Citigroup And The Fiscal Cliff
Christopher Grosvenor, CMT | Nov 25, 2012 01:56AM ET
The potential fiscal cliff will adversely impact U.S. equity valuations. Citigroup, Inc. (C) and the fiscal cliff are the focus of this paper.
Before I discuss the fiscal cliff it is important to discuss the current state of the market for common equity shares of Citigroup, Inc. The share price of C is trending higher.
The firm is a laggard during this corrective wave and the share price is expected to decline. A catalyst for the decline is the fiscal cliff.
Market participants are expressing some concern over potential US federal government expenditure cuts and revenue increases of more than $600 billion set to take effect in 2013.
Without the fiscal cliff I project a deficit of about $960 billion. Outlays are forecasted to be little changed from the 2012 level, and receipts are forecasted to increase to about $2.59 trillion.
With the fiscal cliff I project a budget deficit of about $850 billion. Outlays decline but receipts also decline as the impact of the decreased government expenditure decreases federal revenue.
Under a third assumption about $200 billion of fiscal cliff takes effect in 2013. Most of the cuts come from reductions in outlays and the budget deficit is roughly $838 billion.
In October, the first month of fiscal 2013, the budget deficit was about $120 billion. The year-to-date deficit was larger than 2012's as outlays increased faster than receipts. The fiscal deficit for 2013 is projected to be about $990.6 billion, according to the Office of Management and Budget. As previously stated, without changes to current legislation I project a budget deficit of $960.9 billion.
Current-dollar GDP was roughly $15.78 trillion in 2012's third quarter. The revenue increases and spending cuts from the fiscal cliff are about 4 percent of GDP.
Apply a multiplier of 1.3 the fiscal cliff would be about 5.2 percent of GDP. Please note, the multiplier of 1.3 is an estimate. In other words, the cliff is quite steep.
Without the fiscal cliff US economic growth is roughly 2 percent. With the fiscal cliff US growth is negative in 2013. With a mild fiscal cliff US growth is slightly slower than under the no fiscal cliff scenario.
That said, Republican leadership expressed a desire not to increase tax rates without tax-codes and entitlements reforms. The leaders of the Democrat party believe taxes on the wealthy should increase. I don't think tax-codes or entitlements reforms are going to happen in a month.
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Thus, the most likely outcome, in my opinion, of the federal budget debate is to maintain current fiscal outlay levels. My preferred outcome is a slight reduction in fiscal 2013 outlays compared to fiscal 2012; the decline may come in current-dollar terms or real-dollar terms.
Under the scenario without the fiscal cliff shares of Citigroup, Inc. return 50 percent next year. The fiscal cliff scenario suggests a return of about negative 50 percent next year. Finally, the scenario with a $200 billion reduction in federal expenditure suggests shares of C should return 30-40 percent in 2013.
Market participants are expecting a continuing resolution, however, I don't expect a resolution to come without causing shares of Citigroup to decline substantially in price.
I will have to see how the year closes, and how the stock trades next year before I can give more accurate 2013 year-end targets.
All of the return assumptions and deficit projections are subject to revision as new information is added to financial models.
Financial Analysis
In terms of the fiscal cliff's potential impact on Citigroup's financial performance, expect lower revenue, earnings and operating cash flow than otherwise. Something along the lines of 2008-2009 but less severe.
From a financial analysis perspective, Citigroup's net income is trending higher. Total equity is also trending higher. The cash balance is increasing, and the Basel I tier 1 common ratio was 12.7 percent on September 30, 2012.
In terms of the operating segments, Citicorp's revenue remains range bound between $15 billion and $20 billion.
The drag in Citicorp's revenue is coming from securities and banking revenue. The other operating segment's revenue is increasing. Part of that may be because of the firm's focus on its consumer banking divisions. Citiholdings continues to wind down.
The firm is resolving outstanding litigation: Citigroup agreed to pay $360 to settle claims stemming from Lehman. While the settlement will be a drag on fourth quarter earnings, the clarity provided by the settlement is a long-term bullish catalyst.
Also, investors will have to watch the results of the Fed's stress test: Citigroup is vulnerable to a negative assessment because of its operations in Asia, and that could reduce the chances of the firm increasing the 2013 dividend. The macro-economic data has been positive for valuations.
Macroeconomic Influences
The advance reading of third quarter GDP said the economy expanded at an annualized rate of 2.0 percent that is up from 1.3 percent in the second quarter. A faster pace of expansion leads to increased demand for financial services.
Interest rates have remained at extraordinarily low levels as the Federal Reserve maintains its quantitative easing program. Recent data points suggest increased demand for auto and home loans. Further, businesses have increased borrowing as lending standards eased.
The PCE price index, excluding food and energy, increased 0.1 percent in September, the same increase as in August. The subdued level of inflation suggests interest rates should remain low, and consumers and businesses should remain relatively confident. Right now, I'm not concerned about the solvency of the enterprise.
Solvency
The tier one capital ratio, a measure of solvency, increased the past several years. At the end of 2004, the tier one capital ratio was 8.7 and reached 11.8 at the end of 2011. At the end of 2012's third quarter, the tier one capital ratio was reported as 12.7. The increase in the firm's tier one capital ratio is expected to be sustained.
In comparison, Bank of America's Basel 1 tier one common capital ratio was 11.4 percent at the end of 2012's third quarter.
Compared to its peers, Citigroup's Basel 1 tier one common capital ratio was higher than JPMorgan's (JPM) and Bank of America's (BAC).
The amount of tier one capital increased and the financial leverage ratio decreased. In 2008, the financial leverage ratio was 13.67 and declined to 10.54 at the end of 2011. At the end of 2012's third quarter the financial leverage ratio was 10.34. Based on the financial leverage ratio, Citigroup became more able to meet its debt obligations.
Citigroup's financial leverage ratio is above Bank of America's and below JPMorgan's.
Valuations
Based on a present value dividend discount model Citigroup is worth about $27.50-share. The current market price of about $36.10-share suggests the firm is overvalued. The dividend discount model may be inaccurate because the price forecasts suggest a continued down trending share price.
Using short-term multiplier model valuations the firm is overvalued. Based on the absolute values of the multiplier model valuations the firm is fairly valued.
On a price-sales basis compared to the average of its peer's ratios, Citigroup is undervalued. Historically compared to itself on a price-sales basis, Citigroup is undervalued.
Investment Thesis
Overall, Citigroup is performing well financially and has a solid financial position. That said, the short-term valuations are ahead of reality.
There has been plenty of good news that has been discounted by the market. At this point, it would take extraordinary news to move shares higher in price.
The uncertainty surrounding the fiscal cliff should act as a catalyst to drive share prices lower as the premium investors are willing to pay for shares of Citigroup declines.
A resolution of the fiscal cliff could stem the decline and shares of Citigroup could form a technical bottom.
Traders should be short shares of Citigroup, Inc. Investors should reduce long-equity exposure. Long-term investors should accumulate shares following a decline to roughly $30-$32.
Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.
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