Citigroup - A Little Post-Earnings Bump, But A Lot Of Work Still To Do

Aug. 31, 2022 5:43 PM ETCitigroup Inc. (C)BAC, COF, PNC11 Comments
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Stephen Simpson
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Summary

  • Citigroup reported better-than-expected results for Q2, but the competitiveness of the core U.S. banking operations is still in question as competition intensifies in areas like cards.
  • Citi is winding down its consumer and commercial lending operations in Russia, and the sale of its Mexican subsidiary could be compromised by government mandates concerning local ownership and employment.
  • Very modest long-term growth assumptions can support a substantially higher share price, but a more meaningful rerating remains tied to visibility on 10%+ ROTCE.
Major Banks In U.S. Report Quarterly Earnings

Justin Sullivan

The long wait for substantial improvement at Citigroup (NYSE:C) goes on; second quarter earnings were better than expected, and something of a standout next to peer banks, but underlying results still show a lot of need for improvement. Down more than 20% since my last update, Citi has done a little better than other large banks, but that outperformance has started to fade more recently.

The need to build capital will limit capital returns to shareholders in the near term, and there are still meaningful uncertainties around the company’s efforts to simplify and restructure the business, not to mention compete effectively with more vigorous competition in core banking. The biggest positive for the Citigroup investment case is the exceptionally low level of expectations built into the share price, but regaining a double-digit return on tangible common equity not only remains a key driver for the shares, but one that looks to be at least two years off.

Looking For Differentiation In Main Street Banking

One of the bigger takeaways from the second quarter is the relative strength of “Main Street” banking versus money center banking – basic lending and services to businesses and consumers as opposed to capital market activities (trading, et al). That tempers some of the enthusiasm over Citi’s relatively better performance in areas like trading and Treasury & Trade Solutions activities like liquidity management and payments, particularly given some modest evidence of underperformance in more basic lending and deposit-gathering functions.

Citi wasn’t one of the more asset-sensitive banks to begin with, and what sensitivity it has is moderating some as the rate cycle moves on. Deposits declined modestly on an end-of-period basis in the second quarter, with a 2% decline in non-interest-bearing deposits, and Citi is currently among the banks paying the most for CDs (along with Citizens Financial (CFG) and Capital One (COF)) versus banks like Bank of America (BAC), PNC (PNC), and Wells Fargo (WFC) that can rely on larger, stickier, high-quality deposit franchises. Interest-bearing deposit costs rose 20bp qoq in the second quarter, and Citi’s ability to attract and hold low-cost deposits will be an important factor in this next phase of the cycle.

Likewise with lending activity. While Citi remains competitive in card lending, loan growth ex-cards was weaker than the sector average. With mortgage lending looking less attractive and banks like Bank of America and PNC significantly stepping up their efforts in middle-market lending, Citi has work to do here as well to show differentiation and competitiveness in Main Street banking. I'd also note that, while spending growth in cards has been good (up 31% from 2019 levels), fees are actually down slightly from 2019 levels as the market has become significantly more competitive.

Restructuring Goes On

Citi continues to work toward winding down its expansive non-U.S. operations. Most recently, the company announced that it would begin winding down its Russian consumer and commercial banking operations, having not been able to find a buyer. I don’t see much credit risk in this business at this point, as much of the lending exposure to the Russian operations is to large multinationals, and I’d also note that the bank isn’t exiting its large corporate client business. All in all, I would expect the costs of unwinding this business to cost around $0.10 to $0.12 per share over the next 12 to 18 months.

In the meantime, substantial uncertainties remain around Citi’s ability to extract full value for its Banamex operations (its Mexican banking subsidiary). The President of Mexico has set out several conditions for the deal that will complicate matters for Citi, including effectively pushing out potential non-Mexican bidders like BBVA (BBVA), HSBC (HSBC), and Santander (SAN), and insisting that there be no post-deal layoffs. While Lopez Obrador’s statements don’t have the force of law, as a practical matter Citi likely won’t get anywhere defying them given that the deal has to be approved by regulators appointed by Lopez Obrador.

The Outlook

Although I think this phase in the cycle favors core Main Street banking operations (a positive for banks like PNC, relatively speaking), I don’t ignore the recent improvements at Citi’s Treasury & Trade Solutions operations; these global operations make up a substantial portion of the company’s deposits, they’re quite profitable, and they require low levels of capital. At a time when the bank is having to shrink risk-weighted assets to boost its CET 1 capital ratio, success here is even more valuable.

Even so, I want to see better results from the core U.S. banking operations. As I’ve discussed before, Citi’s U.S. banking operations are different from more traditional branch banking operations, with a much greater focus on core urban markets (New York, Chicago, Miami, LA, et al) and a national digital bank. Card lending remains a key profit driver, and while Citi’s card operations are still quite competitive, many other banks are trying to grow their card businesses.

My concern is that Citi is going to see greater competition now on multiple fronts – more competition for national digital bank deposits (as other banks pursue expanded “branch-light” strategies), more competition for business loans in attractive urban markets, and more competition in its lucrative card businesses.

I haven’t been expecting a lot of growth from Citi, and that expectation remains in place. My core earnings modeling assumptions call for basically no growth from pre-pandemic (2019) levels to 2026 and only around 1% long-term core earnings growth. More concerning to me is the apparent erosion in the outlook for ROTCE. Management is still targeting a double-digit ROTCE, but I think it may not happen until 2024 or later, and this is a key gating event for a higher rating.

The Bottom Line

Citi looks undervalued on the basis of its core earnings potential and its likely ROTCE over the next 24 months, but the reality is that sub-10% ROTCEs are still a big issue with many investors and Citi has to show that it can generate attractive returns from the ongoing operations – including its U.S. core banking operations. I do still see undervaluation here, but I likewise see the risk that Citi remains a value trap if results from core banking don’t improve more meaningfully over the next 18-24 months.

This article was written by

Stephen Simpson profile picture
18.03K Followers
Stephen Simpson is a freelance financial writer and investor. Spent close to 15 years on the Street (sell-side, buy-side, equities, bonds); now a semi-retired raccoon rancher. That last part isn't entirely true. Probably.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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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