C: Hold the Plague

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Howard Mason



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:

  1. 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[1], 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

  1. 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[2] 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[3].

Exhibit 4: CitiHoldings Loan Portfolio (includes One Main)

Source: Company Reports

Appendix: C Model

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, BAC, C, WFC, and GS.

  1. As of 2015Q2, $31.6bn of DTA was excluded from CET1
  2. Firm-wide RWA is $1.279bn of which $325bn is related to operating risk.
  3. Half of the CitiHoldings home equity portfolio resets over 2015-2017.
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