Cabot Value Investor Issue: September 5, 2023

What Is the Problem With Citigroup Shares?

Citigroup (C) shares have continued to slide, now down about 8% year to date and about 38% since our November 2021 initial Buy recommendation. Interim dividend receipts of $3.59/share have softened the loss to about 31%, but this is still sizeable. What is Citi’s problem, how low can the shares reasonably go, and when will the shares start to recover?

At its core, Citi’s problem is that earnings are not growing much, nor appear likely to grow much for the foreseeable future. Earnings per share look stalled in the $5.50-$6.50 range. And, those earnings will continue to produce only a modest return on tangible capital of around 7%. Compared to JPMorgan (JPM), a benchmark of strong bank performance with respectable earnings growth and a roughly 20% return on tangible capital, Citi’s results are verging on embarrassing.

Citi’s net interest income is stalled as its loan growth and its ability to earn a profit on its lending are weak. The bank is retreating from some geographic markets and business lines, weighing on growth. Also, Citi has less of a franchise in its markets – minimal in the consumer segment and weak in the corporate/business segments – so it needs to work harder (higher expenses) to earn its revenues. This franchise effect also suggests that it needs to pay higher interest rates for its deposits, which constrains its net interest margin. Citi is large and strong so it is considered a “go-to” bank when smaller banks struggle, but it clearly is not a JPMorgan in deposit-gathering prowess.

Fee income looks stalled as well. While the Institutional Services operations hold an impressive franchise, they are not large enough to offset the sloppy and no-growth Markets and Banking segments, nor the uninspiring growth in the Personal Banking and Wealth Management operations.

Citi is fighting rising credit costs as well. Credit costs are increasing across the banking industry, and our bank is not immune. Citi’s quarterly write-offs and reserve building will likely continue, creating an enduring headwind likely through at least next year.

With all of its asset sales, fix-it projects, regulatory monitoring and risk management initiatives, Citi’s expense base is increasing. Expenses rose 9% from a year ago. Beneath all of the add-on costs, Citi is probably becoming more efficient. But the add-on costs will likely linger for years. An indicator of how elevated Citi’s costs are: its efficiency ratio is likely to end the year at about 68%. For comparison, expenses relative to total revenues (which comprise the efficiency ratio) for JPMorgan will be about 53% this year. Giving up 15% of its revenues to add-on costs is expensive for Citi, equal to about $4.50/share in annual earnings.

With a rolling over of net interest income, volatile but not growing fee income, rising expenses and higher credit losses, Citi is unlikely to see much earnings growth until the end of the current credit cycle (whenever that is) and whenever most of its restructurings are completed (another two years, perhaps).

Related to the dull earning outlook is the chronic disappointment in the company’s earnings trajectory. In 2019, the company earned about $8.00/share, so the new $6.00 base is about 25% below earnings from only four years ago. By itself, this would be enough to push away many investors. Worse, however, is the steady downward burn in consensus analyst estimates. About 18 months ago, analysts expected the bank to earn $8.11/share in 2023. After a year and a half of grind-down, the 2023 consensus estimate is now only $5.78. Estimates for next year (2024) have slid as well, from $9.50 to the current $6.23. Most investors, even many value investors, are reluctant to buy shares until the earnings outlook at least stabilizes. Citi hasn’t reached this point yet.

Another headwind is rising capital requirements. Citi will likely need to retain more capital and thus slow/discontinue its share buybacks over the next year or two to meet the new Basel III Endgame capital rules.

What is keeping us in Citi’s shares? One is the valuation. At 48% of tangible book value, the shares are remarkably inexpensive. Tangible book value is a rough proxy for liquidation value, so investors are buying Citi shares at a large discount.

An old-school but still useful valuation metric for financials is that they trade at a price/tangible book value (P/TBV) multiple that is about 10x their return on tangible book value. Citi’s 7% return on tangible book value warrants somewhere around a 70% P/TBV multiple using this rule of thumb. So, the shares are cheaper than they should be.

JPMorgan produces a roughly 20% return on tangible book value, so it should theoretically trade at around a 2.0x P/TBV multiple. The actual 1.9x multiple is close enough. If Citi generated a stronger profit, or even if it showed the prospect of earning significantly more, its shares would rise accordingly.

On a price/earnings basis, the 6.6x multiple of 2024 estimated earnings is subpar, as well. JPMorgan’s 10x estimated 2024 earnings multiple is out of reach for now, but Citi’s multiple is too low, even if estimates slide a bit further.

We see limited downside in Citi’s shares as weak fundamentals are already reflected in both the valuation and earnings estimates. Shares of any stock can decline for any reason at any time, but unless the economy or yield curve move sharply against Citi, the shares should hold their value.

We remain confident that CEO Jane Fraser’s turnaround of the bank will eventually work. It will just be a grind for the next year or two. But, a potential double in the shares combined with limited downside is highly appealing, especially since we are being paid a Treasury-like 5.1% dividend yield to wait.

Share prices in the table and our discussion below reflect Friday, September 1 closing prices.

Note to new subscribers: You can find additional color on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Value Investor on the Cabot website.

Send questions and comments to Bruce@CabotWealth.com.

Today’s Portfolio Changes
None.

Portfolio Changes Since Last Month
Comcast Corp (CMCSA) – Retaining our Hold rating.
Allison Transmission (ALSN) – Retaining our Hold rating.

Growth & Income Portfolio

Growth & Income Portfolio stocks are generally higher-quality, larger-cap companies that have fallen out of favor. They usually have some combination of attractive earnings growth and an above-average dividend yield. Risk levels tend to be relatively moderate, with reasonable debt levels and modest share valuations.

Strong Buy – This stock offers an unusually favorable risk/reward trade-off, often one that has been rated as a Buy yet the market has sold aggressively for temporary reasons. We recommend adding to existing positions.
Buy – This stock is worth buying.
Hold – The shares are worth keeping but the risk/return trade-off is not favorable enough for more buying nor unfavorable enough to warrant selling.
Sell – This stock is approaching or has reached our price target, its value has become permanently impaired or changes in its risk or other traits warrant a sale.

Note for stock table: For stocks rated Sell, the current price is the sell date price.

Cisco Systems (CSCO) is facing revenue pressure as customers migrate to the cloud and thus need less of Cisco’s equipment and one-stop-shop services. Cisco’s prospects are starting to improve under a relatively new CEO, who is shifting Cisco toward a software and subscription model and is rolling out new products, helped by its strong reputation and entrenched position within its customers’ infrastructure. The company is highly profitable, generates vast cash flow (which it returns to shareholders through dividends and buybacks) and has a very strong balance sheet.

On August 16, Cisco reported a solid fiscal fourth quarter, with adjusted earnings of $1.14/share increasing 37% and beating the $1.06 estimate by about 8%. Revenues rose 16% and were about 1% above estimates. Revenue metrics were robust, and profits were further boosted by expanding gross margins. Guidance for full-year 2024 was for 1% revenue growth and 4% earnings growth, supporting our case that the company is a slow but steady grower with a fortress balance sheet ($18 billion more cash than debt) that is returning much of its prodigious free cash flow to shareholders through dividends and share buybacks.

Cisco will be presenting at several investor conferences which are accessible on the company’s website, including Goldman Sachs Communacopia and Technology Conference (Sept. 6, 2:30 ET) and the BankofAmerica Securities Global AI Conference (Sept. 11, 11:00 a.m. ET).

CSCO shares rose 1% for the week and have 15% upside to our 66 price target. Based on fiscal 2024 estimates, the valuation is attractive at 10.1x EV/EBITDA and 11.4x earnings per share. BUY

Comcast Corporation (CMCSA) – With $120 billion in revenues, Comcast is one of the world’s largest media and entertainment companies. Its properties include Comcast cable television, NBCUniversal (movie studios, theme parks, NBC, Telemundo and Peacock), and Sky media. The Roberts family holds a near-controlling stake in Comcast. Comcast shares have tumbled due to worries about cyclical and secular declines in advertising revenues and a secular decline in cable subscriptions as consumers shift toward streaming services, as well as rising programming costs and incremental competitive pressure as phone companies upgrade their fiber networks.

However, Comcast is a well-run, solidly profitable and stable company that will likely continue to successfully fend off intense competition while increasing its revenues and profits, as it has for decades. The company generates immense free cash flow which is more than enough to support its reasonable debt level, generous dividend and sizeable share buybacks.

There was no significant company-specific news in the past week.

Comcast shares fell 4% in the past week and remain roughly at our 46 price target. For now, we are keeping our Hold rating. The shares aren’t particularly cheap, but the fundamentals continue to remain sturdy. HOLD

Buy Low Opportunities Portfolio

Buy Low Opportunities Portfolio stocks include a wide range of value opportunities. These stocks carry higher risk than our Growth & Income stocks yet also offer more potential upside. This group may include stocks across the quality and market cap spectrum, including those with relatively high levels of debt and a less-clear earnings outlook. The stocks may not pay a dividend. In all cases, the shares will trade at meaningful discounts to our estimate of fair value.

Strong Buy – This stock offers an unusually favorable risk/reward trade-off, often one that has been rated as a Buy yet the market has sold aggressively for temporary reasons. We recommend adding to existing positions.
Buy – This stock is worth buying.
Hold – The shares are worth keeping but the risk/return trade-off is not favorable enough for more buying nor unfavorable enough to warrant selling.
Sell – This stock is approaching or has reached our price target, its value has become permanently impaired or changes in its risk or other traits warrant a sale.

Note for stock table: For stocks rated Sell, the current price is the sell date price.

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap manufacturer of vehicle transmissions. While many investors view this company as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world, Allison actually produces no car or light truck transmissions. Rather, it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its EBITDA margin is sharply higher than its competitors and on par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. The company generates considerable free cash flow and has a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years.

There was no significant company-specific news in the past week.

ALSN shares ticked up 1% in the past week and remain slightly above our recently raised 59 price target. The shares offer a reasonable 1.5% dividend yield. We are keeping our Hold rating for now, given the acceptable valuation combined with the strong management and company fundamentals. HOLD

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. We expect that activist investor Cevian Capital, which holds a 5.2% stake, will keep pressuring the company to maintain shareholder-friendly actions.

On August 16, Aviva reported first-half earnings of £0.20/share, increasing 10% from a year ago and beating the consensus estimate of £0.19. The company continues to grind forward with healthy performance following its shrink-to-growth turnaround.

Gross premiums written rose 12% and funds continue to flow into its wealth products. Costs remain controlled with no increase from a year ago on an adjusted basis despite 7% underlying inflation. Operating profits rose 8% and capital strength is sturdy. Aviva generated 26% growth in its funds generation. The company is on track to meet or exceed its targets.

There was no significant company-specific news in the past week.

Aviva shares fell 3% this past week and have 48% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, which we believe is a sustainable base level, the shares offer a generous 8.7% yield. On a combined basis, the dividend and buybacks offer more than a 10% “shareholder yield” to investors. BUY

Barrick Gold (GOLD), based in Toronto, is one of the world’s largest and highest-quality gold mining companies. About 50% of its production comes from North America, with the balance from Africa/Middle East (32%) and Latin America/Asia Pacific (18%). Barrick will continue to improve its operating performance (led by its highly capable CEO), generate strong free cash flow at current gold prices, and return much of that free cash flow to investors while making minor but sensible acquisitions. Also, Barrick shares offer optionality – if the unusual economic and fiscal conditions drive up the price of gold, Barrick’s shares will rise with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside. Barrick’s balance sheet has nearly zero debt net of cash. Major risks include the possibility of a decline in gold prices, production problems at its mines, a major acquisition and/or an expropriation of one or more of its mines.

On August 8, Barrick reported a reasonable quarter, with adjusted earnings of $0.19/share falling 21% from a year ago but beating the consensus estimate of $0.18/share. Results were broadly improved from the prior quarter (first quarter 2023). The company said it is on target to meet its full-year 2023 production guidance. Rising costs continue to chip away at otherwise decent profitability, but management seems well aware that they need to deliver on their production and profit goals. We are watching what effect achieving these near-term goals will have on Barrick’s long-term fundamentals.

There was no significant company-specific news in the past week.

Over the past week, commodity gold rose fractionally to $1,953/ounce. The 10-year Treasury yield ticked up to 4.25%. Rising bond yields are weighing on gold prices but not by much, it appears. Usually, these two prices move in opposite directions. Perhaps the growing awareness of the tenuous U.S. Federal government financial picture, highlighted by the Fitch downgrade, as well as the hefty new bond issuances, are pushing yields higher.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) was essentially unchanged at 104.74. Rising yields are pushing up demand for the dollar but weighing incrementally on gold prices.

Investors and commentators offer a wide range of outlooks for the economy, interest rates and inflation. We have our views but hold these as more of a general framework than a high-conviction posture. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares fell 2% in the past week and have 69% upside to our 27 price target. BUY

Citigroup (C) – Citi is one of the world’s largest banks, with over $2.4 trillion in assets. The bank’s weak compliance and risk-management culture led to Citi’s disastrous and humiliating experience in the 2009 global financial crisis, which required an enormous government bailout. The successor CEO, Michael Corbat, navigated the bank through the post-crisis period to a position of reasonable stability. Unfinished, though, is the project to restore Citi to a highly profitable banking company, which is the task of new CEO Jane Fraser.

Citi will be presenting at the Barclays Global Financial Services Conference on Sept. 13 at 10:30 am ET, with the live webcast and replay available on the Citi investor relations website.

Citi shares fell 1% in the past week and have over 100% upside to our 85 price target. The shares remain attractive as they trade at 48% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 5.1% yield.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers a higher yield and considerably more upside price potential. Clearly, the Citi share price and dividend payout carry considerably more risk than the Treasury bond, but at the current valuation Citi shares would seem to have a remarkably better risk/return trade-off. BUY

Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high-quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018. Following several sell-downs, Blackstone has a 43% stake today.

On August 4, Gates reported a good quarter that came in ahead of estimates across the board. The company incrementally raised its profit guidance for the year. Adjusted earnings of $0.36/share rose 13% from a year ago and beat estimates by about 9%. Revenues rose 3% (by 4% excluding acquisitions and currency effects) and were fractionally above estimates. Adjusted EBITDA of $197 million rose 9% and was 3% above estimates.

The company continues to execute well, illustrated by its expanding gross and EBITDA margins. Free cash flow was strong at 114% of net income. Gates repurchased $250 million in shares during the quarter, equal to about 7% of its market value. The balance sheet remains sturdy with cash essentially unchanged from a year ago, although debt has ticked up incrementally to fund the share buybacks. Leverage at 2.8x EBITDA has improved due to stronger EBITDA.

Gates will be presenting at several investor conferences which are accessible on the company’s website, including the Morgan Stanley Laguna Conference (Sept 13, 2:40 pm ET) and the RBC Global Industrials Conference (Sept 12, time TBD).

Gates’ shares were flat in the past week and have 31% upside to our 16 price target. The recent price dip, due apparently almost entirely to the Blackstone sale, offers a worthwhile opportunity to add to positions. BUY

NOV, Inc (NOV) – This high-quality, mid-cap company, formerly named National Oilwell Varco, builds drilling rigs and produces a wide range of gear, aftermarket parts and related services for efficiently drilling and completing wells, producing oil and natural gas, constructing wind towers and kitting drillships. About 64% of its revenues are generated outside of the United States. Its emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, while strong economies of scale in manufacturing and distribution as well as research and development further boost its competitive edge. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services.

We see the consensus view as overly pessimistic, given the company’s strong position in an industry with improving conditions, backed by capable company leadership and a conservative balance sheet.

There was no significant company-specific news in the past week.

The price of West Texas Intermediate (WTI) crude oil jumped 8% to $87.21/barrel, as Saudi Arabia said it would extend its voluntary cut of 1 million barrels/day until the end of the year. The price of Henry Hub natural gas fell 6% to $2.60/mmBtu (million BTU). Natural gas prices are driven by domestic demand, as import/export volumes are minuscule, although supply disruptions in Australia are leading to incrementally higher local prices in the U.S.

NOV shares rose 4% in the past week. NOV shares have 15% upside to our 25 price target. The dividend produces a reasonable 0.9% dividend yield. BUY

Sensata Technologies (ST) is a $3.8 billion (revenues) producer of nearly 47,000 highly engineered sensors used by automotive (60% of revenues), heavy vehicle, industrial and aerospace customers. About two-thirds of its revenues are generated outside of the United States, with China producing about 21%. Investors undervalue Sensata’s durable franchise. Its sensors are typically critical components that generally produce high profit margins. As the sensors’ reliability is vital to safety and performance, customers are reluctant to switch to another supplier that may have lower prices but also lower or unproven quality. Sensata has an arguably under-leveraged balance sheet and generates healthy free cash flow. The relatively new CEO will likely continue to expand the company’s growth potential through acquisitions. Electric vehicles are an opportunity as they expand Sensata’s reachable market. Our Sensata investment remains an underperforming (from a business fundamentals perspective) work in progress.

Sensata will be joining the S&P Midcap 400 Index effective pre-market on Monday, September 18.

ST shares rose 2% in the past week and have 94% upside to our 75 price target. Our price target looks optimistic and we are re-evaluating it in light of our concerns over the company’s management and strategy. BUY

Disclosure: The chief analyst of the Cabot Value Investor personally holds shares of every recommended security, except for “New Buy” recommendations. The chief analyst may purchase or sell recommended securities but not before the fourth day after any changes in recommendation ratings has been emailed to subscribers. “New Buy” recommendations will be purchased by the chief analyst as soon as practical following the fourth day after the newsletter issue has been emailed to subscribers.

The next Cabot Value Investor issue will be published on October 3, 2023.