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When Citigroup (NYSE:C) reported fourth quarter 2012 earnings in January, most analysts were disappointed. The bank generated earnings per share of $0.69 for the fourth quarter (excluding one-time charges), which was much lower than the expected $0.97. For the whole year, Citigroup's net income fell by 32%, mostly driven by lower non-interest revenues. And yet, the share price has shown impressive performance, up over 12% year-to-date, outperforming the S&P 500's 6.5% return for the same period.

Banking stocks were harshly hit during the financial turmoil. Their share prices have exhibited significant volatility in the past five years and after their strong recent performance, a reasonable question comes in mind; how sustainable is the recovery this time? In the graph below, the S&P 500 Financials Index is currently on a three year high. After strong first quarters in the years 2010, 2011, and 2012, a market correction inevitably followed.

S&P 500 Financials Sector Index Three-Year Performance:

(click to enlarge)

Source: Bloomberg.com

Although most financial companies are in much better shape than they were there years ago, it is hard to be bullish on the sector as a whole. Tougher regulation, cost-cutting pressures, high competition, and sensitivity to more problems in the Eurozone are some factors that still threaten the sustainable recovery in the share prices.

If I had to choose one U.S. bank stock at the moment, that would be Citi, as it looks relatively cheap compared to peers in the U.S. and Europe.

Valuation. First, let's look at a simple comparison based on price to book and price to earnings. Included below are ten of the biggest banks in the U.S. and Western Europe. The group trades at an average price-to-book of 0.90x and an average price-to-earnings of 12.17x, based on fiscal year 2012 or trailing twelve month results.

Company Name

MCAP (USDm)

Reporting Period

P/B

P/E

P/E 2013E

HSBC Holdings

210,601

Q3 2012

1.22

9.98

15.51

Wells Fargo

187,006

Q4 2012

1.29

9.90

9.75

JPMorgan & Chase

186,929

Q4 2012

0.96

8.78

9.07

Citigroup

134,332

Q4 2012

0.72

17.81

9.69

Bank of America

131,980

Q4 2012

0.60

31.51

12.22

BNP Paribas

76,759

Q3 2012

0.76

7.52

8.43

Goldman Sachs Group

74,684

Q4 2012

1.10

9.99

11.36

Barclays

62,838

Q3 2012

0.75

39.80

8.59

Morgan Stanley

46,653

Q4 2012

0.77

neg.

11.47

Deutsche Bank

46,228

Q3 2012

0.62

15.80

8.93

Peer Group Average

  

0.90

12.17

10.50

Source: Bloomberg.com

What's more is that the historical price-to-book ratio for Citi is closer to 0.90x. The bank is trading significantly below peer and historical levels. Citi also trades below the peer average on a forward P/E basis. But this is fair? It would be if Citi's balance sheet and assets were subpar, or if it had below average profitability; this is not the case…

Asset quality. Citi still outperforms top banks, such as JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC). Listed in the table below is the non-performing loans of the seven largest banks in the U.S. (by assets), as of the fourth quarter in 2012. Citi has one of the lowest ratios of non-performing loans (NPL) to total loans ratios. Its NPL to total loans is 1.9%.

Institution

Total Loans (USDm)

Adj NPLs* (USDm)

NPLs/Total Loans

JPMorgan Chase

732,762

21,475

2.9%

Bank of America

912,394

32,058

3.5%

Wells Fargo

815,769

25,078

3.1%

Citigroup

600,569

11,613

1.9%

U.S. Bancorp

230,092

2,534

1.1%

Capital One

206,187

3,515

1.7%

Bank of New York Mellon

34,983

250

0.7%

100 Largest Banks

7,695,217

177,568

2.3%

*Adjustment for government guarantees

Source: BankRegData

The industry as a whole is showing signs of strengthening. Over the past three years, bank asset quality has steadily been improving:

Non-Performing Loans to Total Loans - 100 Largest U.S. Banks

Source: BankRegData

Furthermore, Citi has booked $25.5 billion in allowances for loan losses, or 3.9% of gross loans. This is on the conservative side, as most banks in the U.S. have booked about 2% in allowances. Citi has Tier 1 Common Ratio of 12.7% and Tier 1 Common Capital Ratio of 14.1%. For comparison, Bank of America (NYSE:BAC) has Tier 1 Common Capital Ratio of 11.06%. The ratios measure financial strength. The higher they are, the better positioned the banks are to sustain adverse operational developments.

What's more is that in early February, Moody's upgraded Citi's outlook to stable from negative. The negative outlook was assigned after the previous CEO resigned unexpectedly at the end of last year. The rating agency saw higher risk that the bank might delay the implementation of improved risk management practices. The new CEO Michael Corbat, however, instilled confidence that this process would not be delayed.

Profitability. Citi has some leading profitability in the industry, according to its net interest margin (NYSE:NIM). The prolonged low interest-rate environment in the U.S. has exerted downward pressure on margins. As of the fourth quarter of 2012, the average NIM of the 100 largest banks in the U.S. stood at 3.36%, very close to the 10-year low of 3.20% in 2006. This year, margins might fall further down, but expected to be at a slower rate than in 2012.

Net Interest Margin - 100 Largest Banks in the U.S.

(click to enlarge)

Source: BankRegData

Currently, Citigroup has one of the highest net interest margins in the group, at 3.69%:

Institution

Av. Earn. Assets (USDm)

NIM

JPMorgan Chase

1,707,123

2.61%

Bank of America

1,428,226

3.17%

Wells Fargo

1,149,506

3.66%

Citigroup

1,136,138

3.69%

U.S. Bancorp

300,921

3.71%

Bank of New York Mellon

255,633

1.09%

PNC Bank

251,814

3.87%

100 Largest Banks

12,510,253

3.36%

Source: Bloomberg.com

Conclusion. Citi appears to be a solid investment in chaotic industry, with a solid asset portfolio, cheap valuation and industry leading profitability. A majority of Citi's revenues are generated from outside the U.S., namely in developing countries that should see faster GDP growth when compared to the likes of the U.S.

Although Wells Fargo has a robust NIM (3.66%), in line with Citi, we remain Wells Fargo given their over exposure to the declining mortgage refinancing market. Wells Fargo's significant mortgage banking operations and considerable variability in mortgage servicing operations limit the company's potential. Last quarter Wells Fargo's outperformance was driven by strong mortgage banking revenues, including 4% loan growth. This key revenue driver, mortgage banking and mortgage refinancing, should see slowing growth as the activity in mortgage refinancing slows, thanks in part to interest rates finding a floor.

As far as the other major banks, the NIM on Bank of America (3.17%) and JPMorgan (2.61%) lags that of Citi. Bank of America has an elevated cost structure, which should continue as it works through legacy issues. Back in mid-2012, Moody's downgraded the bank, which will only push its cost structure higher going forward, thanks to higher funding costs. Another issue with Bank of America is its $11.5 billion exposure to Europe.

JPMorgan's top-line is expected to be down 5% year over year this quarter as trading revenue continues to contract, and management expects pressure on NIM to continue. JPMorgan also has a robust exposure to Europe at $13.9 billion, compared to Citi's $8.9 billion.

Source: Banks Might Be A Good Buy, Citi Is A Great One