A Compelling Case for Citigroup

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From Standard & Poor's Equity Research

One of the potential advantages Citigroup has over its competitors, in our opinion, is its ability to provide customers with a full spectrum of credit products in addition to its traditional capital market services. Although we believe that this "universal" banking model may be necessary in order for competitors to compete on a global basis and fully participate in all capital markets activities, we think high-margin, specialized services such as mergers and acquisitions advisory will continue to be more of a "relationship" business and less of an "institutionalized" business. It appears to us that a large credit provider such as Citigroup may hold an advantage in winning investment banking or advisory mandates.

Job Cuts

One of Citigroup's biggest hurdles has been its inability to rein in expense growth. We think the company addressed much of this concern in its structural expense review. The cost saving plan, announced Apr. 11, is expected to generate expense savings of $2.1 billion in 2007, $3.7 billion in 2008, and $4.6 billion in 2009. The company took a pretax charge of $1.38 billion in the first quarter and will take $200 million in additional charges over the rest of 2007. Approximately $1 billion of the charge is related to severance packages for 17,000 job cuts. Most of the job eliminations are expected to come from back-office, middle-office, and corporate functions, and approximately 57% will come from international operations.

Although we were a bit surprised to see a higher percentage of job cuts coming internationally—as Citigroup is currently emphasizing its international growth—much of the reductions come as an effort to eliminate duplicated functions on a global, regional, and country level. We believe management was careful not to hurt its ability to generate future revenue growth, and therefore limited the impact of the job cuts on client-facing functions.

Over the past few months, there have been numerous changes in the management structure. In December, 2006, the company named Robert Druskin, president and chief executive officer of Citigroup corporate & investment banking, as the chief operating officer of Citigroup. In January, 2007, the company removed Sally Krawcheck as chief financial officer, and named her the CEO of Citigroup's Global Wealth Management Division.

Diversified for Stable Growth

Finally, in February, the company named Gary Crittenden, formerly the CFO with American Express (AXP), as the new CFO. Although we sometimes view excessive management changes in a negative light, we think each of these moves served a purpose and has provided Citigroup with a stronger management team.

By our analysis, total segment revenues will continue to increase, rising 8% in 2007 and 9% in 2008, on a managed basis, driven by continued strength in market-sensitive businesses such as investment banking, trading, and investment management. Citigroup's diversified business mix should allow it to sustain relatively stable growth even if global economic conditions were to decelerate substantially—a development that we do not anticipate. We believe its new expense discipline will help to offset any revenue challenges that Citigroup may encounter.

The shares were down about 7.4% year to date through April 5, 2007, underperforming the S&&P 500 and the average of domestic large capitalization banks. Based on our 2007 operating EPS estimate of $4.61, the shares recently traded at approximately 11.2 times, slightly below the midpoint of their five-year historical range of 7 to 18 times, and at 2.1 times current book value. We believe the shares' valuation is mainly attributable to concerns over short-term growth prospects, a challenging interest rate environment, execution of its expense savings plan, weak U.S. consumer results, and worries over the company's ability to sustain earnings growth.

Attention to Ethics

We think the stock's current valuation discount relative to its historical range and to other domestic large capitalization banking companies fully reflects our assessment of risk. We consider the shares to be undervalued. Our 12-month target price is $63, based on a p-e multiple of 13.7 times our 2007 EPS estimate, in line with its historical average.

While corporate governance had been under scrutiny at Citigroup in the past due to numerous regulatory investigations regarding ethics, trading practices, and conflict of interest, to name a few, it seems to have dissipated somewhat over the past year. CEO Charles Prince has instituted a company-wide initiative to bring attention to ethics and encourage sound decision-making. Prince has also formed committees to make major decisions, encouraging openness and bringing in many different viewpoints.

Citigroup has also settled many of the claims against it and continues to aggressively seek settlement where it is warranted. While the company's size and the nature of its business will likely present future corporate governance challenges, we believe the framework for a new culture is in place and, over time, will help slow the occurrences.

Risks to our recommendation and target price, in our view, include the following:

• Credit Risk: Credit risk arises in many of Citigroup's business activities, including lending, sales & trading, derivatives, securities transactions settlements, and when the company acts as an intermediary on behalf of its clients and third parties. Citigroup could incur unexpected losses from the failure of a borrower or counter party to honor their financial or contractual obligation.

• Market Price and Interest Rate Risk: Many of Citigroup's businesses are affected by changes in interest rates, foreign-exchange rates, equity and commodity prices, and by their implied volatilities. Failure to manage these risks may have an impact on margins and earnings.

• Country Risk: Events that occur in countries in which Citigroup conducts business activities may have an unexpected adverse impact on earnings.

• Cross-Border Risk: Cross-border risk reflects various economic and political risks, including those arising from restrictions on the transfer of funds as well as from the company's potential inability to obtain payment from customers on their contractual obligations as a result of actions taken by foreign governments, such as exchange controls, debt moratorium, and restrictions on the remittance of funds.

• Regulatory Risk: Citigroup is subject to supervision and/or examination by federal and state banking regulators, state insurance regulators, securities and commodities regulations, and the supervisory authorities of host countries. Changes in laws or government regulations could have an adverse impact on the company's earnings.

• Litigation Risk: Unexpected adverse outcomes of current or future litigation may require additional expenses that may have an impact on earnings.

Analyst Braden follows shares of life and health insurance companies for Standard & Poor's Equity Research Services.