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Nicholas Coppola, CFA
August 9, 2018
As you may have seen in your trade confirmations, we added a small position in Citigroup (C) yesterday. Our bullish view on the stock is based on a number of factors including 1) an attractive valuation, 2) expected revenue growth with disciplined cost control, and 3) a significant return of capital to shareholders (i.e., through both share repurchases and dividends).
In regards to valuation, we view the stock as inexpensive, trading at just 10.4x next twelve months consensus earnings. To provide some context, this is significantly cheaper than the S&P 500, which currently trades at ~17.6x forward earnings. Citigroup is also somewhat cheaper than their banking peer group, which trades at a meager (albeit higher) ~11.4x forward earnings. Turning to their balance sheet, Citigroup trades at just ~1.2x tangible book value. Importantly, we expect go-forward earnings improvement and are hopeful that multiples will expand (though we are not counting on it) as the company executes on its strategy.
As a matter of background, Citigroup is a global diversified financial services company with businesses including consumer banking and credit, corporate and investment banking, securities brokerage, trade and securities services, and wealth management. By geography, as of their most recent fiscal year, revenues were ~50% derived in the United States, ~21% in Asia, ~16% in Europe, the Middle East and Africa (EMEA), and ~14% in Latin America. The company famously struggled in the financial crisis, but looking forward, is highly focused on execution and plans to stick to their now smaller knitting. At their investor day last summer, management laid out financial targets to be achieved by 2020. Targets included ~$20B of earnings and approaching ~$9.00 of EPS on a lower share count, as well as an operating efficiency ratio in the low 50%s. To provide a quick basis for comparison, Citigroup in FY’17 posted $15.8B of adjusted earnings and $5.37 of adjusted EPS (excluding charges due to the impact of tax reform), as well as an operating efficiency ratio of 58%. These targets represent ~68% EPS growth and arguably ~400 - 800 bps of improvement in operating efficiency. Note that operating efficiency in the banking industry is defined as operating expenses divided by revenues, excluding any one-time items (i.e., securities gains). Expected improvement represents the anticipated impact of leveraging revenue growth and strong expense discipline. Through Q2’18, Citigroup’s efficiency ratio has now declined on a year-over-year basis for seven consecutive quarters. And importantly, as of their most recent earnings report in mid-July, management indicated they are on track to hit their 2020 targets.
So what’s driving the expected improvement on the expense side of the equation? In recent years, the company has worked to simplify their business, exited non-core markets, reduced headcount and cut their real estate footprint (includes both retail branches and corporate office space). Going forward, the next leg of expense reduction is expected to be driven by the implementation of cost saving technologies (i.e. more automation, more mobile and cloud computing), digital customer facing initiatives (i.e., introducing more digital tools which leads to lower call volumes and fewer paper transactions), and moving headcount away from high cost locations, among other initiatives.
On the revenue side, loan volume and resulting interest revenue should follow economic growth. Additionally, as interest rates rise and potentially as the yield curve normalizes (which we believe should eventually occur), net interest margins (i.e., the difference between the rate a bank pays to depositors/lenders and earns from borrowers) should improve. Note that management has indicated their greatest interest rate sensitivity is in the United States, with the biggest sensitivity occurring at the short-end of the curve. We are encouraged that as the Fed continues to raise rates, Citigroup stands to benefit. In regards to the institutional group, the company should benefit from their global network of businesses including treasury services, trading and investment banking. We view Citigroup as well positioned to serve a variety of larger clients, particularly given their wider breadth of services and more global footprint versus many of their competitors. Institutional revenues are expected to be driven by economic growth leading to a larger opportunity set, higher interest rates, and efforts to deepen client relationships leading to a greater share of wallet.
Last but certainly not least, management has committed to returning all capital to shareholders above what’s necessary for operations and to satisfy regulators. At their investor day last summer, management committed to returning ~$60B through dividends and share repurchases over the next three regulatory cycles. To provide some context here, the Federal Reserve conducts an annual Comprehensive Analysis and Review (CCAR) in their effort to promote stability in the financial system. This process includes ensuring banks maintain adequate capital, and as a result, capital returns are subject to regulatory approval. That said, ~$19B was returned over the last year and another ~$22B over the next four quarters has already been approved. Consistent with our view that the stock is undervalued, we view further buybacks favorably. Additionally, given expectations for growing earnings and a shrinking denominator, Citigroup’s return on equity should also improve. Note that in Q2’18, Citigroup’s return on tangible common equity was 10.8%, which represented a 300 bp YOY improvement. Over the longer-term management has a goal of increasing return on tangible common equity to ~14%. As the company executes their strategy, and improves their return metrics, we believe that the stock has an opportunity to trade at a higher multiple, providing further upside.
As always, we also pay close attention to what could go wrong. As Walter Cronkite once said, “in seeking truth you have to get both sides of the story”. Of course, rates could move slower than expected. There could also be a downturn in the economy (i.e., either in the United States or in the international markets that Citigroup serves), which could negatively impact the banking sector in a variety of ways, including reduced loan demand, an acceleration of credit losses, and lower demand for investment banking services. That said, our view is that the economy, particularly in the United States where the greatest portion of Citigroup’s business is located, continues to strengthen on the heels of tax reform and reduced regulation. Additionally, we believe that management has prudently targeted higher quality accounts in both their consumer and institutional businesses, and as a result, is in a much better position in terms of asset quality than prior to the recession. To paraphrase management, the company has become a simpler, smaller, safer and stronger institution in recent years.
While there continue to be a number of sizeable risks to the investment thesis, we believe the risk/reward profile is currently favorable. As a base case, looking out to 2020, analyst expectations call for ~$8.66 of EPS (which is somewhat below the guidance provided at last year’s analyst day). Using the current ~10.4x forward multiple, this implies a fair value of ~$90 by the end of FY’19. This translates to a ~15% CAGR over the next ~18 months, or a ~25% total price improvement. In the meantime, investors pick up a ~2.5% dividend yield. Opportunities for further upside can be divided into two categories -- greater than expected earnings growth and multiple expansion. Potential catalysts include further rate increases, a stronger than expected economy, or higher returns on equity driven by company-specific initiatives.
All that said, in our estimation, Citigroup appears to be an attractive investment opportunity. We thank you for your continued trust. And as always, please let us know if you have any questions about recent trades or any positions in your portfolio.
Nick Coppola, CFA
Nicholas Coppola, is a Senior Portfolio Manager at Kays Financial Advisory Corporation. He can be reached at (770) 951-9001 or at email@example.com.
This report and Mr. Coppola’s comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance. Any security mentioned in this report may not be suitable for all investors. No investment mentioned in this newsletter constitutes a recommendation to buy, sell or hold a particular investment. Such recommendations can only be made on an individual basis after an assessment of an individual investor’s risk tolerance and personal circumstances. Past performance of any investment mentioned is not a guarantee of future performance. Statements regarding the investment concerns and merits of any investment and fair market value computations are strictly the opinion of Kays Financial Advisory Corporation. Employees of KFAC and KFAC clients may have positions and effect transactions in the securities of the issuers mentioned here in.