Citigroup C
announced an ambitious cost-cutting program aimed at reducing expenses
by $900 million in 2013 and as much as $1.1 billion by 2014, in its
first significant move since Michael Corbat replaced Vikram Pandit after
the bank reported third-quarter earnings. Citigroup will eliminate
11,000 jobs as a result. We see the announcement as evidence that Corbat
plans to more aggressively pursue a strategy of scaling back
operations. We believe this makes sense, given Citigroup's past problems
managing its size and complexity. The company expects that revenue
could be reduced by no more than $300 million as a result of the
changes, but it will record a $1 billion restructuring charge in the
fourth quarter. Our forecast and valuation incorporate a reduction in
the company's expense base, so we do not expect to make any major
changes to our fair value estimate as a result of the announcement.
About
one fourth of the announced restructuring charges will be incurred in
the company's corporate segment, as operational and technological
processes are streamlined. We think this should be achievable as the
conglomerate undertakes long-overdue steps toward better integration.
Global consumer banking will incur approximately 35% of the charges as
Citigroup scales back its branch network in peripheral markets, another
strategically sound action. Securities and banking will incur 25% of the
charges, again primarily resulting from cuts related to operational and
technological functions. The company is also cutting back in the
competitive arena of cash equities and realigning its expense base to
fit a more temperate investment banking environment. In general, we
expect to see a smaller, more focused, more efficient Citigroup in the
next three years, and we think these cuts are another step in the right
direction.
In our view, there are two main risks to the
cost-reduction program. The first is that back-office cuts will affect
control and communication--two areas that have not been strong points at
Citigroup. We'll be looking for both financial and anecdotal evidence
that the cuts are hampering, rather than helping, performance. The
second risk is that some of the expense reductions, especially in the
investment bank, will prove temporary in the event that business picks
up from current levels. It's relatively easy to cut costs when deal and
trading activity is slow, but it will be much harder for management to
maintain its focus on expenses in a more favorable environment.
Stabilized
by massive government capital injections in the depths of the financial
crisis, Citigroup now offers investors something unusual for a
U.S.-based bank: the possibility of loan growth. Thanks to its presence
in developing economies, Citigroup is poised to continue adding
high-margin loans to its balance sheet while many of its peers in the
U.S. and Europe suffer from low interest rates and minimal loan demand
in deleveraging developed economies. All else equal, this tailwind (and
the company's newly boosted capital levels) might be enough to make
Citigroup the envy of its money center peers around the world.
However, Citigroup's turnaround is by no means complete. Citi
Holdings--the bank's collection of unwanted assets--still accounted for
11% of the balance sheet as of March 31 and resulted in a large portion
of the company's credit losses in the first quarter of the year. These
assets are likely to eat away at earnings for several more quarters and
contribute to slow to negative balance sheet growth for the company as a
whole.
Furthermore, risk management has never been a strong point at
Citigroup. The company has been involved in financial fiascoes ranging
from the subprime crisis to the less-developed country debt crisis in
the 1980s. Arguably, the bank's presence in so many countries and
businesses also makes it vulnerable to relatively small missteps in
far-flung locales, as it is difficult to keep tabs on operations
spanning 100 countries and six continents. We're therefore pleased that
Citigroup has scaled back its ambitions under Vikram Pandit's
management.
The company's newly replenished capital levels also serve to mitigate
risk. Near insolvency in late 2008, the company now boasts a
much-improved tangible common equity ratio and reserves sufficient to
cover well over 4% of the loan book, dramatically reducing risk. These
levels position the company to withstand a significant deterioration in
credit quality, in our view. At the same time, Citigroup can afford to
invest in fast-growing markets in Latin America and parts of Europe, the
Middle East, and Africa, where consumer loan yields can be up to twice
the level the bank receives in its North American consumer business.
While management's capital return plan was scuttled by regulators, who
found that Citigroup could find itself just shy of capital minimums in a
stress case scenario if its dividend/repurchase plan were approved, we
don't see this as a major negative. The lack of approval means the
company will not be able to create value for shareholders through
repurchases this year, but it also ensures the company will not fall
behind peers on the capital front, in our opinion. As this is a positive
for bondholders, the company could also find its funding costs falling
and margins expanding. In any case, with a market capitalization
approaching $100 billion, Citigroup would need a fairly large repurchase
program to create much value.
We
are lowering our fair value estimate to $46 per share from $52 based
primarily on an increase in our cost of equity. We are now assigning
Citigroup a 12% cost of equity (versus 10.5% previously) based on the
volatility of the company's post-provision revenue, the moderate level
of operating leverage inherent to the business, and the bank's high
level of financial leverage relative to the rest of our coverage
universe. In our base-case valuation, we think assets will remain
relatively flat over the next five years, with the continued runoff of
Citi Holdings' assets offset by the growth of loans outside the U.S. We
think the net interest margin will average 2.9% over the next five
years, improving slowly as nonperforming assets fall and the company
adds higher yielding emerging market loans to its balance sheet. We
forecast noninterest income to increase by approximately 15%
cumulatively over the next five years, as capital markets revenue
normalizes. We expect net charge-offs to slowly decline over our
forecast period, averaging 1.8% in the long run. We expect the company's
efficiency ratio to fall to 60% by 2016. Our valuation reflects a
middling level of profitability, with return on assets reaching 0.9% and
return on tangible equity reaching 12% by the end of our forecast
period.
Citigroup's
presence in emerging markets is the company's biggest advantage, but
also the source of the most risk. Rapid credit growth can be highly
profitable on the way up, but almost never ends well. Citigroup is
banking on the long-run rise of the global consumer, but there are bound
to be bumps on the way, leading to volatile financial results. A
secondary source of risk is the company's investment bank, a business
that we consider to be a perennial source of disappointment for
investors.
Management & Stewardship
CEO
Vikram Pandit joined Citigroup in 2007 and was named CEO shortly
thereafter. We think he performed admirably, given the difficult task he
was assigned as the institution plummeted toward failure. Pandit
accepted an enormous amount of government assistance, diluting existing
shareholders, but positioned the company for an eventual resurgence. He
also refocused the company on its core competencies, designating
billions of dollars in assets for disposal as a part of Citi Holdings.
Citigroup's board of directors has also made great strides in recent
years, adding members like Michael O'Neill, who served as CEO during the
transformation of Bank of Hawaii BOH from an average institution to a truly outstanding bank.
We think it's too early to judge management's capital allocation
skill, but are encouraged that Pandit has refocused the company's
attentions on a simple strategy. We're disappointed that the company
misjudged regulators' appetite for returning capital to shareholders,
but considering that both Citigroup and Bank of America BAC
have made this mistake in recent quarters, we're beginning to suspect
that lines of communication with regulators are not as clear as we
initially thought. We believe that Citigroup is likely to repurchase
shares once it is approved--an excellent decision, in our view, as long
as the company is trading below tangible book value.
Overview
Citigroup
is now in acceptable financial health, with a tangible common equity
ratio of 7.7% as of March 31 and an allowance for loan losses sufficient
to cover 4.4% of its loan book. The company is also now consistently
profitable.
Profile:
Citigroup
is a global financial services company doing business in more than 160
countries and jurisdictions. It serves commercial and consumer clients
through its regional consumer banking segment and provides investment
banking, treasury, and securities services through its institutional
clients group. The company is winding down its involvement in the
brokerage, asset management, and consumer lending businesses that are
part of its Citi Holdings segment.
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