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Not all earnings beats are created equal, and in the case of Citigroup‘s (NYSE:C) third quarter results, the stronger-than-expected net interest income growth is offset at least in part by the company having talked down expectations during the quarter (beating a lowered bar, in other words). What’s more, the primary drivers of the beat (rate leverage and credit costs) seem unsustainable at this point in the cycle, and the company’s lack of operating leverage is likely to loom larger over sentiment.
I do think that Citi is undervalued, and I think the Street gives the bank (and its stock) too little credit for the transformative actions underway. That said, this turnaround has been long in coming and investors are understandably skeptical that the bank is finally on the right track. Moreover, with weak prospects for near-term operating leverage and growing risks to the macro environment in 2023, I can see why institutional investors aren’t rushing to step into what is still a multi-year self-improvement story.
A Bottom Line Beat On Strong Rate And Credit Leverage, But With Some Issues
Citi beat expectations, but those expectations were guided lower by management during the quarter, and most of the drivers of the upside are likely to peter out from here as rate leverage and credit quality become less significant positive drivers.
Adjusted revenue declined 1% year over year and 9% quarter over quarter, with strong net interest income (up 18% yoy and up 5% qoq) offset by a 31% qoq decline in fee income. Net interest income was comfortably above expectations (about $0.17/share), but fee income was weaker than expected on weaker investment banking (down 64% yoy and down 22% qoq, missing by $0.12/share) and trading (down 7% yoy and down 24% qoq, missing by $0.06/share).
Expense performance was unimpressive, with expenses up 7% yoy and up 2% qoq on an adjusted basis, driving around $0.03/share of downside relative to sell-side expectations. To be fair, expectations for operating leverage were weak already given Citi’s ongoing reinvestment into its turnaround plans, and operating leverage was better in core banking than in the trading/investment banking operations.
Core adjusted pre-provision profits declined 17% yoy and declined 28% qoq, missing by around $0.05/share. That miss was driven by the Institutional Client Group (i-banking and trading). Better credit added a bit to earnings, and Citi likewise benefited from a lower-than-expected tax rate.
Weaker Lending Growth And Likely Limited Leverage From Here
Average loan balances declined 2% yoy and less than 1% qoq. Not only was the average loan balance for the quarter about 3% below expectations, but Citi noticeably underperformed the 10% yoy and better than 1% qoq growth in average loans for large banks in the third quarter.
Deposits were flattish, up a bit yoy and down a bit qoq, but deposit costs rose 69bp yoy and 55bp qoq. Higher funding costs and rising deposit betas are an industrywide issue that I’ve discussed many times this year, but Citi’s funding cost increases were the highest of the large banks that have reported so far – about 20bp-30bp higher than First Republic (FRC), JPMorgan (JPM), PNC (PNC), and U.S. Bancorp (USB), and even higher than Wells Fargo‘s (WFC) 10bp yoy and 12bp qoq increases.
Herein is one of the issues with Citi’s model at this point in the cycle – Citi doesn’t have the strong core deposit franchise that banks like Bank of America (BAC), PNC, and Wells enjoy, and the bank is more reliant on competitively-priced CD financing. Likewise, with Citi needing to reinvest in its systems and restructure its operations to drive double-digit returns in the coming years, the bank has weaker operating leverage than its mega- and large-cap rivals.
I’m also not as bullish on the opportunities to drive further meaningful upside from credit costs. Credit losses were remarkably good during the pandemic downturn, and Citi’s report in the third quarter was good, but charge-offs are near record lows for the bank across most of its businesses, and I expect costs to increase as rates increase and the economy slows.
The Outlook
As I’ve written in prior pieces, I believe money center banks like Citi are not likely to lead a near-term rebound in bank stock sentiment. Instead, I expect regional and community banks with more substantial “Main Street” banking operations to outperform as banks like Citi and JPMorgan work their way through capital-building and limited operating leverage as they look to position their businesses for better long-term growth.
I do expect Citi to see a year-over-year decline in earnings in 2023 (that’s not a change to my expectations), and I do see some risk of higher opex spending next year, though the bank is making better progress on capital building. Rising deposit costs remain a significant risk, and I do see some risk to loan demand if the economy decelerates more noticeably in 2023.
I do expect a return to growth in FY’24, and I think Citi can achieve mid-single-digit core earnings growth for a few years thereafter with its restructured operations, and long-term core adjusted earnings growth in the very low single-digits. I’m still not expecting the bank to achieve double-digit ROE or ROTCE anytime soon, though, and that remains an important sentiment headwind.
The Bottom Line
I value banks through a combination of discounted core earnings, ROTCE-driven P/TBV, and P/E, and Citi continues to look undervalued. Even if I use a 25% haircut to the normal “fair” TBV multiple for the ROTCE I expect in FY’23 (around 8.5% now), the shares look undervalued below the mid-$60s, and long-term discounted core earnings support a fair value in the $70’s provided the company can show minimal growth relative to the pre-pandemic baseline.
The investment story for Citi remains frustratingly the same – it’s about the bank’s management building confidence and credibility in its ability to execute on this latest turnaround plan and for that plan to drive a sustained improvement in operating results (namely, double-digit returns). I still believe that Citi is on the right path now, but I also acknowledge that this is a story that’s going to take time to work, and I can appreciate why investors may look to other names with less execution risk and/or more near-term upside.
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