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As a deep value investor, I like to buy as much sustainable earnings as I can for the cheapest price possible, in businesses that I understand. I like to think of owning the whole business and what I’d be willing to pay for it. Over the last four years, Citigroup (NYSE:C) has averaged net income of $17.61B in a near-zero interest rate environment. The current tangible book value per share is over $80. After a 13% up day, the stock still trades for less than $50 and has a market capitalization of $85B. Is the business blowing up or likely to in the near future? Absolutely not, it is in the best financial condition in its history, which is only going to get better as a new talented management team divest non-core international consumer operations. The reality is that Mr. Market can be manic depressive, especially when it comes to banks post the Financial Crisis. For those willing to tolerate these nasty ebbs and flows in temperament, a lot of money can be made by focusing on the facts and ignoring the panic propagandists.
Citigroup and other banks have sold off based largely on fears of a recession. While I think a technical recession seems likely, I don’t think it will look anything like the past two recessions where we had the Great Recession and the COVID-19 lockdown. Consumers and businesses have much better balance sheets than in any other recession in my lifetime. While people feel pressured and are adjusting to this ridiculous inflation, after enduring two years of lockdown-driven misery, they are still anxious to get experiences such as travel. From a micro standpoint, I’ve been to Las Vegas and Disneyland recently, and both were as busy as I’ve ever seen them. People might be stressed when they fill up their tanks, but they want to get out and do stuff. The banking system, loan underwriting, and housing supply are all far more stable than in 2007. 2020 was an unprecedented economic catastrophe that was minimized by the most immense stimulus package in history. We are now seeing the impact of it with the worst inflation in 40 years, but we aren’t going to see anything like the 15% unemployment rate, which emerged in only 3 months as the United States and other countries for the first time in history decided to lockdown to combat a virus. In a recession credit worsens, but market participants are underappreciating the enormous tailwind of higher interest rates, which is dramatically mitigating the impact of weaker capital markets activity, and potential credit loss enhancements. Is Citigroup or other big banks going to lose money in a recession over a 12-month period? The answer is an unequivocal no.
On July 15th, Citigroup reported a very strong 2nd quarter with revenues up 11% to $19.6B, generating $4.5B of net income (down 27% YoY), or $2.19 of EPS. The annualized ROTCE was 11.2% and tangible book value per share grew by 3% YoY to $80.25, which is impressive given rising rates have been reducing AOCI, so C is unique among most of the big banks with book value growth recently. Net interest income was up 14% YoY and 10% sequentially to $11.964B, while the NIM rose to 2.24%, from 2.05% in Q1. Management believes that there is another $1.8B increase in NII coming in the back half of this year as rates continue to rise. Non-interest revenue was up 5% YoY and down 8% sequentially to $7.674B. This was pretty good performance relative to competitors as Citi benefited from strong Markets performance, along with having less exposure to mortgage origination activities, which plummeted for other banks such as Wells Fargo (WFC). Expenses were up 8% YoY due to transformation and business-led investments.
Credit costs of $1.3B, were driven by NCLs of $850MM and an ACL build due to the economic uncertainty we are seeing. At the end of the quarter, Citi had approximately $18.3B in total reserves with a reserve-to-funded loan ratio of 2.44%. In U.S. Cards, Citi has a reserve-to-loan ratio of 7.5%, despite net charge-offs being minimal at this juncture. This is a very conservative loan loss reserve that is well equipped to handle some very pessimistic scenarios for the economy, and we saw in 2020 how quickly Citi can ratchet up reserves while remaining profitable, even in an immensely stressful economic environment where unemployment rocketed to 15% in 3 months. On Citi’s $2.4T of assets, about 22% or $531B are high-quality liquid assets, and the company maintained total liquidity resources of roughly $964B. Over 80% of Citi’s corporate exposure are investment-grade and you can bet that more collateral is demanded on the non-investment grade clients. While lower income consumers are most certainly pressured in this rampant inflationary environment, most of Citi’s consumer clients are prime. With unemployment so low, people are unlikely to completely stop paying their debt. Many of the companies announcing layoffs are in Tech, which have very high incomes and with skillsets that are easily transferrable, so we’ll see how stuff filters into the real economy. Most employers are having a tough time filling positions, so it is a far cry from 2008 or 2020.
The bank returned $1.3B in capital to common shareholders in the quarter, while still growing its CET1 level to 11.9%, up from 11.4% in Q1. In October 2022, the regulatory requirement will increase to 11.5% driven by the Stress Capital Buffer increasing from 3-4%. In January 2023, the regulatory requirement will increase to 12% as a result of an increase in the GSIB surcharge. Citi management is planning to build to a 13% CET1 target inclusive of a 100-bps management buffer, which it expects to get to midyear 2023. I can’t reiterate enough how ridiculous it is that these requirements change so much on a year-to-year basis, making it very challenging to run a bank and to plan. This doesn’t help the economy whatsoever and these stress tests models aren’t even close to predicting what would happen in a real-world stress test. Each year they get more draconian and at some point, regulators should be confident that the banking system has double the capital and double the liquidity of prior to the Financial Crisis. Next year there will be another SCB test and Citi will likely score far better, given the divestitures, and the improved PPNR that the company is generating with higher rates and good business performance. If I could chat with management, I’d advocate reducing, or delaying the management buffer, and taking advantage of buybacks at current prices, as there simply is nothing better, they can do to create value for long-suffering shareholders.
In the ICG, TTS revenues were up an outstanding 33% YoY driven by higher rates, more deposits and strong fee growth. TTS average loans were up 17%, deposits were up 2%, and cross-border transactions were up 17% YoY. This was the best quarter in a decade and augurs very well for future quarters. Securities Services were up 16% YoY due to higher rates and elevated activity levels. The Markets businesses really capitalized on the insane Q2 volatility with 25% YoY growth, as corporate clients were very active in FX, rates, commodities, and equity derivatives. As expected, investment banking fees dropped by 46%, as capital markets really froze up in Q2. Total ICG revenues were $11.419B and net income was $3.961B, which was good for an ROTCE of 16.6%. This was just an impressive quarter in a very difficult environment for a bank wrongfully priced like it is going out of business.
Personal Banking and Wealth Management produced total revenues of $6.029B and net income of $553MM, which was only good for an ROTCE of 6.8%. In Branded cards, spend volume was up 18% and average loans were up 11% YoY. In the increasingly important Global Wealth Management, average deposits were up 7% YoY, while average loans were up 2%. Citi continues to add advisors, growing their count by 8% YoY. Over time this unit will benefit from the international consumer divestitures and the increasing tilt towards wealth management. There will be less capital allocated and what is leftover will be higher returning business, bolstering the overall ROTCE of the company. Management flagged that the company added 800 Private Bank clients and over 50,000 Citigold clients since last year.
Citigroup completed the sale of its Australia consumer business and is in the process of closing 8 other consumer business transactions. The bank is also continuing the wind-down process of its Korean operations where they couldn’t find a buyer. The biggest domino to fall will be when Citigroup sells its Consumer bank in Mexico where it has a leading presence. That deal is complicated, and the business is very profitable so I’m not too worried about the outcome either way, although freeing up the capital would be great for buybacks. Citigroup ended Q2 with $8.4B of Russian exposure, with 85% of that related to ICG large corporate clients that are local subsidiaries of multi-national corporations headquartered outside of Russia, mostly in the US and Europe. They have $1.6B in remaining credit reserves for this exposure, which has grown a bit due to the appreciation of the Ruble. Management estimates that the capital impact on a severe stress scenario would be $2.0B, which is quite manageable, and I think they will end up better than that. Many of these multinational companies have parent company guarantees on their Russian exposures, which greatly reduces the risk. That severe stress number declined from $2.5B to $3.0B in Q1 so the bank is actively reducing its exposure there. Citigroup has 9,000 employees dedicated to the transformation of meeting all its Consent Orders and made progress in Q2 getting the AML Consent Order lifted. Further progress on that front could only help the stock.
The bottom line is Citigroup is insanely cheap. The business isn’t as good as JPMorgan (JPM) or Bank of America (BAC) but it isn’t bad, and it is getting better. Jane Fraser is the right CEO in my opinion, and I think she probably impressed Warren Buffett, as Berkshire Hathaway built a sizable stake in the company. The strategy is sound divesting non-core international businesses that suck up capital and generate low returns, while focusing on expanding in the lucrative wealth management arena and focusing on strengths such as TTS. If Mr. Market wants to sell the company at $50, that doesn’t preclude it going to $40, but within 2-3 years I’m very confident it will once again be at $80. While you are waiting, you can enjoy a stable 4.62% and cross your fingers that management will pull the trigger and buyback stock at 62% of tangible book value per share. 2Q earnings showed that Citigroup could earn a 10% ROTCE in a terrible Investment Banking environment, while adding to credit loss reserves. The benefits of higher rates have been completely ignored, so the long-term investor can take advantage of the disconnect between price and value.
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