Citigroup is growing around the world as it shrinks domestically

To contact us Click HERE
by Jim Sinegal (Analyst at Morningstar)
Citigroup C announced an ambitious cost-cutting program aimed at reducing expenses by $900 million in 2013 and as much as $1.1 billion by 2014, in its first significant move since Michael Corbat replaced Vikram Pandit after the bank reported third-quarter earnings. Citigroup will eliminate 11,000 jobs as a result. We see the announcement as evidence that Corbat plans to more aggressively pursue a strategy of scaling back operations. We believe this makes sense, given Citigroup's past problems managing its size and complexity. The company expects that revenue could be reduced by no more than $300 million as a result of the changes, but it will record a $1 billion restructuring charge in the fourth quarter. Our forecast and valuation incorporate a reduction in the company's expense base, so we do not expect to make any major changes to our fair value estimate as a result of the announcement. 
About one fourth of the announced restructuring charges will be incurred in the company's corporate segment, as operational and technological processes are streamlined. We think this should be achievable as the conglomerate undertakes long-overdue steps toward better integration. Global consumer banking will incur approximately 35% of the charges as Citigroup scales back its branch network in peripheral markets, another strategically sound action. Securities and banking will incur 25% of the charges, again primarily resulting from cuts related to operational and technological functions. The company is also cutting back in the competitive arena of cash equities and realigning its expense base to fit a more temperate investment banking environment. In general, we expect to see a smaller, more focused, more efficient Citigroup in the next three years, and we think these cuts are another step in the right direction.
In our view, there are two main risks to the cost-reduction program. The first is that back-office cuts will affect control and communication--two areas that have not been strong points at Citigroup. We'll be looking for both financial and anecdotal evidence that the cuts are hampering, rather than helping, performance. The second risk is that some of the expense reductions, especially in the investment bank, will prove temporary in the event that business picks up from current levels. It's relatively easy to cut costs when deal and trading activity is slow, but it will be much harder for management to maintain its focus on expenses in a more favorable environment.  Stabilized by massive government capital injections in the depths of the financial crisis, Citigroup now offers investors something unusual for a U.S.-based bank: the possibility of loan growth. Thanks to its presence in developing economies, Citigroup is poised to continue adding high-margin loans to its balance sheet while many of its peers in the U.S. and Europe suffer from low interest rates and minimal loan demand in deleveraging developed economies. All else equal, this tailwind (and the company's newly boosted capital levels) might be enough to make Citigroup the envy of its money center peers around the world.However, Citigroup's turnaround is by no means complete. Citi Holdings--the bank's collection of unwanted assets--still accounted for 11% of the balance sheet as of March 31 and resulted in a large portion of the company's credit losses in the first quarter of the year. These assets are likely to eat away at earnings for several more quarters and contribute to slow to negative balance sheet growth for the company as a whole.
Furthermore, risk management has never been a strong point at Citigroup. The company has been involved in financial fiascoes ranging from the subprime crisis to the less-developed country debt crisis in the 1980s. Arguably, the bank's presence in so many countries and businesses also makes it vulnerable to relatively small missteps in far-flung locales, as it is difficult to keep tabs on operations spanning 100 countries and six continents. We're therefore pleased that Citigroup has scaled back its ambitions under Vikram Pandit's management.
The company's newly replenished capital levels also serve to mitigate risk. Near insolvency in late 2008, the company now boasts a much-improved tangible common equity ratio and reserves sufficient to cover well over 4% of the loan book, dramatically reducing risk. These levels position the company to withstand a significant deterioration in credit quality, in our view. At the same time, Citigroup can afford to invest in fast-growing markets in Latin America and parts of Europe, the Middle East, and Africa, where consumer loan yields can be up to twice the level the bank receives in its North American consumer business. While management's capital return plan was scuttled by regulators, who found that Citigroup could find itself just shy of capital minimums in a stress case scenario if its dividend/repurchase plan were approved, we don't see this as a major negative. The lack of approval means the company will not be able to create value for shareholders through repurchases this year, but it also ensures the company will not fall behind peers on the capital front, in our opinion. As this is a positive for bondholders, the company could also find its funding costs falling and margins expanding. In any case, with a market capitalization approaching $100 billion, Citigroup would need a fairly large repurchase program to create much value.
Valuation
We are lowering our fair value estimate to $46 per share from $52 based primarily on an increase in our cost of equity. We are now assigning Citigroup a 12% cost of equity (versus 10.5% previously) based on the volatility of the company's post-provision revenue, the moderate level of operating leverage inherent to the business, and the bank's high level of financial leverage relative to the rest of our coverage universe. In our base-case valuation, we think assets will remain relatively flat over the next five years, with the continued runoff of Citi Holdings' assets offset by the growth of loans outside the U.S. We think the net interest margin will average 2.9% over the next five years, improving slowly as nonperforming assets fall and the company adds higher yielding emerging market loans to its balance sheet. We forecast noninterest income to increase by approximately 15% cumulatively over the next five years, as capital markets revenue normalizes. We expect net charge-offs to slowly decline over our forecast period, averaging 1.8% in the long run. We expect the company's efficiency ratio to fall to 60% by 2016. Our valuation reflects a middling level of profitability, with return on assets reaching 0.9% and return on tangible equity reaching 12% by the end of our forecast period.
Risk
Citigroup's presence in emerging markets is the company's biggest advantage, but 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.
Management & Stewardship
CEO Vikram Pandit joined Citigroup in 2007 and was named CEO shortly thereafter. We think he performed admirably, given the difficult task he was assigned as the institution plummeted toward failure. Pandit accepted an enormous amount of government assistance, diluting existing shareholders, but positioned the company for an eventual resurgence. He also refocused the company on its core competencies, designating billions of dollars in assets for disposal as a part of Citi Holdings. Citigroup's board of directors has also made great strides in recent years, adding members like Michael O'Neill, who served as CEO during the transformation of Bank of Hawaii BOH from an average institution to a truly outstanding bank.
We think it's too early to judge management's capital allocation skill, but are encouraged that Pandit has refocused the company's attentions on a simple strategy. We're disappointed that the company misjudged regulators' appetite for returning capital to shareholders, but considering that both Citigroup and Bank of America BAC have made this mistake in recent quarters, we're beginning to suspect that lines of communication with regulators are not as clear as we initially thought. We believe that Citigroup is likely to repurchase shares once it is approved--an excellent decision, in our view, as long as the company is trading below tangible book value.
Overview
Financial Health: 
Citigroup is now in acceptable financial health, with a tangible common equity ratio of 7.7% as of March 31 and an allowance for loan losses sufficient to cover 4.4% of its loan book. The company is also now consistently profitable.
Profile: 
Citigroup is a global financial services company doing business in more than 160 countries and jurisdictions. It serves commercial and consumer clients through its regional consumer banking segment and provides investment banking, treasury, and securities services through its institutional clients group. The company is winding down its involvement in the brokerage, asset management, and consumer lending businesses that are part of its Citi Holdings segment.