Description

Citigroup so far has been an outlier, in the negative sense. The bank is still earning single digits ROTEs, +15 years after the GFC. The other 3 large US banks are earning +15% ROTEs, while doing simple banking business and taking, what seems like, limited credit risk.

The good thing is current valuation of 0.65x TBV implies that profitability won´t improve. If that were the case, still the company trades at +10% earnings yield, implying a decent return profile.

In addition to that, given the recent changes to regulatory capital requirements it seems Citi has excess capital. The company has CET1 of 13.6%, which provides a margin to eventually return to large buybacks. This probably will happen next year after there is more clarity on the regulatory front and they IPO the Mexico consumer unit.

For a great outcome here, we only need Citi to reach 10% ROTE in 2 years. That would probably lead to shares doubling from current levels. That might be too much to ask for this company, but think there are decent odds. By the end of 2026, TBV/share might be $100 and EPS of $10. That is not a huge accomplishment but would yield great results from current prices.

I don´t have particular reason to be optimistic about Citi or how its plan is going (as any big bank, there is the "black box" component in this investment). My thesis here is that the bar is just too low. There is a margin of safety in the sense that current valuation already discounts ROEs remaining low forever. In addition, we have excess capital that provides some safety. On top of that, the bank has the benefit of being a large US bank, is well reserved and has very little in loans as % of deposits.

As seen in the 2023 mini banking crisis, Citi has the benefit of being one of the large TBTF banks in the US. That significantly reduces funding costs and the risk of clients pulling their deposits suddenly. Of course this can still happen at Citi, but the risk is lower than in smaller institutions and company might benefit from being perceived as TBTF. Mr. Market is not giving any value to this advantage that Citi has over other smaller players.

Another positive might be the reversal of the unrealized losses in the HTM book, which as of 2q24 stand at $20bn. Over the last month, this has shrunk as rates have come down. This will help TBV growth and equity. Also, as securities mature they have been reinvesting at higher rates, which should support NIM. Most banks made a big mistake in expanding their securities book with fixed rates and long durations, but that pain might be receding.

In 2022, the company set a plan to reduce exposure to operations outside US and focusing on serving corporations (treasury services, IB, etc) and US consumer (credit cards and wealth management). The company has sold off many of its complex operations outside US (9 operations), with the biggest, Mexico, remaining. The company has plans to IPO the Mexico consumer division in 2025. This strategy makes sense as they are reducing complexity in order to focus on areas where they can earn the cost of capital. As Fraser mentioned, the days of being a financial supermarket are “over”. They are focusing on offering cross-border services for corporations, wealth management and consumer bank in US. These businesses all have the likelihood of becoming at least decent return units, without taking significant risks. This makes total sense as there are few benefits in offering consumer services in international markets (adds complexity/risk and offers little in returns). The company has been proactive in exiting these markets, the problem is so far, profitability has not improved. There are still many one-offs and adjustments, so difficult to see true progress.

The plan also indicated 11-12% ROTE by ~2026, which results in something like $12/share in earnings power. This sounds a bit optimistic and there is no evidence that the return profile might be accomplished. However, as mentioned before, we need much less than that for great results. Fraser has not walked away from these targets, so we will see what happens. Reality is Citi should earn something close to these levels, as they have scale and operate in decent businesses. If not, there is no reason for the business to exist in the current structure.

There is a home-run scenario where they get to 12% ROTE in 3 years, while repurchasing shares at a discount over this period. That yields $14 per share in earnings power, with a more profitable, highly capitalized, large bank. That would probably be worth something like 11x or $150/share in 3 years plus dividends, +2.5x return.

Catalyst

-Buybacks once there is clarity on capital levels

-Mexico IPO

-Profitability improves to a modest ~10% ROTE