The competitive advantage of Citigroup (C) has been its vast presence across the globe. However, if the economic recovery doesn't pick up in Asia, this edge could prove to be a disadvantage for the bank. We believe this slowdown has bottomed and signs of a recovery in the region are evident. The bank has attractive valuations with near 20% upside.
Positioned as a global diversified financial services company, Citigroup provides services to governments, institutions, corporations and consumers. The company has a vast global footprint in over 160 countries, with 22% of the revenues coming from Asia alone. The operations of the bank are divided into two segments for the purpose of reporting: Citicorp and Citi Holdings. The following three graphs give a clear picture of the geographical sources of income for Citigroup, the contribution in earnings from each business sub-segment within Citicorp, and how much Citigroup relies on net interest income and non-interest income.
The largest chunk of the bank's revenues come from North America (40%), followed by Asia and Latin America (22% each), while 16% of the revenues come from the EMEA region. The bank also has a heavy reliance on the net interest income as a source of revenue. It accounts for around 85% of the entire revenues of the bank, while the remaining comes from the non-interest income. Global Consumer Banking earns the largest chunk (52%) for the Citicorp business segment of the bank; followed by Securities and Banking at 27%, while Transaction Services contributes 21% to the earnings for Citicorp.
Recent quarter's performance review
Citigroup surprised the Street when it reported its performance for the third quarter of the current year. The earnings per share of $1.06 exceeded consensus mean estimate by 6.9%, while $19.4 billion revenues beat expectations by 1.03%.
The third-quarter results were supported by growth in the bank's core business and a boost in the bank's revenues coming from fixed income trading. A similar trend in the fixed income revenues was also witnessed in the results of Goldman Sachs (GS) and JPMorgan (JPM) when they disclosed their third-quarter performances.
Total revenues of $14 billion for Citigroup declined 25% compared to the linked quarter, while the net income plunged a significant 84% during the same time period. The interest income declined 2% while the net interest income plunged 77% compared to the same quarter of the previous year.
The graph below shows the compression in the net interest margin (NIM) from year 2011 to 2012. This has been the result of several initiatives by the Fed, latest of which was QE3. The Fed intends to keep the yield curve flattened so that borrowers can borrow at cheaper rates.
The deterioration in results compared to the previous periods was blamed on widening in the bank's credit spreads, leading to a negative impact of $776 million. An after-tax loss of $2.9 billion resulting from the sale of Citigroup's holdings in Morgan Stanley Smith Barney (MSSB) also suppressed the results.
Extensive global footprint - an advantage?
While we believe Citigroup has the largest potential to increase its capital return, the extensive global footprint could become a disadvantage if international Comprehensive Capital Analysis and Review (CCAR) scenarios built by the Fed come true.
When the Fed released its economic and financial market scenarios on November 15, the domestic scenarios were modestly less stressful vs. the international ones. One notable difference this time is a sharp slowdown in the Asian powerhouse, China. The country's GDP grew at 7.4% during the third quarter of the current year. Since Citigroup is one of the only U.S. money center banks with such a huge presence across the globe and it relies on Asia for 22% of its earnings, the bank would be hit hard if the situation in Asia doesn't improve. Compared to this, Goldman Sachs's earnings are 12% reliant on Asia, followed by Bank of America (BAC) at 10% and Morgan Stanley (MS) at 6%. JPMorgan has the least reliance on Asia (6%) as far as its earnings are concerned.
In the previous stress test, the Fed assumed a moderate slowdown in the economic activity in Asia. This time around the Fed assumed a severe stressed scenario as a result of a spillover of the recession in the U.S., Europe and Japan. The Fed will provide the results of the stress test by late February 2013.
The bank maintains a tier 1 capital ratio of 13.9% and a total capital ratio of 17.1% at the end of the third quarter of the current year. This is compared to 13.6% tier 1 capital ratio for Bank of America . Wells Fargo (WFC) has a tier 1 capital ratio of 11.5% and a total capital ratio of 14.5% at the end of the third quarter of the current year. Citigroup has been able to increase its Tier 1 capital ratio on a consistent basis. The capital ratio is the key indicator for a bank, particularly when the next round of regulatory stress test is round the corner.
Analysts have a tilt towards a buy rating for the stock with mean recommendation at 2.2. Of the 32 analysts covering the stock, 15 recommend their investors to buy the stock, while 7 have a strong buy rating for it. Only one analyst reached a sell recommendation for Citigroup.
Citigroup has attractive relative valuations compared to its peers in the U.S. money center banks sector. The stock that has seen over 37% appreciation in price is trading at a 43% discount to its book value. This is compared to a 53% discount and a 20% premium for Bank of America and Wells Fargo. Using a book value multiple of 0.68 times, we arrive at a target price of $43.2 for a stock that is currently trading at $36.1. This gives investors an upside potential of 20%. The consensus mean price target is $42.9.
In conclusion, we believe the bank could face a significant risk if the economic recovery in Asia doesn't pick up. However, the bank has strong fundamentals and attractive valuations compared to its peers. Therefore, we reiterate our buy rating on the Citigroup.