Citigroup Looks Undervalued Despite Its Strong Q1 Performance

Citigroup (NYSE:C) reported an extremely strong start to the year late last week, as the geographically diversified banking giant made the most of resurgent debt trading activity worldwide to report earnings that were well above investor expectations. ((Q1 Earnings Press Release, Citigroup Investor Relations, Apr 13 2017)) As we have pointed out on several occasions in the past, Citigroup is one of a handful of global banks that chose to focus more on growing their presence in the debt trading industry compared to the less capital-intensive equity trading business despite stringent capital requirement rules. And the benefits of this stand have been evident in the bank’s results over recent quarters. At the same time, the bank’s geographical diversification has helped it largely mitigate the impact of prolonged interest rates on its income statement while providing it significantly more growth opportunities than its other U.S.-based peers.

Then why exactly is Citigroup still trading at such a steep discount to its book value nearly a decade after the economic downturn? With the bank winding down its non-core Citi Holdings unit sufficiently by the end of 2016, its balance sheet is definitely much cleaner than what it was in early 2009. The organization-wide cleanup process also helped the bank report pre-tax operating margins in excess of 30% consistently for the first time since 2006. And with a common equity tier 1 (CET1) capital ratio of 12.7%, the bank is better capitalized than every other U.S. banking giant besides Morgan Stanley.

We believe that three primary factors are responsible for Citigroup’s stock performance. Firstly, the volatile nature of the securities trading business – and of debt trading in particular – has raised Citigroup’s overall risk profile for investors. Secondly, the strengthening U.S. dollar has resulted in the U.S. becoming a more important part of Citigroup’s business model, and the bank has been losing market share in the country’s retail banking space over recent years to its competitors. And finally, Citigroup’s poor record at the Fed stress tests over the last four years makes investors wary about its ability to return sizable cash in the near future despite its strong capital position.

While these concerns hold merit, we believe that investors may be focusing on them a bit too much. We maintain a $65 price estimate for Citigroup’s stock, which is roughly 10% ahead of the current market price.

See our full analysis for Citigroup

The table above summarizes the factors that aided Citigroup’s pre-tax profit figure for Q1 2016 compared to the figures in Q1 2016 and Q4 2016. The strong performance by the bank’s trading and investment banking division stands out here, as these revenues jumped almost $1 billion compared to the year-ago period. While the first quarter of the year is usually a seasonally strong period for investment banking operations, debt trading revenues were particularly upbeat for the period. The consumer banking division had a lukewarm period, though, as gains in North America and Asia were nullified by a reduction in revenues from Latin America. Other Citigroup revenues here represent the bank’s revenues from private banking, treasury services as well as securities services, and also saw notable improvements. The Corporate/Other division consists of Citigroup’s non-core operations and is affected considerably by one-time gains or losses, which explains the difference in these revenues.

Notably, Citigroup did well to report a reduction in compensation as well as other operating expenses y-o-y despite growing revenues by a sizable amount. Operating expenses also fell sequentially – indicating that the bank continues to work on streamlining its business model and cutting costs. The increase in compensation expenses compared to the previous quarter is justified given the seasonally high employee payouts for the first quarter coupled with an increase in the performance-linked component of salary. As revenue growth comfortably exceeded growth in expenses, Citigroup’s efficiency ratio (expense to revenue ratio) fell to below 58% for the quarter – nudging towards the bank’s target level of 55%.

Citigroup’s Trading Business Notches Best Performance In Three Years

Citigroup generated revenues of almost $4.4 billion through its trading operations (fixed income and equity taken together) for the first quarter of the year – a figure 15% higher than the $3.7 billion it reported a year ago as well as in the previous quarter. This was the combined result of elevated debt trading revenues (a trend seen over the last few quarter now), the rally in equity markets over the quarter and also seasonally higher trading volumes. You can see how changes to Citigroup’s debt trading yield affects our estimate for the bank’s share price by modifying the chart below.

In addition to strong trading revenues, Citigroup’s performance also received a boost from a notable increase in debt and equity underwriting fees. The table below details the changes in Citigroup’s investment banking revenues for Q1 2017 compared to Q1 2016 and Q4 2016.

Exchange Rate Movements Drove Lukewarm Consumer Banking Performance 

We believe that Citigroup’s biggest strength compared to its U.S. banking peers is its extensive global presence. This allows the bank to benefit from diversified revenue streams that are not subject to the restrictions faced by its peers who are largely focused on U.S. markets. The table below highlights the changes in Citigroup’s revenues for Consumer Banking (CB) and Institutional Securities Group (ICG) by geography.

While Citigroup’s retail operations saw marginal improvements in Asia as well as the U.S. compared to the year-ago period, revenues from Latin America have been hurt over recent quarters. However, adjusting Latin American consumer banking revenues for negative forex changes, revenues actually improved y-o-y from $1.1 billion to $1.15 billion. Given the current macro-economic trends, the forex headwinds are likely to remain a cause for concern to Citigroup’s profits over several quarters to come. You can see how lower consumer banking fees impact our estimate for Citigroup’s stock by making changes to the chart below.

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