Michael M. Santiago
It’s been a year since I last wrote on Citigroup (NYSE:C), and the progress of this perpetual turnaround story has been mixed. Earnings have held up relatively better than for other giant banks, but double-digit ROTCE is still several years away and management is about to launch the second major restructuring within two years. To be fair though, it’s increasingly clear just how poorly-managed this bank was for nearly two decades, so expecting to get it all done quickly is not particularly fair or even reasonable.
The shares have declined about 8% since my last update, which is actually pretty good against a 22% drop among larger banks since then. I do still believe that the shares are meaningfully undervalued and that Citi should be able to deliver pre-provision profit growth in both ’24 and ’25, but I can understand why investors may not be interested in a stock where there’s still a lot of work left to do, particularly when there’s no shortage of undervalued equity in the banking sector.
Good Numbers, And You Have To Dig Deeper To Find Complaints
Alongside JPMorgan (JPM), I’d argue that Citi produced one of the best sets of results (relative to expectations) of the larger comparable banks that we’ve seen so far, with only earning asset growth underperforming (and many banks are underperforming there).
Revenue rose 10% year over year and 2% quarter over quarter, beating by about $0.21/share. Results were pretty even among the two large going concerns, with Personal Banking up 10% yoy and 6% qoq and Institutional (or ICG) up 12% yoy and 2% qoq, and both contributing to the top-line beat (about two-thirds ICG and one-third Personal).
Net interest income rose 10% yoy and fell 1% qoq, but was up closer to 3% on a core basis and drove two-thirds of that revenue beat. Growth came in at 9% yoy and 7% within Personal, while NII in ICG grew 20% yoy and shrank 2% qoq. Net interest margin improved 1bp sequentially and beat expectations by 11bp.
Operating expenses rose 6% yoy and fell 1% qoq, adding another $0.12/share relative to sell-side expectations. Pre-provision profits rose 21% yoy and 7% qoq, beating by $0.33/share. Again, both of the major units contributed similarly, with Personal up 17% and 13% and ICG up 18% and 10%, both beating expectations. Citi also posted better-than-expected provisioning expense, adding another $0.04/share to results (core earnings beat by about $0.31/share).
Citi ended the quarter well-capitalized, with a CET1 ratio of 13.5% and management is in place to return more capital via buybacks. Tangible book was also up, improving 2% qoq on a per-share basis.
And Now For The Less-Good Parts…
I can’t say that I’m thrilled with the performance of the card business right now. Revenue growth was good (Branded up 12%, Retail Services up 21%), but loan growth (up 12% yoy in Branded, and 8% in Retail) lagged Bank of America (BAC), JPMorgan, and Wells Fargo (WFC), and this isn’t the first time. Likewise with underlying card spend.
Citi is also seeing accelerating bad credit in its card business. Charge-offs rose 18bp sequentially to 3.31% (up 25bp qoq to 2.72% in Branded, up 7bp qoq to 4.53% in Retail), and this was worse than Bank of America and JPMorgan (Wells was 10bp higher), though Citi has been doing better than average overall (banks like Capital One (COF) and Synchrony (SYF) have been lifting the averages).
Citi also continues to see above-average growth in deposit costs, with total deposit costs up about 190bp yoy and 30bp qoq. Given that Citi has never had a strong core retail deposit franchise that drives robust non-interest-bearing deposits (about 60% of deposits come from ICG), this isn’t exactly surprising, but it does leave the company vulnerable to ongoing increases in rates and Citi has the highest deposit beta (60%) of any companies I’d consider peers (excluding pure card companies like American Express (AXP)).
Also in the “less good” category, management will be launching another major restructuring, but won’t be providing details until the fourth quarter report (so, mid-January of 2024). I don’t think another round of restructuring is bad, but Wall Street isn’t a patient place and likely wants more details on the scale of headcount and cost reductions and the probable impact to 2024/2025 profits and capital.
The Outlook
I think there is, on balance, a fair bit more good than bad here. The first restructuring continues to progress, with management having done a lot of work exiting foreign markets. While the switch from a sale of Banamex to an IPO is perhaps not ideal, it’s clear that the sale process was dragging and that the government wanted a major say in the process.
I also think that there has been underrated progress on internal improvements. The Street didn’t like the initial guide for 7% expense growth in 2023, but management has stuck to that target. What’s more, I think some on the Street underestimated how much the company needed to reinvest in the business – not just to deal with consent orders, but also to maintain/improve the infrastructure to competitive. A quick look at Banamex shows depressing market share losses over the past decade, and while I’m not saying Banamex reflects on the entire franchise, I think it’s emblematic of how past management teams really mishandled the business.
At this point, calling for pre-provision profit growth in ’24 may be aggressive, but time will tell, particularly in light of management’s upcoming restructuring announcement. Beyond this, I’m looking for minimal core earnings growth over the next five years (sub-1%) and only around 2% growth over the next decade. I don’t expect 10%+ ROTCE over the next three years, and I do think this is a psychologically important hurdle rate, as the market has long tended to value banks more harshly when they can’t earn their cost of equity.
Using what I think is an inflated cost of equity for the next few years (to reflect ongoing restructuring uncertainty and challenges in the business like higher card losses), I still get a fair value in the mid-$50’s. Using a 0.66x P/TBV multiple (consistent with the lowest valuations I’ve seen over the last two decades for 6% ROTCE) and an 8x multiple on ’23 EPS (below the almost-10x multiple I use for larger banks), I get a fair value range of $47.50 to $57.25.
The Bottom Line
One article can never capture all that’s going on with Citi, so discussing progress in areas like trading and treasury management will, maybe, have to wait for another day. As is, though, I do think Citi is making progress and is in better shape than the valuation reflects. By the same token, turning around a supertanker takes time (especially when it was listing badly to start with) and that may not suit all investors, particularly when there are a lot of undervalued-looking bank stocks.
