Has Citigroup Cleared The Decks, Or Found New Problems?

By Stephen D. Simpson, CFA | January 16, 2013 AAA

Something is oddly logical about the performance of Citigroup (NYSE:C) shares over the past year. While this bank clearly is not back to operating on par with banks such as JPMorgan (NYSE:JPM) or U.S. Bancorp (NYSE:USB), it's in better shape than Bank of America (NYSE:BAC) in many respects. Accordingly, its 2012 stock performance seems fair in the context of being about halfway between the "good banks" (which matched or slightly beat the S&P 500) and the "troubled banks" that saw significant share price appreciation.

That's all in the past, however, and investors are now trying to digest a fourth-quarter report that was surprising and disappointing in a few respects. With a new CEO running the show, this may have been a "kitchen sink" quarter designed to sweep away past problems. Still, it raises the specter of future problems and reminds investors that these banks are still not out of the woods.

SEE: The Industry Handbook: The Banking Industry

Fourth Quarter Walloped By a Big Provision
Citigroup is one of those banks that reports a laundry list of charges, "items" and assorted accounting detritus. Consequently, there's some variability between each analyst's "adjusted earnings." That said, it's safe to say that Citi did worse than expected this quarter, largely due to higher-than-expected provisions and lower resulting reserve releases.

Operating revenue rose 3% from last year and fell about 2% from the third quarter - a little weaker than the aforementioned U.S. Bancorp or Wells Fargo (NYSE:WFC), but in line with Bank of America. By unit within global consumer banking, Latin America, Europe and Asia saw modest growth (very modest in Asia's case) while North America was slightly down.

Net interest income increased by 2% sequentially. Net interest margin improved slightly to 2.93%, and Citigroup's NIM is actually pretty high by money center banks' standards. Also unusual was that Citi's average earning assets were flat sequentially, where most banks have reported growth.

Fee income was a little disappointing, falling 9% sequentially. Investment banking fees increased about 8%, but fixed income trading revenue fell 27% - worse than both JPMorgan and Bank of America. Core adjusted expenses increased a bit and drove the efficiency ratio back over 70%, but there was a two-point improvement from last year.

SEE: Analyzing A Bank's Financial Statement

Higher Provisions are Definitely Interesting
Whereas Citi saw about 19 cents per share of benefit from loan loss reserve releases in Q3, that plunged to 2 cents this quarter due to higher provisions. These provisions didn't come from the "holdings" operation (basically Citi's "bad bank"), but, rather, seemed centered on Citi's North American cards business. Given the consistent trends across the board (JPMorgan, Wells Fargo, Bank of America and U.S. Bancorp) with lower loss experiences in cards, this is surprising. It's worth wondering whether Citi is cleaning up old issues or seeing worsening trends on the horizon.

Fix It Up, Cut Costs, Get Back to Business
When so many banks clearly made huge lending mistakes during the housing bubble (and magnified those mistakes by being slow to recognize losses, attempting to pass along bad mortgages and/or cutting corners with the foreclosure process), it may seem a little unfair to castigate some banks more than others. That said, Citi seems to have dealt with its problems more directly than Bank of America, and the finish line seems a little closer as a result.

Clearly bad credit levels are still elevated, and there's more work to do. That said, I believe the company can also start devoting more attention to fixing its basic operations. Citi has lost a lot of share in the U.S. mortgage market, and regional and community banks have moved aggressively to take deposit share as well. Expenses are also still bloated here, and improving the company's overall operating efficiency is likely to be a key focus over the next two to three years. Said differently, I think Citigroup is close to transitioning from repair mode into self-improvement.

SEE: The Banking System

The Bottom Line
Citi is still very much levered to an ongoing improvement in the housing market and personal credit. That said, I believe that the company can regain a 9% return on equity down the line, an estimate that fuels a mid-$40 price target in my return on capital model. Improving results should slowly lead to a better multiple on tangible book value. While a 0.8 multiple is probably fair today, a 1.0 multiple could be in the cards if the company continues to hit its credit and cost targets.

Although I do think Citi is undervalued in its long-term potential, I find it hard to get excited about these shares when stronger banks such as U.S. Bancorp and Wells Fargo trade at discounts to their fair value. I don't want to understate the potential rewards of better performance from Citigroup, particularly as many good banks will see real pressure on spreads and loan growth this year. That said, there's still a fair bit of risk in the Citi story, and that may not appeal to all investors.

At the time of writing, Stephen D. Simpson owned shares of JPMorgan for more than five years.

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