Yet we believe the bank is finally on the road to rehabilitation. It has raised capital, shed assets, and bulked up its board of directors and management team with experienced bankers. Management’s focus on buybacks over dividends will also provide much-needed flexibility. The company is still “too big to fail,” with complex operations spanning multiple continents. As such, Citigroup is not likely to ever completely escape the cost burdens of regulation and litigation. However, we think Citigroup investors should be able to sleep more soundly over the next decade.
In our view, Citigroup’s truly global presence differentiates the bank from nearly all of its peers. With significant revenue coming from Latin America and Asia, the bank is poised to ride the growth of these economies through the coming decade, without excessive exposure to any particular country. At the same time, Citigroup is not merely a domestic lender, and it should remain a bank of choice for global corporations, thanks to its ability to provide a variety of services across borders. Developing economies should offer an attractive combination of high margins and rapid credit growth over time--especially in comparison with the low rates and declining leverage that we expect to persist in the United States and other Western economies for the next few years. Investors should be prepared for volatile results out of emerging economies. However, with nearly $150 billion in common equity Tier 1 capital, Citigroup is now prepared to weather most storms, in our view.
On the downside, it’s still difficult to see how some of Citigroup’s lines of businesses fit together. In 2016, Latin American consumer banking accounted for 7% of revenue, while Asian consumer banking accounted for 10%. We’re not convinced that these produce valuable synergies with the U.S. consumer and institutional business, and we would not be averse to further simplification of Citigroup’s business.
Economies of Scale Are Key Source of Advantage
We assign a narrow moat rating to Citigroup. We expect Citigroup to achieve returns on tangible common equity slightly below our assigned 11% cost of equity by the end of our five-year forecast period. Our base-case forecasts incorporate returns on tangible common equity of 10% by 2019. However, when deferred tax assets are excluded, the company’s returns on tangible common equity exceed its cost of capital, and we expect returns to trend higher as the deferred tax assets and the capital required to support them fall over time.
Citigroup is the result of numerous mergers and acquisitions over the years, with predecessor institutions in a variety of countries. Michael Corbat has been tasked with the bank’s turnaround, and we think the task of instilling a consistent corporate culture will be a tough one. We like that the company is shedding businesses and refocusing on its core competencies.
Citigroup’s commercial and investment banking businesses are fairly resistant to disruption, in our view. Its cross-border lines of business will be particularly difficult to disrupt.
Citigroup is unique among its U.S. peers in that it also has significant operations in Latin America and Asia. However, we don’t see individual exposures large enough to alter our overall view.
Citigroup’s competitive advantage stems from cost advantages in its core banking operations and from switching costs and intangible assets in investment banking. Of $900 billion in deposits, about one fourth cost the bank nothing in interest expenses. We see economies of scale as the key source of Citigroup’s cost advantage. The bank is a major consumer lender in many markets it serves, and its securities services and issuer services businesses have $16 trillion in assets under custody.
Noninterest expenses--including massive litigation costs--consumed as much as 78% of net revenue at Citigroup in recent years. We expect this figure to improve significantly over our five-year forecast period, owing to a normalization of the interest rate environment and reductions in expenses related to the financial crisis, and we believe the bank can achieve a 54% efficiency ratio over the next five years, thanks to economies of scale.
Citigroup’s widespread consumer lending operations result in fairly high--and volatile--credit costs over time.
Citigroup is a systemically important institution and therefore subject to additional capital charges and regulatory costs. We think its presence in numerous geographies and its growing derivatives business will place a significant burden on returns, as Citigroup must deal with multiple regulators around the world.
From a systemic standpoint, we believe the U.S. offers a fair banking environment. Though the quality of regulatory monitoring has strengthened considerably in the past several years, the country still uses a complex and somewhat archaic system of regulation. Furthermore, the company’s banking market is quite fragmented--Citigroup must compete with a variety of regional and community banks, as well as large money-center institutions. Over the past 50 years, the banking system has achieved returns roughly in line with its cost of capital, which supports our view of the environment as intensely competitive. Our outlook is more positive from a macroeconomic and political standpoint. The U.S. is still the world’s leading democracy and maintains the world’s reserve currency. However, its military involvement around the globe potentially detracts from its economic and political stability, and the country has experienced a number of financial crises during its history.
Emerging-Markets Presence Holds Reward but Also Risk
Citigroup does face several cyclical headwinds in the near term, including higher capital levels, increased regulation, low interest rates, and depressed loan demand, thanks to a difficult economic environment. However, none of these factors affects Citigroup’s scale advantages.
Citigroup’s presence in emerging markets is the company’s biggest advantage, but it’s 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.
While the restoration of the company’s dividend is a plus, we would look favorably upon repurchases as well. A substantial buyback program seems a good fit for possible earnings volatility, thanks to Citigroup’s investment bank and international consumer book. The value of its buybacks is even greater when the stock trades well below our fair value estimate.