Citigroup Earnings: Is the Stock as Cheap as It Seems?
On Monday morning, Citigroup (NYSE:C) reported its second-quarter earnings figures. The stock rose over 3 percent in early trade, giving the impression that the company reported solid earnings. However, I think the rise in the stock was more of a relief rally following the company’s settlement with the Department of Justice over its illegal sales of RMBS. The company will have to pay $7 billion, which is more than analysts had estimated. However, it is also less than the DoJ had been seeking. Furthermore, I think investors were just glad that the uncertainty surrounding the lawsuit has ended.
But while this may be a good thing, I think holders of Citigroup shares should consider selling into the rally, which I suspect that it could have some legs over the next week or two. First, if we look at the company’s basic metrics, it is somewhat disappointing. Year-over-year quarterly revenue shrank 6 percent to $19.4 billion. Furthermore, adjusted earnings declined from $4.2 billion to $3.9 billion.
These figures don’t look so bad, but there are a couple of things that I find troubling. The first is that the company’s loan loss provisions shrunk year over year to $17.9 billion from $21.6 billion. When a bank is concerned about defaulting loans, it takes money and segregates to cover these anticipated losses, and on its income statement it takes a loss equivalent to the amount that it segregates. But when it moves this money back onto its “regular” balance sheet, it books a profit. This rapid decline in loan loss provisions is likely behind a sizable portion of the company’s earnings, and so I would view the above number with a grain of salt.
We should also note that the company generated a lot of growth in its investment banking segment. This essentially means that businesses were completing more deals (e.g. mergers and acquisitions) and it employed Citigroup as an advisor. This is good, but it is also growth that is likely unsustainable. Given how low interest rates are, companies are finding it profitable to make deals because it is so inexpensive to borrow money and to use that money in order to buy a company. But if interest rates rise, we can see a significant slump in M&A activity and Citigroup’s investment banking segment by extension.
Finally, it is worth noting that the company’s net interest margin improved to 2.87 percent. Now, on the surface this looks good. But in general interest rates have been falling, so how do we explain this? In all likelihood the company’s loan portfolio has become riskier. While this is fine while real estate prices are rising we saw in 2008 that a higher risk portfolio can prove to be deadly for a bank.
Given these points, I don’t think Citigroup’s earnings were that great. Furthermore, I don’t think the stock is cheap despite the fact that it trades at below its stated book value and despite the fact that the shares trade with a low double digit price to earnings ratio. More generally, however, investors need to keep in mind that banks are complex institutions. Their financials may look simple as you can find terminology such as “EPS” or “revenue” or “book value,” but as we have seen there is a lot under the hood. So for retail investors, financials are risky given how complicated they are.
If you must own a financial, consider a regional bank that makes money the old fashioned way of borrowing money at one rate and then lending it out at a higher rate for a profit. While it may sound boring, and while you may have to pay more than 12-times earnings and 90 percent of book value, at least you will understand what you own.
As we have seen, Citigroup may look cheap based on the number presented to us, but I don’t think it is, and I think investors should consider selling the strength we are likely to see over the next couple of weeks.
Disclosure: Ben Kramer-Miller has no position in Citigroup.