by Ramu Iyer
Citigroup (C) has announced second quarter results which beat the consensus estimates of analysts, but were nevertheless down from the same quarter of the previous year. But, it does appear that Citigroup is managing to keep its head above water in these difficult times by slowly improving its financial position and its operations. Earnings per share were $.85 per share and, if you exclude the effect of CVS/DVA and the sale of its Akbank stake, earnings per share (EPS) stand at $1. Analysts predicted an EPS of $.89 per share. Analysts have been increasingly pessimistic about Citigroup’s performance. Three months ago, the consensus estimate was $.99 a share.
Since the financial crisis of 2008, there has been a noticeable change in Citigroup’s business mix. Consumer banking now makes up over 45% of earnings before tax compared to 18% earlier. During the same period, earnings from Securities and Banking have halved to 27% from 54 %. This has some important implications: Citigroup now looks less risky because it now has the look of a more traditional bank instead of an investment bank. Moreover, the consumer banking business has strong franchises in Latin America and Asia which means that the bank would benefit from the growth in these emerging markets. The North American consumer banking business showed increased earnings as a result of higher mortgage revenues but the gains were offset by the decline in the credit card business. Despite an effort to control costs, North American consumer banking costs showed an increase of 5% on a year on year basis. Revenues from the securities and banking segment declined, but an 8% decrease in expenses helped to generate a 16% increase in net income. Transaction services revenue increased by 5% year on year, and, as a result, the business achieved a 6% increase in net income.
Before I proceed with further analysis and comparisons, it is important to understand Citigroup’s composition so that you can achieve a more meaningful understanding of its operations. You should really look at Citigroup as two distinct banking companies in one. Citicorp is made up of businesses that Citigroup wants to retain and grow, and these businesses include consumer banking, corporate and institutional banking, and transaction services. Over 95% of Citigroup revenues are derived from Citicorp. The other company is Citi Holdings, which is often referred to as the “bad bank”. This company holds assets, mainly toxic mortgages, which Citigroup will try and sell off or, in the absence of buyers, allow them to run down. This continues to be the major problem area, even though the bank has aggressive sought to reduce the size of the portfolio through asset sales, and has, on average, sold $40 billion worth of toxic assets every quarter since 2008. To give you some perspective on the problem, Citigroup without Citi Holdings has a return on equity that is almost double the return on Citigroup including Citi Holdings.
This has been a difficult quarter for the banking industry, and combined revenues were the lowest since the low point of the 2008 financial crisis. Traditional investment banks suffered the most because of a decrease in deal making and trading, and both Morgan Stanley (MS) and Goldman Sachs (GS) reported double-digit declines. The traditional banks are able to offset this decline because of their traditional businesses but did not entirely succeed. Only Bank of America (BAC) and Wells Fargo (WFC) managed to report year on year increases in net income, and even Bank of America managed this because of the reduction in mortgage loss reserves. Only Wells Fargo managed a double-digit increase from operations because of increased revenues from the mortgage business. Citigroup is roughly in the same position as Bank of America and has a lot of catching up to do with the likes of JPMorgan Chase (JPM) and Wells Fargo.
Amidst this gloom, there was a bright spot for Citigroup shareholders as the bank disclosed that it had received an offer from Morgan Stanley to acquire an additional 14% in their jointly owned Morgan Stanley Smith Barney brokerage. Currently, Morgan Stanley holds 51%, while Citi holds 49%. The unit was created in 2009 when Citigroup was desperate for cash and received $2.7 billion in cash and a minority interest from Morgan Stanley. But the Wall Street Journal says that previously, analysts had valued Morgan Stanley Smith Barney at between $15 billion and $24 billion. Responsibility for determining the value has now been entrusted to an independent appraiser.
Both Citigroup and Bank of America have just half the market capitalization of financially stronger megabanks JPMorgan Chase and HSBC (HBC), which means that they have less of a capital cushion to protect them from global economic uncertainties. This is reflected in the price/book ratios with both Citigroup and Bank of America at around 40%, while JPMorgan Chase trades at 80% and HSBC at 90%. Citigroup certainly looks cheap, but the big question is whether it is worth an investment now. Its transformation from an investment bank into a traditional bank certainly provides more stability, and its strong franchise in emerging markets in Latin America and Asia bodes well for the consumer banking business, which is now the mainstay.
I do not see any catalysts that will provide gains in the short-term, and even dividend yields are subject to regulators approving dividends and buybacks, which they did not do recently. I do not recommend buying Citigroup unless you have the patience to wait for at least two to three years and the patience to deal with Citigroup’s temporary setbacks. If you have an existing holding in Citigroup, I recommend holding onto it.