Analysts Love Citi

The 24 analysts who follow Citigroup Inc. (C) are bullish as Table 1 shows. No Sell recommendations. One-year price target is $67 compared to September 17 price of $44.86.

Table 1 Analyst Coverage for Citi as of 9/17/2020 (Source: YCharts)

Chart 1 shows bank analysts like Citi more than its megabank peers.

Chart 1

Citi’s Low Valuation: Opportunity or Value Trap?

Analysts often cite Citi’s low valuation as a primary reason for the bank’s upside. Chart 2 shows the Price to Tangible Book Value of six big banks as of September 20.

When a bank, or any investment for that matter, has a deep discount to apparent value, investors must ask: Is the discount an opportunity or a potential value trap?

Chart 2

Risk of Citi Being a Value Trap: Very High

Citi is a heartbreaker: It has a long and sordid history of dashing great expectations.

The last time I wrote about Citi was in December 2016. The article posed this question: “Does Citi Deserve to Sell Under Tangible Book Value?”

My answer was “yes.”

I provided as evidence the chart below. It shows that investors discount bank valuations based on historical stock price volatility. The greater the historical volatility, the greater the discount. Citi was and is the most discounted big bank because its stock price is the least predictable historically.

If the chart went back 40 years, not just 20, Citi’s volatility would be even more pronounced.

Unfortunately, Citi deserves its low valuation and will not, in my judgment, gain parity with peers any time soon given its latest travails.

Chart 3

“Citi Faces Rebuke for its Handling of Risk”

So reported the Wall Street Journal page 1 headline on September 14, just five days after Citigroup Inc (C) announced the unexpected retirement of its respected CEO, Michael Corbat.

The new CEO is Jane Fraser, the bank’s head of Consumer Banking 2009. In the bank’s September 10 press release, Fraser said:

We will invest in our infrastructure, risk management and control to ensure that we operate in a safe and sound manner and serve our clients and customers with excellence.”

Infrastructure, Risk Management, and Control Gaps

Readers who have followed my writing on Seeking Alpha since August 2016 likely know that I spent 31 years working for a megabank in a variety of senior roles, including the last couple years overseeing operational risk for the bank. Operational risk covers people, technology, systems, and external factors.

Since my retirement in 2011 I have remained close to the industry, having written two books about banking and numerous risk management articles as well as teaching and speaking around the country on bank investing and risk management.

My bank writing is directly informed by my experience as an “insider” who recognizes:

  • The complexity of megabanks.
  • The power of bank regulators.
  • The dearth of talent capable of managing highly complex megabanks.
  • The dearth of talent capable of managing the vast and highly complex systems and technology of megabanks.
  • The urgency for boards to address safety and soundness concerns.

Based on my experience, I draw four conclusions from the Citi press release of September 10 and the ensuing Wall Street Journal article.

1. The unconfirmed Wall Street Journal is likely accurate: Citi is under intense regulatory scrutiny that likely includes a “Consent Order” demanding immediate board attention.

2. The best evidence is found in the September 10 press release that includes the new CEO’s comments about infrastructure, risk management, control, and most concerning, safety and soundness; be assured the new CEO’s words were chosen carefully and intended for her primary audience, the OCC and Federal Reserve.

3. Consequently, the new CEO and board will have no choice but to spend whatever it takes to address gaps; the bank will also have to suspend growth initiatives that require capital expenditure.

4. Citi’s two primary regulators, the OCC and the Federal Reserve, do not like seeing page one articles in the national press questioning the safety and soundness of a megabank, and by implication, the banking system; the Wall Street Journal leak likely will have consequences as it further reveals Citi’s control problems.

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Analysts are Too Bullish for Two Big Reasons

My view is that the analysts who follow Citi are too bullish for two big reasons.

First, Citi’s legacy of unpredictability is an Achilles’ heel that was recently further exposed by the $900 million error reported August 25 by multiple media sources.

Errors of this magnitude remind regulators and investors that Citi has a history of big goof-ups.

Smart Citi investors acted decisively on September 10 when the bank announced management changes. They acted decisively again when the Wall Street Journal report came out.

Citi’s stock price relative to peers has plummeted since September 9 as seen in the next chart.

Chart 4

My second reason for believing analysts are too bullish with Citi relates to my experience as a bank risk executive and bank investor.

Wells Fargo & Co. (WFC) and U.S. Bancorp (USB) have both endured regulatory rebukes in the recent past. Investors are wise to study what happened to their income statements and stock prices in the aftermath.

Lessons Learned from Wells Fargo and U.S. Bancorp

On November 29, 2017, Wells’ stock price hit $56.68 (today $25.08). The next day Seeking Alpha posted my article entitled, “Wells Fargo: Here’s Why It’s Time to be Defensive.

Here are the first two bullets of the article:

  • “Defensive Wells Fargo investors should take advantage of the recent jump in stock price and sell a portion of current holdings.”
  • “Two revelations recently reported by the Wall Street Journal suggest risks at Wells Fargo now overshadow return potential over the next year.”

The article described my chief concern that investors failed to understand the gravity of the operational failures brought to light in the Wall Street Journal article of November 28, 2017.

On March 27, 2018, I wrote another article about Wells (stock selling at $51.10 at the time), again voicing caution. This time I recommended investors avoid Wells until the Board and management stepped up and bought shares.

My view was informed by my experience that only the bank’s senior-most risk and line executives (probably less than 15 executives) and the board had full view of the bank’s status in resolving regulatory gaps. The fact that none were buying shares was telling.

I offer this story of Wells and the reporting of the Wall Street Journal for two reasons.

First, the Journal has a history of being right on big scoops; investors in WFC who played defense at the time the article was published would have avoided the 50%+ decline in stock price.

Chart 5 shows the change in stock price of Wells over three time frames since the article was published. Note that Wells’ stock price is the worst performer among big banks for two of the three times measured and second to last for the other.

Chart 5

Turning to U.S. Bancorp.

The only time I have written about USB is August 2017 when I documented in considerable detail my view that the bank’s valuation looked expensive.

At the heart of my concern with USB’s valuation was the bank’s escalating operational expenses associated with remediating a serious compliance failure.

In the article I recommended that bank investors avoid USB given the bank’s high valuation, regulatory problems, and associated expense trend.

Chart 6 shows that over the next year, USB’s stock price trailed all five big bank peers. Since the article was published, only Wells’ stock price has performed worse.

Chart 6

Quantifying the Cost of Fixing Problems

Citi today faces two big challenges.

First, Citi is in the crosshairs of its regulators.

Second, because of the first, investors should expect Citi’s expenses to increase materially just as investors in Wells and USB saw in the aftermath of material regulatory concerns.

It is impossible to quantify precisely what it will cost Citi to remedy infrastructure, risk management, and control problems. However, the experience at Wells and USB is instructive.

Before examining expense trends at Wells and USB, it may be helpful to remind readers that big banks are part of holding companies. In all cases, the bank’s assets make up most of the holding company’s assets.

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Also, big banks are supervised primarily by the OCC whereas holding companies are examined by the Federal Reserve Board of Supervisors. The FDIC plays a minor role in big bank supervision.

However, as overseer of the Bank Insurance Fund, the FDIC establishes reporting requirements for the banks (not holding companies). It is the FDIC’s quarterly reports (called “Call Reports”) that bank investors rely on to get under the hood to see how each bank operates.

The chart below shows the Overhead Ratio by quarter for all three banks from 2015 to 2020. It is important to note that the data is for each bank, not the holding companies.

The Overhead Ratio is calculated in this chart as the rolling four quarters of non-interest expenses divided by average assets.

Chart 7

Several observations can be drawn from the chart.

First, note the trends. Citi has been on a steady decline while Wells shows a decidedly upward tilt. USB showed a big jump in 4Q 2017 – 4Q 2018 and has since trended downward.

Second, Wells’ Overhead Ratio has increased roughly 35 basis points while USB popped about 20 basis points before reversing direction.

Third, Citi’s much lower Overhead Ratio has clearly caught the eye of the OCC; this fact is evidenced by the new CEO’s pledge to address infrastructure, risk management, and control problems.

The math:

It is not unreasonable to use the experience at Wells and USB to estimate the expected increase to operating expenses associated with Citi’s response to operating gaps as well as heightened regulatory scrutiny.

Citi’s operational problems will cost money to fix. The run-up in operational expenses at Wells and USB provides an order of magnitude estimate for how much it might cost Citi to remediate its operational gaps.

The math suggests a 20 to 35 basis point increase in the bank’s Overhead Expense run-rate.

Here comes the tricky part in estimating the cost.

Citi’s bank subsidiary has an annual non-interest expenses run rate of $30 billion. This number represents about 71% of the holding company’s total non-interest expenses.

My best guess based on Wells’ and USB’s experience is that Citi’s bank subsidiary will see non-interest expenses increase over the next 18-24 months by 20 to 35 basis points which is equivalent of $3 billion to $6 billion which is equivalent to an increase of about 10% to 20% in operating expenses.

The $3 to $6 billion estimate is a good guess for Citi’s US bank subsidiary but may prove too low overall for Citigroup Inc., the holding company.

Here’s why: A comparison between Citi and Wells and USB is made difficult because Citi’s bank sub’s assets represent only 83% of Citi’s holding company compared to 93% at WFC and 98% at USB.

Investors should know that Citi’s global regulators (outside US) coordinate supervision with the OCC and Fed. It is a reasonable expectation that Citi’s global regulators are intensifying scrutiny of Citi’s activities taking place across the globe. Such scrutiny will require more frequent reporting, more meetings, an increase in risk management headcount, accelerating spending on consultants (including many former bank regulators) and a bigger budget for infrastructure.

Final Thoughts

Pre-tax Earnings to Decline $1.40-2.75 Per Share

Citi investors can reasonably assume that non-interest expenses will grow materially over future quarters and into at least 2022. My estimate is that the added Overhead expenses will eventually cost Citi between $1.40 and $2.75 a share pre-tax annually.

Last year the bank earned $23.9 billion pre-tax which is $11.48 pre-tax income per share based on the bank’s June 30, 2020, share count of 2.082 billion shares.

If my conservative estimate of the increase in non-interest expenses proves roughly accurate (between $3-6 billion, which is $1.40 to $2.75 per share pre-tax), and if the bank’s 2019 earnings run-rate can be sustained (which is unlikely in 2020-21), annual pre-tax earnings are likely to decline to a range between a high of roughly $10.10 and a low of $8.75. These numbers suggest a decline in annual pre-tax earnings of 12% to 24%.

The wild card on Citi’s future expenses is the cost to the bank of added regulatory scrutiny from global bank supervisors.

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Banks operate overseas under the supervision of not just US regulators, but domestic supervisors. Regulators in Australia, UK, Singapore, etc. will most certainly have heightened concerns with Citi in the aftermath of the recent revelations. Given Citi’s vast global footprint, the cost impact of heightened global regulatory scrutiny could be additive to the numbers shown.

Expect Revenue Growth to Suffer

Until infrastructure, risk management and control issues are remedied, revenue growth will be muted. Expect big bank peers to show better revenue growth than Citi.

Share Buybacks/Dividend

All big banks are currently blocked by the Fed from buying back shares or increasing dividends. Recent reports indicate that the Fed will likely extend the current prohibition through at least the rest of the year.

Will Citi be able to do buybacks and increase dividends when the Fed lifts the prohibition?

The Fed Stress tests are highly instructive in this regard. Assuming credit losses remain consistent with 2015-19, and assuming non-interest expense growth is in the range of my expectations, the bank should be able to preserve and grow dividends and resume buybacks. However, if regulatory concerns are so acute that more aggressive supervisory action needs to be taken (see Wells), all bets are off on dividends and buybacks.

Management and the Board

To his credit and that of his colleagues, Citi’s retiring CEO strung together nearly a decade of improving performance.

During Corbat’s tenure, non-interest expenses fell from $51 billion (2011) to $42 billion (2019); during that time total assets did not change. The 18% decline in non-interest expenses was a major driver of the bank’s earnings improvement which fueled a growing dividend and stock buybacks.

Since investors now know that the new CEO will make spending on infrastructure, risk management, and an improved control environment, it can be inferred that her predecessor underspent on these three areas.

Regarding the board, it should be observed that John Dugan replaced board chairman Michael O’Neill in November 2018.

As I noted in my 2016 article on Citi, I have enormous respect for Mr. O’Neill. See article for details. The retirement of a banker of his stature was a huge blow to Citi.

His successor as board chairman, a lawyer by training who has served in the US Treasury as well as head of the OCC, has been in the role for nearly two years.

Investors in Citi can reasonably ask:

  • Do former bank regulators make effective board chairmen? (See Wells Fargo’s experience.)
  • Do lawyers with no direct bank management experience bring the breadth of operational knowledge needed to chair highly complex financial institutions? (For that matter, other than the rare case of an individual like Michael O’Neill, can any independent director effectively serve as a board chair? Should the preferred organization model for megabanks be for the CEO and chair roles to be combined as is the case at Bank of America Corporation (BAC) and JPMorgan Chase & Co. (JPM)?)
  • Will the new CEO who was Citi’s 10-year head of Consumer Banking bring the breadth of knowledge and experience needed to run Citi’s arcane non-consumer businesses? (See Barclays PLC (BCS) former CEO Antony Jenkins, a Consumer Banking executive, who resigned as Barclays CEO after reportedly struggling with developing strategy and followership with non-consumer businesses.)

Too Risky for this Defensive Investor

Citi is a heartbreaker. Too much risk and too many questions for this defensive bank investor.

The bank’s current low valuation (.62 Price to Tangible Book Value) may very well be a value trap. Other big banks, all of which are selling at discount to historical valuations, represent safer bets for the next couple years.

Disclosure: I am/we are long JPM, PNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As a retired banker with BAC, I continue to have certain financial interests in BAC,