BLUF (Bottom Line Up Front)
Transformation is disruptive, expensive, and requires patience on the part of investors. The ideal time to add an asset to your portfolio that is undergoing this kind of rebuild is prior to the future gains and benefits of disruption already being priced into the stock. Fortunately, Citigroup (NYSE:C) is still trading at a price to tangible book value that is a fraction of its peers and is in the early innings of a transformation that will restore its valuation to a fair level.
When the “ugly duckling” stigma that Citi has rightfully earned for its historical mismanagement is lifted, even a 1.0x multiple on its current tangible book value per share ($79.07 – 3Q21 Press Release) represents approximately 30% upside for a long position. The transformation is already in implementation phase, and while there is always the possibility for more friction in the near-term, I will only continue to add to my position.
What “inning” are we in of the transformation?
While the October 2020 Consent Order (CO) and associated $400 million dollar Civil Money Penalty (CMP) for “deficiencies in its data governance, risk management, and internal controls” (Enforcement Action Letter) is a hefty fine and a nasty headline, it is far from unprecedented and is not any real cause for concern. A deep dive into the enforcement actions from the Office of the Comptroller of the Currency (OCC) for Citi and its peers shows that on a quantitative basis (# of COs and associated CMP fine totals) there is nothing concerning about Citi’s performance. In addition, Citi outperforms its peers on the average amount of time it takes to terminate an open CO. From a qualitative perspective, Citi’s transgressions are much less sinister than some its peers (e.g. Wells Fargo fake account scandal that resulted in a cap on its assets and ~$3 billion in damages.) Not to throw spears at anyone who would use OCC COs as part of a bear thesis, but there is nothing substantive here (except potentially Bank of America (NYSE: BAC) as a positive outlier) and definitely no reason to be an alarmist about Citi on these grounds.
During the 2021 Goldman Sachs U.S. Financial Services Conference on December 8th, Mark Mason gave a pertinent signpost for where Citi is in its CO mandated improvements by saying that they are out of design mode and have “pivoted to execution.” This comment indicates that Citi took approximately a year to study its problems and design a comprehensive plan that was ready to present to the regulators. This is important because it indicates that the company is moving towards the “middle innings” and has its focus on the future, such as exiting the 13 markets that are not worth the time or capital, and no longer on the past (fixing CO related deficiencies within the bank resulting from prior management team incompetence.)
What is a fair price for this stock and what takes it there?
Citi’s tangible book value per share over the last 10 years has grown at just under 4% annually but has recently accelerated, with the 3Q21 value 7.1% above the 4Q20 value. Citi has maintained the largest tangible book value per share for over a decade, with the 2016 to 2017 slump firmly in the rear-view mirror and steady growth since. The below chart is important because it presents the primary underlying valuation metric used for banks in a long-term, competitive view.
There has rarely been a time in the past 10 years where the stock has not traded at a discount to its tangible book value per share. For a bank that has been mismanaged to the extent of Wells Fargo (closest peer by valuation multiple), who also lost almost all of its support from Warren Buffett in March 2021, to trade at a premium to Citi is irrational. It is clear that from a valuation multiple basis the best risk-adjusted return opportunity is Citi.
You would pay approximately 1.5x tangible book value for Wells Fargo, with a stock price up over 71% from a year ago. Similarly, you would pay over 2.0x tangible book value for Bank of America and JP Morgan, with stock prices up roughly 56% and 30%, respectively from a year ago. This compares to Citi, which trades below 1.0x tangible book with a stock price that has only appreciated in the low single digits from a year ago.
Aside from the street giving credence in the next 18 to 24 months to Citi’s transformation and allowing it to trade at a reasonable multiple to tangible book, the interest rate outlook is a real tailwind for the banks. The Federal Reserve minutes released on January 5th of this year allude to quickening the pace of the asset purchasing program and allowing it to raise interest rates as early as March. This result is a net-positive for U.S. banks operations. Citi will also benefit more so than its peers from the global trend of increasing interest rates, as seen recently in Mexico, Brazil, and the United Kingdom. While most sectors within the U.S. equity universe will see downward pressure from rising interest rates, bank stocks will represent an attractive place for investment as typical beneficiaries of increasing interest rates.
Citi emphasizes that the combination of its three priorities of transformation, strategy refresh, and culture/talent improvement are creating a “new Citi.” The “ugly duck” valuation relative to Citi’s peers is not a recent phenomenon that represents some rare opportunity to invest at a discount. However, the “Citi perma-bears” that consistently point to a history of underperformance apparently do not believe that the level of positive disruption occurring at the bank right now, in terms of personnel and strategy, will lead to any real change. My response to them would be that Citi is going to keep growing its tangible book value per share, whether the valuation multiple increases or not, and has the most solid valuation floor. While the company did pause share buybacks in 4Q21, management has already signaled that it will resume buying back its stock in 1Q22, driving tangible book value per share higher.
What are the risks of an investment in Citi?
I view three risks to my thesis on Citi’s performance over the next 24 months. First, that Citi remains a “value trap” as a result of the new management team’s inability to successfully execute on its top three priorities. Second, geopolitical risk is a factor for every investment, especially for a global bank like Citi. There is currently an increased chance of meaningful conflict on many fronts in the world, and a near-peer skirmish of any sort would bring down equity prices across the board. Lastly, the is a possibility that Citi and other large bank’s share prices would not go unscathed during interest rate inspired sell-offs, despite the positive long-term implications for increased profitability.
There will continue to be shocks to U.S. equities as the Federal Reserve increases interest rates over the course of 2022 and beyond. Finding companies that show prospects for growth and are not already trading at extreme valuations is a challenge, and the likely impact of rising interest rates on the various sectors makes deploying capital right now that much more precarious. Citi has a floor that is much closer to its current stock price than any of its competitors, both in terms of its price performance over the last 5+ years and its depressed price to tangible book value multiple. You do not buy an asset based on what has happened in recent history, or even distant history. You buy an asset based on the price you have to pay for it right now compared to its intrinsic value. And right now, you can buy Citi at a bargain price, with high market outperformance potential, and on the verge of potential real transformation. I look forward to the 4Q21 print and the much touted investor day on March 2nd, and I will continue to pick up shares at the present valuation level.