Citigroup Will Give You The Risk, But What About The Reward?

| About: Citigroup Inc. (C)
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I don't know if this is an argument in favor of the efficient market hypothesis, but I'm struck by how many large banks seem similarly under-priced on the basis of an excess return model. While the projected return on equity and discount rate for Citigroup (C), JPMorgan (JPM), U.S. Bancorp (USB), and Wells Fargo (WFC) are all different, the resulting fair values suggest about 30-35% return potential.

In the case of Citi, though, it's a rather different risk-reward trade-off than for the others. Citigroup has by far the largest global retail banking franchise and the most upside if ROEs recover further than expected, but also arguably the worst risk management and the most work yet to be done in repairing the balance sheet and business.

Q1 Showing A Fair Bit Of Progress

If you ask 10 analysts you'll probably get about 15 different versions of adjusted numbers at Citigroup, so your mileage may vary. Unfortunately, this is just not a case where out-of-the-box GAAP works well.

Adjusted operating revenue rose about 1% at Citigroup, with a small decline in net interest income that actually surpassed expectation. Net interest margin held steady sequentially (and beat estimates) at 2.90%. While it's low relative to the likes of Wells Fargo and U.S. Bancorp, it's better than that of JPMorgan.

Fee income was a little soft, but Citi made good progress on expenses. Unfortunately, they had (and have) a lot of work to do here, so the efficiency ratio is still not so great.

Loan growth was mixed. Though a little soft in Asia and a little weak in North America (in part due to a weaker card business), loan growth was strong in Latin America and the EMEA region. As for credit, Citi saw a minor increase in the non-performing asset ratio, but Citi continues to make progress with its credit quality.

Try, Try Again With The Capital Test

Citigroup was one of the very few companies to fail the Fed's CCAR test, but Citigroup's margin of failure was quite slight. While the resubmission process will probably mean that Citi won't raise its dividend until the end of third quarter, Citi is actually in pretty fair shape now with its capital.

But it's coming at a cost. Because the new Basel 3 rules punish minority stakes in financial companies, Citi is selling a big chunk of its stake in Turkey's Akbank and sold its stake in Shanghai Pudong. Citi is likely also hoping that Morgan Stanley (MS) moves to buy more of its stake in Morgan Stanley Smith Barney.

So, How Is This Bank Doing?

In comparison to the likes of Wells Fargo, JPMorgan, or U.S. Bancorp, Citi still has its problems, though I would argue that the bank is in better shape than Bank of America (BAC) in many respects. What's more, Citi has a solid business in areas like Mexico (Banamex) and worldwide coverage from South Korea to South Africa.

When all the dust is cleared and things like DVA impacts and reserve releases are factored out, Citi is doing surprising well in investment banking and trading, reasonably well in transaction services, and okay in retail banking.

Plenty can yet go wrong. Things have been going too well for too long in Latin America to feel entirely comfortable there, and Citi's retail branch network is seeing a great deal more competition. Remember, too, that this is a bank with a long history of reactive risk management, so if conditions are eroding it seems fair to assume Citi will be the last to tell us about it. That said, pre-crisis Citi had a very good run with respect to return on equity, and this remains a business that can do better.

The Bottom Line

As I mentioned in the open, all of these major banks seem to be equally undervalued with respect to their particular characteristics. In the case of Citi, I use both a higher discount rate and a lower long-term ROE assumption (10% versus low to high teens for JPMorgan, Wells Fargo, and U.S. Bancorp).

With this bank, then, there is definitely more upside potential (an extra 1% of ROE means an extra $6-$7 of implied fair value). There's still ample opportunity for it all to go very wrong. If you buy Citigroup, you're definitely taking on the risk but getting no such guarantees with the reward.

Disclosure: I am long JPM.