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Good morning. We have the ingredients for a deal on the US debt ceiling, though negotiations will continue as the pact is pushed beyond the outer wings of both parties in Congress. However, even assuming default is averted, it is unclear how markets will or are expected to react. An initial relief rally in stock and long bond prices would make sense. But as the debt ceiling interlude fades, the main themes of market opera – inflation, interest rates, asset valuations – will reassert themselves. Investors might notice that economic data, for example the April personal consumption expenditure report, has been hot; that the real GDP for the quarter tends towards 2%; and the yield on two-year bonds is rising. The idea of another Federal Reserve rate hike, if not in June then later, is no longer laughable. Could the relief rally be brief? If you know, for God’s sake, email me: firstname.lastname@example.org.
Four years ago, I wrote a long article on Citigroup, which claimed that the bank’s business model was not working and needed to be changed. Almost everyone I spoke to – former bank executives, investors, analysts, senior insiders – privately acknowledged that a new approach was needed. The low return on equity of banks, the underperformance of stock markets and the low valuation made the point irrefutable, even if its leaders could not say it loud and clear.
About a year later, Citi appointed a new CEO, Jane Fraser, who initiated many of the changes discussed in my article (I can’t claim she was inspired by my work, however brilliant. Like I said, everyone knew what to do). More importantly, it moved to divest a large portion of its global retail banking franchise to Citi, which had no synergy with its best businesses, namely transaction banking, credit cards and securities markets. on fixed income. Those divestments culminated last week with the announcement that Citi would pursue an IPO of its Mexican retail business. A sale to another bank had been hoped for, but at least the separation process continues.
Fraser and Citigroup were not rewarded for doing the right things. The stock continues to underperform other large diversified US banks and its valuation remains sleepy. Here is its tangible price-to-book ratio, compared to those of JPMorgan Chase and major regional bank Comerica:
Not surprisingly, Citi’s valuation is lower than that of JPMorgan Chase, the bank with the best balance between retail, wealth management, commercial banking, investment banking and trading. Surprisingly, it even lags behind a regional bank with the characteristics that currently give investors chills (lots of uninsured deposits and a large securities portfolio).
What is the problem? In a way, the answer is simple: Citi is a demonstration story, and the bank has yet to show that it can improve its returns. Citi’s return on tangible common stock (8.9% last year) is lower than in 2019, and the gap with its large peers (in the mid-teens) has not narrowed. Retail divestments and other reforms have yet to move the needle. The undersized U.S. retail banking operation (a big source of returns for Bank of America and JPMorgan) continues to dampen card and transaction banking business. An overhaul of the bank’s core risk and compliance systems kept spending ahead of revenue growth. Fraser still has mountains to move.
Given this, the temptation is to delist Citi. When a bank has a price-to-book ratio well below 1, my simplistic interpretation is that the market has concluded that the return on equity is less than its cost of equity (“book value” means “value of equity “). I think of a bank or any company in that situation as destroying shareholder value, even if it shows profits on its income statement. Given the uncertainty of when and if Fraser’s restructuring will bear fruit, why own a bank that does this?
Maybe I was too dismissive. New York University valuation expert Aswath Damodaran argued in favor of Citi ownership. He does so despite being lucid about the weaknesses of the bank and the challenges facing the industry:
Citi clearly lost the battle not only to JPMorgan Chase, but to most other major US banks. It generated low growth and below-average profitability. . .
Almost every aspect of banking [as an industry] is under stress, with deposits becoming less sticky, increased competition for the lending industry from fintech and other disruptors, and heightened risks of contagion and crisis. . . I believe that the long-term trends for the [industry] are negative.
Banks are difficult to value because free cash flow, the crucial element of most valuation models, is difficult to measure in a business that consists solely of financial assets and liabilities. In a bank, whether money is profit or working capital is always an open question. Damodaran solves this problem by using future net income as a proxy for future cash flows, adjusting it for net contributions to regulatory capital, and discounting it at a rate that reflects the bank’s particular risks.
Citi, Damodaran notes, had sufficient regulatory capital and grew its assets slowly but steadily, suggesting net income will grow over time. In order to assess the bank’s degree of risk, it examines net interest margin, regulatory capital ratios, dividend yield, return on equity, deposit growth and securities portfolio accounting. of the 25 largest US banks. Citi scores above the median on the first three of those six metrics — the best performer among banks that trade at an accounting price/discount. It sums :
[Citi’s] the weakest link is return on equity. . . below median for US banks, and while this suggests a below median price-to-book ratio, the discount at Citi exceeds that expectation. Citi’s banking business, though growing slowly, remains lucrative with the higher interest rate spread in this sample. I will add Citi to my portfolio. . . It’s a slow growing, heavy bank that seems to be priced on the assumption that it will. . . never earning an ROE even close to its cost of equity, and that makes it a good investment.
I find Damodaran’s case for Citi analytically compelling, but I have two concerns. First, the argument is purely quantitative, and I wonder if it ignores the structural factors that keep the bank’s performance low – notably its small retail banking franchise in the United States – and how badly those problems could be difficult to solve. Second, and much less rationally, people have been betting that Citi is too cheap and losing that bet for at least 20 years. Are things really different this time around?
If there are any Citi investors out there, on both the long and short side, I’d be very keen to hear from you.
A good read
Something has gone wrong at the volatility laundromat.
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