Strong Q2 Performance, Recently Announced Payout Hike Justify $73 Price For Citigroup’s Shares

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Citigroup (NYSE:C) followed up an extremely strong operating performance for the first quarter of the year with another earnings beat for the second quarter announced late last week. While the banking giant’s consumer banking business leveraged its diversified geographical footprint to make the most of improved economic conditions globally, its debt trading desk did very well despite the industry-wide reduction in activity. Also, the impact of the Fed’s rate hikes began to show on its top line, as the resulting improvement in net interest margins helped net interest revenues recover from the unusually low figure of under $10.9 billion for the previous quarter (which was the lowest in nearly eleven years) to $11.2 billion this time around.

We believe Citigroup’s Q2 results showcase the strength of its business model. While the bank’s wide geographical presence clearly gives it an advantage over peers, the bank is just beginning to reap the benefits of its decision to focus on debt trading when other major investment banks slashed their presence in this space. At the same time, Citigroup is better capitalized than every other U.S. banking giant besides Morgan Stanley, with a common equity tier 1 (CET1) capital ratio figure of 13%. While the excess capital has had a negative impact on Citigroup’s return on capital (RoC) figures over recent years – leading to the bank trailing its peers on this key operating metric – we believe that it also puts the bank in a strong position to return cash to investors in the future. Citigroup has already demonstrated this with its recent plans to return almost $19 billion to shareholders by the end of June 2018.

Investors have clearly taken note of the upside Citigroup’s shares present in the long run, which is why its share price jumped to a post-recession high of almost $69 last month – making it the first time the bank’s shares traded above their tangible book value in nearly ten years. But we believe that investors remain too cautious about the bank, and have revised our price estimate for Citigroup’s stock upwards from $65 to $73.

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See our full analysis for Citigroup

The table above summarizes the factors that aided Citigroup’s pre-tax profit figure for Q2 2017 compared to the figures in Q2 2016 and Q1 2017. As we mentioned earlier, revenues for the quarter were driven by a strong performance by Citigroup’s core consumer banking division. Notably, the banking giant witnessed a year-on-year increase in revenues for its consumer banking operations in each of its reported geographical units of North America, Latin America and Asia (including EMEA). Although the bank’s trading and investment banking division reported a reduction in revenues year-on-year, the reported numbers were far better that the guidance Citigroup provided in late May. Other Citigroup revenues here represent the bank’s revenues from private banking, treasury services as well as securities services – all of which were upbeat in Q2. Finally, the reduction in revenues for Corporate/Other division is a result of the bank’s focus on slashing its non-core operations, and is a desirable trend.

The increase in Citigroup’s compensation expenses compared to Q2 2016 is justified given the better operating performance this time around, which would have resulted in higher performance-linked employee payouts. And the bank’s streamlining efforts also led to a decline in other operating expenses year-on-year. That said, Citigroup’s efficiency ratio (expense to revenue ratio) increased to 59% in Q2 2017 from below 58% in Q1 2017 – moving away from the bank’s target level of 55%. Also, an increase in card charge-offs across the industry also prompted a sizable increase in loan provisions for the period. This was largely expected, though, and we expect card provision to continue to grow for the next couple of years before normalizing, as detailed in the chart below.

Trading Business Exceeds Weak Q2 Expectations

Citigroup generated revenues of $3.9 billion through its trading operations (fixed income and equity taken together) for the first quarter of the year – a notable reduction from the figures of $4.2 billion a year ago and of $4.4 billion in the previous quarter. The decline was primarily due to a reduction in bond trading volatility over the quarter – something that prompted Citigroup to forecast a 12-13% decline in total trading revenues compared to Q2 2016 in late May. However, the actual decline was just 7% year-on-year – much better than the 13% decline in total trading revenues reported by peer JPMorgan. 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.

While trading revenues fared better than expected, Citigroup also roped in considerably higher advisory and underwriting fees, as its wallet share of global M&A advisory, debt origination as well as  equity underwriting fees increased in Q2 2017. The table below details the changes in Citigroup’s total investment banking revenues for Q2 2017 compared to Q2 2016 and Q1 2017.

Consumer Banking Business Is Generating More Revenues, But Expenses Will Need To Be Kept In Check

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.

Notably, Citigroup’s retail operations saw an improvement in revenues across reported geographies. This was aided by strong loan growth globally, and also by a recovery in card balances after declining for three consecutive quarters. Card purchase volumes also jumped to an all-time high of $125.3 billion in Q2 2017 – boosting card fees.

At the same time, Citigroup reported a sequential improvement in net interest margins. This, coupled with an increase in interest-earning assets, helped net interest revenues recover in Q2. It should be noted that Citigroup has only about 50% of its asset base in North America, with the remaining being spread across the world – as opposed to other U.S. banking giants that have their assets concentrated in the U.S. While this allowed Citigroup to fend off the impact of the prolonged low interest rate environment on its income statement to a large degree, this also means that the bank will see more muted gains from the Fed’s ongoing rate hikes compared to its peers.

You can see how changes in net interest margin for consumer loans impact our estimate for Citigroup’s stock by modifying the chart below.

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