Citigroup - Solid Results, But No Compelling Opportunity

| About: Citigroup Inc. (C)


Citigroup reports strong adjusted earnings as Citicorp posts a modest profit.

Mortgage orgination is weak which is no surprise, yet relative and unexpected strength is seen at the trading business.

I shun shares despite attractive earnings and discount to book value. Poor track record, legal overhang, lack of dividends, and weak capital ratios are among my worries.

Citigroup (NYSE:C) reported a solid set of second quarter results and announced a much anticipated multi-billion mortgage settlement which was applauded by investors, sending shares 3% higher at the start of the trading week.

While the bank is performing relatively strong, I am worried about the poor long-term performance, continued overhang of settlements, "lock-up" of capital amidst no dividend payouts and the capital position. The discount to book value and appealing earnings multiple are not enough reasons to convince me to take a long position.

Second Quarter Highlights

Citigroup posted second quarter sales of $19.34 billion which was down 6% compared to the year before. Adjusted revenues, which correct for CVA/DVA, came in at $19.37 billion which marked a 3% decline in annual sales. Analysts were anticipating much weaker revenues around $18.81 billion.

Despite the drop in sales, adjusted earnings were up by a percent to $3.93 billion, coming in at $1.24 per share. Note that reported GAAP earnings totaled just $181 million as a result of the huge new mortgage related settlement, coming in at three cents.

Analysts were looking for adjusted earnings of $1.05 per share, marking a big beat for the company on these metrics.

Looking Into The Performance

Global consumer banking revenues were down by 3% to $9.4 billion on the back of various reasons. Less US mortgage refinancing activity, the repositioning and divestitures out of certain markets and spreads being compressed hurt topline sales. Earnings of the unit dropped by 14% on the back of lower sales and higher restructuring charges in Korea.

Revenues from the institutional clients group dropped by 11% to $8.5 billion. Excluding the impact of CVA/DVA, proceeds were down by just 7%. Banking revenues were up by 6% to $4.5 billion thanks to the investment banking unit which posted a 16% increase in sales on the back of strong equity and debt underwriting markets.

A 12% drop in fixed income revenues to $3.0 billion and a 26% drop in equity markets revenues towards $659 million were better than anticipated as well.

The troubled Citi Holdings unit, which is essentially the bad bank of Citigroup, showed the biggest surprise. Adjusted revenues were up by 35% to $1.46 billions. Yet the biggest surprise was that after backing out the impact of the mortgage settlement, Citi Holdings would have posted net earnings of $244 million. With Citigroup in the process of shutting the unit, the asset base fell by another 15% to $111 billion.

A Look At The Balance Sheet And Capital

The more favorable conditions allowed Citigroup to reduce its allowance for loan losses. Allowances fell by 68 basis points to 2.7% of the loan book, coming in at $17.9 billion.

This is as the entire balance sheet of Citigroup expanded by 3% to $1.80 trillion. This excludes the asset base of Citicorp of $111 billion. Despite the $7 billion settlement, Citigroup reported a 10.6% Basel III Tier 1 Common ratio which was a 60 basis points improvement compared to last year.

On the supplementary Basel III leverage ratio, the capital ratio was just 5.7%. While this is relatively low, it marked an 80 basis points improvement compared to last year.

The bank reported a normal book value of $66.76 per share which was up by 6% compared to last year. Tangible book value was up by 7% to $56.89 per share. Trading at $48.50 per share, shares trade at 0.85 times the tangible book value and just 0.73 times common book value.

At $48.50 per share, equity is valued at around $147 billion. This is equivalent to nearly 2 times trailing annual revenues of around $76 billion and 10-11 times adjusted earnings of around $13-$14 billion.

A Look At The Past, And Gauging What The Future Will Bring

Citigroup suffered hard during the crisis and the severe dilution witnessed during the black chapter in its history has wiped out returns for any long-term investors. While sales are still similar to revenues reported nearly a decade ago, earnings are still lagging amidst settlements and a sluggish bank sector at large.

Yet the real trouble came following the dilution during the crisis with the total share count increasing by a factor of 6 over this time frame This makes current earnings per share just a rounding error compared to earnings per share achieved during 2005-2006 which approached the current share price!

Final Takeaway

Investors are obviously pleased with the results, as the company managed to report a very modest GAAP profit after announcing a huge settlement related to past RMBS and CDO claims, costing the bank some $3.7 billion on an after tax basis.

Speaking about mortgages, the soft conditions in the mortgage origination market have hit Citigroup as well, yet it relies less heavily on the residential mortgage market compared to some if its competitors.

Total originations were just $6.2 billion during the second quarter which was up significantly from the first quarter, but down very sharply compared to last year's $17.2 billion in total originations. This weakness was very much anticipated but more than offset by a relative strong performance of the investment banking business.

Trading revenues was down in the mid-teens, much better than CFO Gerspach's comments for a 20-25% decline in trading revenues which were made as recent as May. Trading conditions, notably for fixed income have improved, especially in June.

So what's the takeaway from these earnings? Citigroup clearly has some momentum going as it continues to wind down Citicorp and simplify operations. At the same time, the company remains very complex, has a poor long-term track record of creating value and is certainly not best of breed. Capital ratios under the sophisticated Basel III approach are still low, preventing Citigroup from paying a meaningful dividend to its investors.

Potential triggers are of course the appealing price-earnings ratio and the discount of the price-to-book valuation in particular. Yet trading at this discount does not automatically create an opportunity for me as capital and dividends are locked up until the balance sheet is bolstered even more, before the FED will allow a meaningful dividend payout. Until that point in time, capital remains at risk, of course, in case of a renewed turmoil in the banking sector.

For these reasons, I remain on the sidelines.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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Tagged: , Money Center Banks, Earnings
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