Citigroup Offers Decent Reward for Above Average Risk
Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Banking giant Citigroup (NYSE: C) has been mired in various types of problems, and “quick fix” solutions were never on the table. However, its Q3 earnings report suggests that a turnaround is happening much quicker than expected. But as the company works carefully to get its house in order, should investors rush to buy the stock with the uncertainty created now that CEO Vikram Pandit is stepping down?
Mixed quarter, could have been worse - but needs to regroup
With stronger-than-expected revenues and EPS, Citigroup pleased investors by exceeding both top and bottom line estimates. For the third-quarter, the bank reported adjusted revenues of $19.4 billion. While this represented a 7% drop year-over-year, it arrived 3% better than the $18.7 billion projected by analysts. Equally impressive, when excluding one-time items, Citi’s adjusted earnings per share rose 26% to $1.06 – beating analysts’ consensus of $0.97 per share.
As notable as this performance may be, bears may point out that Citigroup’s profits actually fell 88% to $468 million, after the company earned $3.77 billion in the year-ago quarter. Perhaps, but its EPS and revenues were adversely impacted by its 49% stake in Morgan Stanley Smith Barney, which generated a pre-tax loss of $4.7 billion. But this was expected. Of the 49% stake, Citi opted to absorb the damage on 35% of the valuation after announcing intent to sell 14% in that business.
What’s in store for the next quarter?
It seems the bank is more optimistic about its prospects than analysts, as average estimates have dropped from $1.04 to $0.99 over the past three months. As a result, during that span, fiscal year estimates have also moved down 4% to $3.89 from $4.07. However, that Citigroup exceeded its Basel III Tier 1 target of 8% during the quarter by 70 basis points to 8.6% is a welcomed indicator of what might result in Q4.
Basel III is a global regulatory standard on bank capital adequacy or a “recurring stress test.” It serves to prevent “too big to fail” type scenarios by enforcing not only bank capital requirements, but also adding minimum standards on liquidity and leverage. Basel III requires banks to hold 4.5% of common equity. In the third quarter, Citi almost doubled that requirement. Nonetheless, it opted not to revise fiscal year estimates, which was a disappointment.
Management did say that it still feels confident that it will be above 8% by year’s end. That seems to be a pretty safe assumption, if not very conservative. A different perspective would suggest over the long term, the bank should be able to perform much better.
For example, if investors take into account consensus estimates and add (reasonably) 140 basis points to the 8.6% the bank has already earned, it is sensible to project that Basel III Tier 1 common ratio can reach double-digits by fiscal year 2014.
Overall, the report was good, and could have been worse. While it’s great that Citi beat adjusted EPS estimates by almost 10 cents, if one looks objectively at the numbers, finding areas where momentum was lacking might be pretty easy - one such area being a modest 1% growth in loans. Consequently, Citi continues to experience shrinking consumer card balances.
Likewise, though the company is enjoying better than expected increases in new mortgages, Citi is underperforming when compared to the likes of JPMorgan Chase (NYSE: JPM), which experienced an increase of 8% in that area, and also Wells Fargo (NYSE: WFC), which was able to retain almost $10 billion in first mortgages.
As noted in the opening, assessing the risk-reward tradeoff of Citi continues to be the biggest challenge for investors. Having the largest global reach amongst all the banks means that the company is highly levered to the global economy. This is in addition to the dependency Citi still has on a housing recovery. On the other hand, it stands to benefit significantly better than its peers when both situations improve.
While there continues to be plenty of optimism with its recovery strategy, the bank is now installing new leadership with Pandit stepping down – adding a layer of uncertainty as to how the transition will unfold. However, this event should yield very little (if any) concern. Pandit’s replacement, Michael Corbat, has been at Citi for almost 30 years. Investors should expect no hiccups.
For the time being, relative to its peers such as Well Fargo and JP Morgan, which trade at 9 times and 10 times earnings, respectively, Citi’s stock seems undervalued trading at only 8 times earnings. Nonetheless, this is an investment for the long term – 2 to 3 years. Reasonable assumptions including sustained growth, both in domestic and global operations coupled with an anticipated recovery in the housing market could easily propel the stock to $55 - $60 per share by fiscal year 2014.
rsaintvilus has no positions in the stocks mentioned above. The Motley Fool owns shares of Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.