C: Hold the Plague
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
January 10, 2016
C: Hold the Plague
- The $42bn discount at which C trades to tangible book value of $180bn is equal to the total cumulative projected pre-tax loss through 2017Q2 under the severely adverse scenario from the bank’s mid-cycle stress tests released on July 21st. This scenario explicitly models a hard-lending in China and other Asian economies, along with recession in developed market economies, and highly unfavorable movements in the rate, equity, and housing markets. Cyber-attacks in the West and regional conflicts in the East are thrown in for good measure.
- We view the core Citicorp business alone as worth $180bn (1.4x tangible book of $125bn given a tangible return on equity of 14%) and the remaining group equity of ~$50bn, supporting CitiHoldings and the deferred tax asset, no less than $25bn*. On this basis, we reiterate our price-target of $65 from our note of September 21st on the bank titled “Expect Improving Returns and Rising Payout to Lift Stock Multiple”.
- *We note that management has commented it expects to run CitiHoldings at breakeven after the sale of One Main to Springleaf in November for $4.5bn with a likely capital gain bringing 2015Q4 earnings for Holdings to $500-700mm pre-tax.
- The risk, of course, is to emerging-market and oil-related write-downs:
- Emerging Markets: The emerging market loan portfolio is ~$350bn of which $235bn is through the institutional clients group (ICG) and $110bn through the global consumer bank (GCB). Within ICG, 60% of loans are through treasury and trade solutions or the private-bank while the majority (70% in China, for example) of the remaining corporate loans are to the subsidiaries of multinationals. Within GCB, China accounts for ~5% of the loan book and, as elsewhere, is targeted at the affluent and emerging affluent; as a result, even in Brazil where economic conditions are dire, the loss ratio is below 5.5% (versus 0.6% in China presently).
- Oil: Citi has disclosed it will take a 2015Q4 reserve increase of $300-400mm reflecting a higher probability of sustained low oil prices, but has seen no increase for now in net credit losses or non-accrual loans; total energy exposure is $60bn of which $16bn is to exploration-and-production (E&P) borrowers, as opposed to integrated oil companies whose oil-price risk is mitigated by refining and other downstream activities; of this $16bn, just over $6bn is funded.
- Citi reports on Friday before the open and we expect it to meet EPS consensus of $1.12 with FICC revenues coming it at ~$2bn (versus $2.6bn in Q3 and excluding valuation adjustments) and assuming a total reserve-build of $500mm. Looking further out, we expect C to maintain for 2016 and 2017 its current guidance for an ROA in the range 90-110bps and an efficiency ratio in the mid-50s; in practice, we expect an increase in the ROA towards the high-end of the range (from an expected 0.95% in 2015) to lift the tangible ROE first firmly above 10% and, by 2018, to 11%. As the capital ratio stabilizes, an improving ROE is consistent with an increase in the net payout ratio from below 20% in 2015 to 65% in 2018. We attach our model as an Appendix.
Emerging Market Risk
As in August 2015, C has sold off meaningfully on concerns around emerging markets in general and a China hard-lending in particular combined, this time around, with more intense investor concerns around oil exposure. With the stock now trading at a discount of over 20% to tangible book value of $60/share, corresponding to an aggregate discount of ~$42bn on aggregate tangible book value of $180bn, we see these concerns as meaningfully over-discounted. Coincidentally, the $42bn shortfall of the market capitalization from tangible book value, is equal to the projected cumulative pre-tax loss in comprehensive income through 2017Q2 under the severely adverse scenario of the bank’s mid-cycle stress tests (see Exhibit 1), which explicitly model a hard landing in China and other Asian economies along with recession in developed economies and commensurate market and monetary response (declines in the equity, housing, and short-rate markets, curve-flattening, and credit-spread widening), released on July 22, 2015.
Exhibit 1: Citi Mid-Cycle Stress-Test Results under “Severe Adverse” Scenario
Source: Company Reports
Were this analysis to be run today, to reflect the sale in November of One Main to Springleaf for $4.5bn, we would expect the loss-estimate to fall by $3bn or more. In practice, as commented in our note of September 21st, we see the narrow emerging-market risk as over-discounted given the quality of the loan portfolio. Within the institutional clients group (ICG), 60% of emerging market loans of $235bn are in treasury and trade solutions or the private bank; of the remaining 40% which is traditional corporate lending most of the exposure (e.g. nearly 70% in China) is to the local subsidiaries of large multinationals. Within the global consumer bank (GCB), China accounts for only ~5% of emerging market loans of just under $110bn and the targeting of loans to affluent and emerging affluent consumers means that even in Brazil, where economic conditions are dire, the loss ratio has not risen above 5.5% (compared with 0.6% in China currently).
We reiterate our price-target of $65/share for C from our note of September 21, 2015 corresponding to an aggregate valuation of $200bn. This, in turn, is generated by treating the core portion of the bank (CitiCorp) separately from the non-core portion (CitiHoldings) and adjusting valuation to take account of the very large deferred tax asset (DTA). Specifically, if CitiCorp were standalone and not saddled with a DTA, it would have generated an ROTCE in 2015H1 of 14% (see Exhibit 2) conservatively consistent, under the standard regression for banks, with a valuation of 1.4x tangible book of $125bn or $175bn.
Exhibit 2: Impact of CitiHoldings and Deferred Tax Asset on Citigroup Returns for 2015H1
Source: Company Reports
As discussed below, we value the remaining ~$50bn of average tangible common equity (TCE), supporting the DTA and CitiHoldings, at $25bn generating a total firm-wide valuation of $200bn or $65/share:
- DTA (supported by $33bn of TCE): In practice, the benefit of running-off the DTA is that it converts the supporting TCE, which is excluded from regulatory capital calculations, to CET1 capital at a rate that is currently ~$5bn/year (see Exhibit 3). Assuming this continues for a further 6 years, until the DTA of just over $30bn is exhausted, the present value at a 10% discount rate is ~$20bn.
Exhibit 3: DTA Utilization Accelerates Formation of Regulatory Capital at C
Source: Company Reports
- CitiHoldings (supported by $17bn of TCE before adjusting for sale of One Main): Since 2011, Citi holdings assets have fallen by $144bn to the current level of $116bn and now represent just 6% of the firm-wide balance sheet (albeit ~13% of risk-weighted assets at $169bn with the excess over GAAP assets due to operating risk). Management has indicated there are $32bn of asset-sales in the pipeline and committed to winding down the business in an “economically rational” manner while “staying above breakeven”. Indeed, with the $4.5bn sale to SpringLeaf of One Main (included in the above $32bn and likely to generate a capital gain of ~$1bn) which is a significant contributor to profits, CFO John Gerspach expects to maintain CitiHoldings at “no worse than breakeven on an annual basis”.
Within CitiHoldings, ~90% of assets are consumer-related and with the consumer loan portfolio being ~$54bn (see Exhibit 4). The run-off rates vary with North America residential first mortgages declining 30% over the last year while home equity balances are down less at 15% largely because there is a limited market for the latter given uncertainty over the credit-impact of rate-resets. At the current run-off rate of ~$1bn/quarter, the home equity book has a duration of ~6 years suggesting a similar haircut to the TCE associated with the DTA and, if applied across all of CitiHoldings, a valuation of ~$10bn. This is likely conservative given that residential first mortgages are running-off more quickly than home-equity and that the marketability of home-equity loans will likely improve as the portfolio demonstrates credit-resilience through the reset period of the next couple of years.
Exhibit 4: CitiHoldings Loan Portfolio (includes One Main)
Source: Company Reports
Appendix: C Model
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