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Tickers in this Article: C, MS
We are reaffirming our Neutral recommendation on Citigroup Inc. C) based on its fundamentals, shedding of non-core assets and strategic expansions in light of the current economic environment and litigation hassles.

Second Quarter Results

Last month, Citigroup reported second quarter 2012 earnings per share of 95 cents that surpassed the Zacks Consensus Estimate of 88 cents on lower loan loss provision, higher transaction services revenues and a drop in expenses. Results included a net loss of $424 million (pre-tax) from the 10.1% stake sale in Akbank.

However, the top line continued to recede and there was an overall drop in revenues in the quarter, which also fell short of the Zacks Consensus Estimate. Yet, asset quality showed improving trends and the company continued to build up its capital levels.

Our Viewpoint

Going forward, we believe that Citigroup has a strong potential to augment its profitability given its diverse business model, which generates a significant portion of revenue from outside the U.S. Its core business, Citicorp, remains attractive and the company continues to expand its business in the emerging markets.

Also, Citigroup remains focused on controlling its expenses and it is among the best reserved banks.  Moreover, the company's long-term strategy to shrink its non-core assets and increase its fee-based business mix would also improve valuation over time.

Notably, in an effort to cut down its non-core assets, Citigroup agreed to sell its Diners Club UK and Republic of Ireland card issuing businesses to Affiniture Cards Ltd., a private investor group. The financial terms were undisclosed. In fact, Citigroup had partly sold off its Diners Club franchisee business over the past few years.

We believe that the company's long-term strategy to shrink non-core assets will ultimately reduce its risk profile and free up capital to be invested in its core businesses. Moreover, Citigroup's decision to go against any hike in its shareholder payout in 2012 and instead boost capital levels would serve as a long-term catalyst for the stock.

Although Citigroup's underlying franchises of the consumer businesses have remained strong, revenues have continuously been under pressure for the past several quarters. Considering the protracted economic recovery and the low interest rate environment, any substantial growth in the top line is expected to remain limited in the upcoming quarters.

Though the strategy to shrink non-core assets would improve valuation over time, the shrinking of the Citi Holdings portfolio would result in revenue challenges, partially restricting the upside potential of the stock.

Also, given its scale of business worldwide, Citigroup continues to be subject to a significant number of new regulatory requirements and changes from numerous sources in both the U.S. and in the international markets. In addition, mounting legal claims can pose a risk for Citigroup, tarnish its image and exhaust its financials, which could have been otherwise invested in growth initiatives.

We also look forward to the third party appraisal results of the Morgan Stanley Smith Barney unit, a Citigroup and Morgan Stanley (MS) brokerage joint venture (JV). According to a filing made by Citigroup with the Securities and Exchange Commission in July, the surprisingly low valuation made by Morgan Stanley for the JV may result in Citigroup incurring a substantial charge in the third quarter of 2012.

Morgan Stanley, which currently holds a 51% stake in the brokerage JV is making efforts to buy an additional 14% stake from Citigroup. While making such deals, Citigroup has valued its 49% stake in the JV at about $11 billion. However, quite astonishingly, Morgan Stanley has valued the full brokerage firm at around 40% of Citigroup's valuation for the JV.

This wide variation in the valuation of the brokerage firm by Citigroup and Morgan Stanley has called in for a third party appraisal process. At the end of August, this third party appraisal process is to be accomplished and by September 7, the 14% stake sale by Citigroup is scheduled to be completed.

We believe that the stake sale is a strategic fit for Citigroup. Though this wider gap in the valuation of the JV by Citigroup and Morgan Stanley has led to the involvement of the third party appraisal process and could result in Citigroup shelling out non-cash charges in the third quarter, the sale would ultimately help Citigroup in roping payments and boosting its Tier 1 Common regulatory capital ratio for Basel III purposes.

As such, the risk-reward profile of Citigroup seems balanced and therefore we have reaffirmed our Neutral recommendation on the stock. Moreover, shares of Citigroup currently retain a Zacks #3 Rank, which translates into a short-term Hold rating.

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