Citigroup Remains The Black Sheep Of The U.S. Banking Industry

| About: Citigroup Inc. (C)

Summary

The market did not like Citi's earnings call at all.

It wasn't so much the Q4 print.

It was the modest guidance near-term.

But is Corbat's guidance too conservative?

Is it indeed a classic case of under-promise and over-deliver?

Citigroup (NYSE:C), as I noted in prior articles, does not benefit as greatly from Trump's reflation trade as some of its large U.S. peers. To recap the key reasons are:

  1. The presumed tax cuts will likely mean Citi will partially write-off its tangible book value
  2. Its liability structure does not greatly benefit from a rise in long-term rates. In other words, it is less interest-rates sensitive than its peers.
  3. Trump's style of protectionism is perceived as negative for EM (Citi is exposed to EM and especially Mexico)

The difference in tone was stark in the Q4 earnings' call - while Bank Of America's (NYSE:BAC) Mr. Moynihan "boasted" of additional $600 million per quarter of additional income ($2.4 billion annually). Mr. Corbat provided a rather somber guidance while assuming one 25 basis points move up by the Fed sometimes in 2018.

The street was disappointed and traders pressed the "Sell" button.

Make no mistake about it - the Q4 numbers were fine. It was the guidance that scared the market. This can be seen by the daily market move during and following the earnings call (which started at 11AM), as Citi shares accelerated its decline and did not participate in the afternoon recovery of its peers.

So what was the guidance about?

In Citi's Gerspach own words:

.....we're on the right path to improve our Return on Tangible Common Equity, excluding the capital supporting disallowed DTA, from 9% in 2016 to at least 10% in 2018. ....We continue to believe that we are capable of producing a Return on Tangible Common Equity of roughly 14% over time a...an important milestone on that path will be achieving at least a 10% RoTCE on the full amount of our Tangible Common Equity. ....as early as 2019, depending on the rate environment as well as the outcome of tax reform.

So summarizing it:

- RoTCE of at least 10% by 2018 on tangible book excluding disallowed DTA)

- RoTCE of 10% (perhaps) by 2019 on full tangible book value

- Some progress made on RoTCE targets demonstrated in 2017.

By the numbers

Citi's total TCE as of 4Q'2016 is $179 billion, its disallowed DTA is $29 billion and end-of-period share count is 2,722 million. So the DTA disallowed represents ~$10.64 of its 65.57 tangible book value.

As such, TBV excluding disallowed DTA currently stands at ~$55. Thus Citi's management is guiding for EPS of $5.50 in 2018 and 10% of 2019 total TBV.

Of course the total TBV will depend on tax reform as well (so readers should not quite think about it as $6.50 EPS for 2019).

Citi generated an EPS of $4.72 for FY 2016. So in 2017, Citi guides to somewhere between $4.72 and $5.50 ($5.19 is currently the consensus).

Why was the market disappointed?

Mr. Market thought the guidance would and should be higher. Peers comparison doesn't hold well either whereby all the other major U.S. banks outlook indicates earnings above cost of capital. CLSA's analyst, Mike Mayo summarized it well:

Then the third question's ROE. What is your ROE target for 2017? Again, this is down to 7.6% RoTCE. That's down from 9.2% in 2015. And after it's gotten worse, you now say exclude the DTA impact, and that would boost it to 9%. I'd say there's no credible accounting theory that would permit the exclusion of the DTA capital, if that was the case you should have taken a reserve, but let's go with the 9%, that's still worst in class so again, waiting two and a half years seems like a long time if we wanted to hold you accountable.

Citi, undoubtedly, remains the black sheep of the large U.S. banking space.

Has the market over-reacted?

In short, yes as Mr. Market has taken Citi's guidance quite literally.

Clearly though, management have arguably factored in overly conservative assumptions. There are really two pieces to that; (I) interest rate assumptions (ii) FICC.

Interest rates and FICC

Citi is factoring in only one rate hike in mid-2018. Whereas market consensus is for 2 to 3 rate hikes in 2017.

FICC for the first half of 2016 was exceptionally weak but finished strongly in the 2nd half, on the back of Brexit and U.S. presidential elections. Clearly though for 2017, Citi is only forecasting a flat to modest year-on-year growth in FICC.

Why is Citi being conservative on rates and FICC?

It reflects a conservative management style and the firm's budgeting cycle (which typically would be done earlier in Q4). Citi's CFO has simply taken a conservative view on interest-rates as alluded to in the Goldman Sachs Investors Conference back in December:

RICHARD RAMSDEN: One of the most tangible things that has changed is interest rates and interest rate expectations, .....Obviously Fed funds futures are also now pricing in a much faster rate of tightening. How do you incorporate that into you budget process, or do you ignore it taking into account that we're just back to where we were a year ago?

JOHN GERSPACH: Well, that's the whole thing. That is exactly the point. With all of that change, we're smack-dab where we were at the beginning of the year (2016).

FICC and other capital markets businesses are volatile and notoriously difficult to predict. These depend heavily on market activity and volumes. In spite of favorable market settings, Citi has clearly taken a conservative view with only modest growth assumed across its Institutional Client Group (ICG) division in 2017.

Let us take a slightly less conservative view

The below slide illustrates Citi's returns by division:

There are a few items that could move the dial, let us consider these one by one:

Global Consumer Bank (GCB)

GCB reported RoTCE is dampened by loan loss reserve build in 2016 as well the Costco (NASDAQ:COST) acquisition (both in terms of increased costs and acquisition accounting for Credit Card portfolios). By the second half of 2017, Citi should lap these headwinds and the positive operative leverage of the franchise should come through. This may be partially offset by reduced Mortgage income. All in all, I believe a 15% RoTCE is achievable on full-year basis, which is still well-below target of 20% RoTCE for the GCB segment.

ICG

ICG was impacted by several one-offs in 2016. Firstly, the first quarter (which is typically a seasonally strong one) was extremely weak due to difficult market conditions. This shaved off a ~$1 billion of net income on a year-on-year comparison with 1Q'2015.

It was also impacted by a one-off loss on Citi's Venezuela franchise (~180 million) as well as ~600 million of loan losses on hedges.

Assuming the capital markets will remain open for business - in my view, Citi should be able to reach ~14% RoTCE on ICG. This represents an additional $1.3 billion of net income compared with 2016. I believe Citi (in a base case scenario), can make up that difference by (1) a more typical Q1 performance (2) avoiding substantial one-offs (up to $800 million pre-tax) (3) further gaining market share in Fixed Income and Equities.

Otherwise, my assumptions are far from heroic (e.g. I am not factoring another 15% growth in Fixed Income year on year).

Interest rates

Assuming the Fed raises interest-rates twice in 2017. Citi should benefit by an additional $500 million pre-tax income in 2017. This is in addition to $500 million already baked in due to the December 2016 rate rise. So in total $1 billion of pre-tax income partially offset by increased TLAC cost and lower day count ($200 million). So in total, I expect an incremental $800 million pre-tax or $550 million net income due to interest rates.

Share count

I expect Citi to purchase around $11 billion worth of shares during 2017 (factoring in a higher CCAR request compared with 2016). At $60 per share, this translates to ~183,000 share count reduction and an average share count for 2017 of ~2.7 billion shares (assuming some of the buybacks are back-ended).

Putting it all together

As can be seen from calculation above, the expected EPS is around $5.80. This compares with a market consensus of $5.19 as per CNBC.

So how do I trade the position?

During recent market rally in banks, I had to sell some of my holdings in Citi. Simply because I broke through my financials concentration limits in my portfolio.

With Citi, the risk/reward opportunity is beginning to look interesting but not yet compelling. Clearly, the main delta is the performance of ICG as per above with other catalysts being CCAR, interest-rates and tax reform. As such, in the next few weeks, I will be looking for further evidence of the robustness of capital markets and depending on the share price, I may initiate an incremental position (it could be a leveraged or a more defensive one).

Final thoughts

In the Seeking Alpha 2017 positioning series on financials - I highlighted BAC as a standout amongst the U.S. banks. Given current macro settings and the Trump reflation trade, the divergent valuation of U.S. banks (as shown below) possibly makes sense (up to a point of course).

Understanding the drivers and inflection points can (sometimes) deliver significant alpha.

I provide independent and quality coverage of U.S., European, Asian, Canadian and Australian large-cap banks - identifying long and short opportunities. If interested in the topic, feel free to add me as a "real-time follower" or message me if interested in a specific banking name.

Disclosure: I am/we are long C, BAC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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