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Mr. Market has been shooting first and asking questions later on many stocks and many industries. Since 2008, banks always seem to endure more than their fair share of pessimism relative to the risks and business prospects, and Citigroup (NYSE:C) is a great example of that. Without a doubt, the global economy is under severe pressure driven by rampant inflation, and a disastrous war in Ukraine. Citigroup and other banks, however, are some of the primary beneficiaries of higher rates, through rapidly rising net interest income. Naturally, there are other areas in these diversified enterprises that are negatively impacted, such as Investment Banking, but over the long-term a higher rate environment should be very favorable for earnings. Credit and capital are very strong, and it is hard to envision a scenario in which the big banks like Citigroup don’t remain robustly profitable, despite valuations that imply a disastrous future. Investors willing to buy when it feels hardest to do based on recent pain, are likely to be richly rewarded as events unfold.
Citigroup reported a solid 3rd quarter in a brutal environment, generating $18.5B of revenues, which were up 6% YoY, bolstered by higher interest rates and the sale of the Philippines Consumer business. Net income of $3.5B was down 25% on higher loan provisioning and weak investment banking, offset by solid net interest income growth and fixed income trading results. Earnings per share of $1.63 were down 24% YoY and the ROTCE was 11%. Excluding divestitures, EPS and ROTCE would have been $1.50 and 7.5%, respectively. Net interest income was $12.56B in the quarter, up from $11.96B in Q2. Ex-markets NII was $11.34B, up from $10.58B in Q2. These figures are both up nearly $2B YoY highlighting the massive tailwind of higher rates. NIM rose to 2.31%, up from 2.24% in Q2, and 1.99% at the same time last year.
Cost of credit was $1.4B, as a result of $900MM of net credit losses, and an ACL build of approximately $500MM, primarily driven by loan growth in PBWM. At the end of Q3, Citi had a whopping $18.7B in total reserves, with a reserve-to-funded loan ratio of approximately 2.5%. YTD, Citigroup has already earned $12.332B of net income, or $5.84 per share. The ROE and ROTCE YTD, have been 8.6% and 9.9%, respectively. These numbers relative to a share price, barely hovering over $40, speak to the absurdity of Mr. Market’s current evaluation of Citigroup’s common stock.
Citi’s crown jewel TTS business recorded 40% YoY revenue growth, driven by 61% YoY growth in net interest income, and non-interest revenue up by 8% YoY. Trade loan origination was up 27% and cross-border transactions were up 10% YoY. Security Services revenue was up 15% YoY driven by higher rates, and the division has onboarded $1 trillion dollars of AUC/AUA YTD. These key accrual businesses are areas where Citigroup has some natural competitive advantages and should propel revenue and earnings growth over these next 3-5 years. Average loans were down 2% YoY to $655B due to currencies and wind-downs, while average deposits were down 2% to $1.316 Trillion, but up on a constant currency basis, unlike many of its peers.
Fixed income revenues were up 1% YoY and are up 9% YTD, lapping a strong 2021, but total trading revenues were down 7%, with weak derivative demand hurting equities performance that was down 25%. Branded Cards saw very impressive growth with spend volume up 14%, and interest-earning balances up 9%. New account acquisitions were up 10% YoY, pointing to further growth. Wealth Management revenues were down 2% YoY largely due to weakness in Asia, while revenues were up 4% YoY ex-Asia. Wealth Management continues to be a key growth platform for Citigroup as it leverages its international commercial banking footprint. Client advisors increased by 5% YoY and ultra-high net worth client acquisitions were up 7% YoY. Investment Banking was exceptionally weak, as geopolitics and fears of a recession dramatically reduced deal flows, leading to that business being cut in half in the quarter. Citigroup took about $110MM in losses related to marks on loan commitments and sales
Citigroup saw material improvement in its CET1 Capital Ratio, which ended the quarter at 12.2%, up from 11.9% sequentially, and from 11.7% at the same time last year. Management is building to 13%, allowing for a 1% management buffer. Tangible book value per share stood at $80.34 at the end of Q3, up 2% YoY, which is a good achievement giving the headwinds on AOCI, driven by higher rates and declining bond prices. Citigroup returned $1B to shareholders via common dividends, while pausing on share buybacks, as it seeks to hit that 13% CET1 goal by the middle of next year. Buybacks are clearly one of the easiest ways to grow intrinsic value given current share prices, so I’d like to see management show a little flexibility on the timing of the 13% goal, as even only $1B a quarter of buybacks at nearly 50% of tangible book can go a long way. The SLR improved to 5.8% from 5.6% in Q2, and Citigroup has abundant liquidity resources of $994B.
Citigroup is making really solid progress on CEO Jane Fraser’s plan to divest many of the international consumer banking operations. In the 3rd quarter, Citi announced the wind-down of the UK consumer franchise, completed the sale of the Philippines consumer business, and continues to wind-down the Russian and Korean operations. Citigroup continues to grow its expenses at a faster rate than its revenues, due to its business transformation. 3Q expenses were up 8% or $900MM YoY to $12.7B, but ultimately these headwinds should lead to the lifting of the consent orders, and more efficient operations. It’s impressive that Citigroup is reporting strong profits, despite this transitional period, and while next year expenses will probably grow again, the gap between revenues growth and expenses should begin shrinking.
I don’t discount the fact that we might be in a recession already, or at best we are likely heading into one. Citigroup’s biggest source of risk in a recession would likely be seen in its credit card portfolio, but I believe those risks are largely already reflected in the current loan loss reserves. Citigroup’s US credit cards portfolio is 81% FICO scores above 680. NCL’s in the 3rd quarter were just $700MM, versus $1.4B on CECL Day 1. NCL’s were 13% higher YoY from near historically low levels, reflecting normalization, particularly in Retail Services. The Allowance for Credit Loss Leases/Loans stood at 3.7% in all of PBWM, and a whopping 7.5%, which is consistent with Day 1 CECL. CECL incorporates recessionary scenarios and credit has been outperforming those expectations, so Citigroup is being conservative. Now as the economy worsens, Citi and other banks will have to add to reserves, but it should be very manageable. I’m still amazed that with the massive provisions seen in 2020, the banks were still able to remain profitable, and I don’t see this being anything like that from a credit stress standpoint.
The ICG business is not highly susceptible to major credit losses, given 83% of its exposure is investment grade, mostly related to strong multinationals. Much of the exposure has collateral behind it and we’ve seen in prior crises such as with energy when oil prices have collapsed, that even in extremely stressed scenarios the ICG unit hasn’t taken much of a hit whatsoever. Nonaccruals are only .4% as of the end of Q3, versus .6% on Day 1 CECL, while the allowance for credit losses stood at 1%, versus .6% on Day 1 CECL.
The bottom line is that Citigroup is priced as though it has the same risk profile as 2008, and that the economy is in close to as bad of shape. Not every recession is a global financial crisis, and while I am concerned about the war and the impacts of higher rates/inflation greatly impacting various sectors of the economy, I don’t see a scenario where Citigroup is not solidly profitable, which is very different than 2008. At a recent price of $43.23, Citigroup trades at just 53.8% of tangible book value per share, and about 6x earnings. The stock offers a very attractive 4.7% dividend yield and within a quarter or two, we should start to see the immensely accretive stock buybacks return in force.
Management is executing a good plan to simplify the operation and expand into key areas of competitive strength. I believe within a few years, an 11-13% ROTCE is realistic on a sustained basis, which would put normalized earnings power at between $8.8-$10 per share. The stock is easily worth at least $80 with potential growth far beyond that. As the company proves to easily withstand this recession, as well as its strong performance during the COVID/Lockdown recession of 2020, Citigroup realistically should deserve a higher valuation. Investors would be wise to take advantage of the disconnect between price and value, which is at some of the highest levels we have seen in the last 20 years.
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