Citigroup (C) was the third major bank to report Q2 2012 earnings (see our analysis of JPMorgan and Wells Fargo). Citigroup reported results that beat expectations, but were down from a year ago. Citigroup's results, like the results of its peers, show that it is managing to navigate through this difficult period and improve its operations.
Citigroup's valuation of 0.5x Tangible Book Value Per Share demonstrates investor concern about its balance sheet and doubts about its operating performance. However, if Citigroup can continue on its present trajectory, the current stock price may represent a good buying opportunity. In this update, we will examine Citigroup's results using our six question checklist. In addition, we will discuss comments from Vikram Pandit, Citigroup's CEO, about the U.S. and global economies.
As we review Citigroup's Q2 2012 earnings, we are looking for clues about whether reduced expectations by analysts and investors take into account the pessimistic outlook for the global economy, or if expectations need to be lowered further.
Did the Company Beat Expectations and Have Expectations Been Rising/Declining?
Citigroup reported Q2 2012 earnings per share of $0.95. Excluding the impact of CVS/DVA and the sale of its stake in Akbank, the EPS was $1.00. According to Reuters estimates (via Capital IQ), analyst estimates called for EPS of $0.89.
However, analysts' estimates have been coming down. Three months ago, estimates called for EPS of $0.99.
Although Citigroup appears to have beaten the estimates, it is important to put this in the context of the reduced estimates over the last quarter.
Considering the actual performance compared to estimates, it could be that the expectations have been lowered to the point that reflects the current pessimistic market sentiment.
How Did the Stock Perform Going Into Earnings?
Citigroup's stock price has been declining since the release of its Q1 earnings. During this period, Q2 earnings estimates have been declining. Also, the overall market experienced a correction, and the Financial Select Sector SPDR ETF (XLF) declined as well.
Citigroup's stock has been trading in the same range that it did during the Q3/Q4 correction of last year, implying very low expectations. It will be interesting to see if the Q2 earnings provide a catalyst for the stock to move upward. We are looking to see if Citigroup can rise through the $29.50 level to mark new upside territory and start a bullish move.
(click to enlarge images)
(Source: FreeStockCharts.com)
What Drove the Results?
Citigroup's Q2 2012 earnings material can be found here.
The following is a summary of the results:
(Source: Citigroup's Q2 2012 earnings material)
We would like to highlight a few items:
Since emerging from the financial crisis of 2008/2009, Citigroup has changed its business mix. As seen in the chart below, Global Consumer Banking has grown to 46% of LTM earnings before tax, compared to 18% two years ago. During the same time, Securities and Banking has fallen to 27% of LTM earnings before tax from 54%. Transaction Services' relative share has remained relatively flat.
The rise of Global Consumer Banking has two important implications for Citigroup. With almost half of its earnings before tax coming from Global Consumer Banking, Citigroup is becoming more of a traditional bank, which should be less risky than a more capital markets-oriented investment bank. Also, the Global Consumer Banking division has large and growing franchises in Latin America and Asia, prov Citigroup with exposure to emerging markets.
(Source: Citigroup's 2Q 2012 earnings material)
In the North America Consumer Banking division, earnings before tax were up year-over-year. Retail banking drove the gains as a result of higher mortgage revenues. We have heard from JPMorgan (JPM) and Wells Fargo (WFC) about the improving environment for mortgages in their businesses as well. However, Citigroup's gains were offset by declines in the credit card business. Although the company made expense cuts in other parts of its business, North America Consumer Banking expenses increased 5% year-over-year.
Revenue for the International Consumer Banking business was down 4% year-over-year, but was impacted by foreign exchange changes. Excluding FX, on a year-over-year basis, revenue for Latin America was up 4%, while Asia was flat and EMEA was down 1%. Expenses were cut 5% in the International Consumer Banking business, helping to drive a 3% increase in earnings before tax.
The Securities and Banking division, which includes investment banking and capital markets activity, experienced a 2% decline in revenues. Investment Banking revenue was down 21% year-over-year, and Equity Markets revenue was down 29% year-over-year. Fixed Income Markets, which is the largest segment in Securities and Banking, was down 4% year-over-year. The weak capital markets results also echo the results from JPMorgan and Wells Fargo. It will be interesting to see how Goldman Sachs (GS) and Morgan Stanley (MS) performed in Q2 when they report results later this week, as they are more tied to the capital markets.
Citigroup's Securities and Banking division cut expenses 8%, which helped to generate a 16% increase in net income for the division (excluding CVA/DVA).
Transaction Services' revenue increased 5% year-over-year, while expenses were held flat, which indicates the operating leverage in the business. As a result, Transaction Services' net income increased 6% year-over-year.
Citigroup continued to wind down its Citi Holdings division, which is often referred to as the "bad bank." As the slide below shows, Citi Holdings has been reduced to 10% of Citigroup's total assets.
(Source: Citigroup's Q2 2012 earnings material)
Citigroup's loan book increased by 1% in Q2. This was comprised of loan growth at Citicorp (the good bank) of 10% year-over-year to $527 billion, and offset by a 24% year-over-year decline in loans to $128 billion at Citi Holdings (the bad bank), which is being wound down, as mentioned above.
The Net Interest Margin ("NIM") declined in Q2 to 2.81%. The NIM is the difference between the interest income and interest expense relative to the size of the loan book, and represents its profitability. The NIM was expected to be approximately 2.85%. Part of the drop in the NIM (~3 bps) was attributed to the card prepayments.
(Source: Citigroup's Q2 2012 earnings material)
On the conference call (see full transcript here), Citigroup's executives said that they expect the NIM to be in the 2.80% range for the rest of the year. They added:
If the NIM stays at roughly, let's call it [2.80%], [2.81%]... we are still looking to see the loan book continuing to grow, and so it may be at a lower NII or lower NIM, but we still see overall nominal margin dollar expansion.
On the call, Citigroup CEO Vikram Pandit said he did not want to comment on the LIBOR scandal. However, he did say:
The only [thing] I can say to you is though we can't discuss any details, do not infer from the situation of one LIBOR submitting bank that every bank is in the same or a similar position, and I think it's not the case you can draw conclusions about the regulatory consequences for any one particular bank.
It isn't clear what he means, but it seems to imply that Citigroup may not face the same problems that Barclays (BCS) is facing.
What Are the Implications for the General Economy?
Pandit offered a lot of commentary on the macro environment, which we will summarize.
Regarding China, he said:
I'd said a little bit earlier [...] we feel better about lot of the Asian economies, [than] we did few months back, and frankly we feel better about that and some of the market perceptions out there. Our ability to grow in China is important to us, and we'll continue to do that. Our ability to do whatever we can in India is important, although there are regulatory constraints in what we can do.
Later in the call, he added that Asia still has a lot of policy room that it can use to boost growth and is continuing to benefit from large scale infrastructure buildouts.
Yeah, let me start by saying [an] overall comment, in Asia given the low amounts of fiscal or government debt and kind of the strong overall nature of the economy still [...] whether China grows at 7%, 8% or 7.5%, 8.5%, rather than 8%, 9%. So given the strong nature of the underlying fundamentals [they have] got ample policy room, that's the first thing to keep in mind, and then [they have] actually been using it, and that's an important perspective to keep in mind in terms of the trajectories of this economy.
Secondly, some of the growth issues have been affected by the supply side issues. Asia needs a lot more infrastructure, we are seeing signs in certain countries where that's changing as well. And so if the impact on Asia [because] of Europe slowing down and the impact on Asia [because] of [the] lack of the export markets. Some of that is being made up or with policy alternatives, a shift towards consumers consuming and infrastructure spending, and we see that so to step on the ground, and that's important. The broader trend, which gets to what [...] the clientele or [...] the clientele we serve, we are largely an urban bank in Asia and cities are growing despite all of these things. Urbanization is a very powerful trend, [the] middle class is growing, people are coming into the cities -- that's what drives our business.
So yes, the macro is important, as I said I'm feeling better about the macro than I did myself a few months back. It's the micro that's really important, our clientele, urbanization, rise of the middle class there, that's where it's coming from."
Regarding the US and Europe, Pandit said:
We continue to be concerned about Europe, and we are managing our risk extremely tightly as a result of that, and obviously you see what's going on in the U.S., you all are as close to it as we are as well, we would all like to see more job creation in the U.S.
Regarding the mortgage business, Citigroup's executives seemed more hesitant than JPMorgan or Wells Fargo. Chief Financial Officer John Gerspach commented:
Well, I think what people see right now would be pockets of improvement. And to the extent that there are some green shoots out there that -- that's great. We're still very focused, as I said, in the prepared remarks, as far as the risk of the foreclosure overhang, I mean there are still an awful lot of foreclosed -- or foreclosures and profits that had yet to hit the market. So I don't look at this yet as being a robust housing situation, and maybe a little bit of it comes from the fact that I'd lived through the mortgage issues of the early 90s, and it took years for that to clear up. And in comparison, the early 90s were small potatoes compared to what we're going through now.
Regarding interest rates, Pandit said:
I don't see long-term rates going up for the next one year or two years, especially from everything I see going on in Europe.
What Is the Guidance Going Forward?
The key guidance from the earnings call was that Citigroup expects its Basel III Tier I capital ratio to be at, or above, 8% by the end of the year. The following chart shows the key capital metrics, including the growth in Tangible Book Value Per Share, which is currently at $51.81:
(Source: Citigroup's Q2 2012 earnings material)
Furthermore, Citigroup's executives did not give specific guidance regarding the dividend, but said that they will review it later in the year.
What Is the Market's Reaction to the Results?
Citigroup's stock price increased 0.6% today, following the release of earnings. The market's reaction to Citigroup's earnings was flat, in line with the rest of the market.
Conclusions
Citigroup's Tangible Book Value Per Share (TBV/S) is $51.81 and has been growing steadily. However, the stock closed today at $26.81, which is a steep discount to TBV/S. Furthermore, the stock has retreated to the area where it traded in the Q3/Q4 correction last year. Clearly, expectations are low for Citigroup.
When it comes to fixing its problems, the company is continuing to make progress. It is winding down Citi Holdings and shifting its focus to become more of a traditional bank through the increased prominence of the Global Consumer Banking division. Despite the challenging environment, Citigroup beat analyst expectations, even if expectations were recently reduced.
There are many reasons to avoid investing in Citigroup. The balance sheet is a black box. The macro environment is challenging. There are increasing regulatory pressures, and Citigroup may face liability from the LIBOR scandal.
However, the stock may be a Buy at, or near, the current price as it is trading at a ~0.5x discount to TBV/S, which is a discount valuation to its peers, and at the level it reached in the correction last summer. It seems that the downside can be limited, as an investor can place a stop in the mid-$20 range in case the macro environment gets worse. Alternatively, investors may want to wait to see if the stock rises above $29.50 per share and starts to mark new upside territory.
Disclosure: I am long WFC. We may trade any of the stocks and ETFs mentioned in this article in the next 72 hours.
