Citigroup, Inc. (C)

lonbker (< 20) Submitted: 9/04/06 12:36 AM : Start Price: $45.21 C Score: -33.56

citi seems cheap to me. Here is my logic.

Return on equity is 18% (vs c15% typical in banking)
Dividend yield 4%
Price:Book 2.1x
div payout ratio 46%

Thus they are investing c9.7% of existing equity back into the business every year from retainer earnings ((100%-46%)*18%). Assuming the P:E ratio remain similar to where it is this implies a c20% annual increase in share price(2.1*9.7%). Then add in a 4% div yield and this gives you a very nice 24% per annum return.

The key risks to this analysis is price to book contraction. The origin of citi's high P:B is that the return on equity of 18% is very high and appears to be about double the required return on equity investors are demanding. Thus there are two risks. First Return on Equity falls. While this may happen it would take a serious recession for the this to fall much below the 15% than any respectable bank should achieve. In this sector economic moats are large and changing banks is a painful process. The one real threat would be a large increase in reserves for bad loans which would accompany a large recession. This is a bit less of a risk than in the past because of better risk management technology but it is very real and could severally dent a few years of earnings. However unless this is a prolonged recession earning levels should come back in a couple of years.

The second risk is that the required return investors look for increase above the c9% they are now demanding. Again this is feasible but I do not see this risk as any greater than for the average listed company.

I think these risks are small compared with an expected 24% return (per year every year for the foreseeable future). The risk return profile appears well out of balance in the favour of new investors. Additionally I think the returns in the medium term could be much higher. This is precisely because 24% is too high. This should fall to something more reasonable for the risk ? say 20-12%. If this does happen that some of the 24% annual gains could be pricing into the stock much sooner.

As for the subjective:

1) While it is true Citi has not made a major acquisitions in some time I do not see this as a cause for concern. First they have been precluded until very recently from making major acquisitions by the Fed as a result of their shoddy internal controls. This restriction has now been lifted because of Mr. Prince's dedicated effort to improving them. It might not be flashy but it was what needed to be done. Secondly I much prefer no acquisitions to the type of value destroying purchases made by some of citi's competitors (just look at almost anything BOA has bought). Now that the restriction has been lifted I expect citi to again seriously look for purchases. With luck their conservative nature will lead them to the type of value creating acquisitions which HSBC has achieved over the last 30 years (except for CCF).

2) Citi grew very rapidly into a "financial supermarket". It is now sorting all of this out and determining where the actual benefits of this strategy. Thus the disposals of insurance and asset management. However I think the charge that they do not know if they want to be BOA or Goldman?s is a bit unfair. Citi was the first retail bank to move aggressively into investment banking and has profited handsomely. Now together with an increasingly assertive HSBC it is in a strong position to increase its market share in large scale M&A over the course of the next decade. Who else but Citi and HSBC could underwrite the multi billion $ amounts they have in a number of recent acquisitions. Goldman?s could never take this kind of risk - it just does not have the balance sheet. I would say the right comparison is than BOA/HSBC want to be Citi, Goldman?s is terrified of Citi/HSBC/BOA, and Citi is fine tuning the investment banking business model of the next 30 years.

3) dodgy accounts. Yes this is a problem for citi and is it is probably worth taking a few percentage points of the expected return as a result. However I do not think this is more than the average in what remains a manipulative US accounting system. Perhaps HSBC is a bit more conservative.

4) Basel 2 - this has been understated in recent times (in part because it was over hyped initially). Over the course of the next 5-10 years large banks who can afford the high fixed costs of setting up their own risk models will likely be able to reduce the percentage of each loan that they must back with their own equity (placed in the national reserve bank, Fed, Bank of England ext) relative to smaller organisations that are required to use the "fundamental" approach which is less accurate and more conservative. This should create a significant differential in earning capacity of the large banks relative to the small banks.

As an example of what may happen consider the following. Small bank has $1 of equity and $12.5 of Assets. They earn 1% on assets thus 12.5% on equity. Big bank only has to put $0.5m for $12.5m of assets. Thus they only need 0.5% return on Assets to get the same 12.5% return on equity or they can get 25% return on equity for the same 1% return on assets. In the first case they will force Small bank out of business and in the second they will be worth twice as much (vs book). Ether way the shareholders of Big bank wins. As well Big bank could buy Small bank for $1 put the loans through it?s own risk management systems and then get a 25% return. Thus Small bank would be worth more to the shareholders of big bank than it own shareholders. As a result ? lots of acquisitions.

5) Growth prospects remain good. As mentioned above my valuation is dependent of citi maintaining a strong return on equity and this requires good places for Mr Prince to put his money. The legacy of restrictive legislation in the US still provides ample opportunities for citi to build new branches and enter new markets domestically. Also Citi's global expansion should continue. Much has been made of possible acquisition of Standard Chartered and Barclays. Standard Chartered would be a great acquisition for Citi at the right price (it shares have had a nice run mainly on takeover rumours). It is a little known fact that Standard Chartered has a bigger presence in East Asia ex Hong Kong than HSBC.

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