reinstatement of buyback programme.
- A strategic shift (i.e., sell Asia and Mexico consumer banks).
- Reversal of the COVID-19 provisions.
- Progress and clarity on the consent orders.
In my view, this presents an asymmetric risk/return profile. The downside is already fully reflected in the price with a substantial upside if any of the above catalysts materialize.
If you enjoyed this article and would like to be notified of additional articles on banks, special situations and conviction ideas, scroll up and click “Follow.” IP Banking Research coverage includes U.S., U.K., Asian and European banks, as well as other special situations, deep value and conviction ideas.
Disclosure: I am/we are long C, JPM, BAC, MS. 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.