Citigroup Q3 Earnings Preview: Why I Stay Long (NYSE:C)

Investment Thesis

The financial world watches with bated breath as the curtain rises on Citigroup Inc.’s (NYSE:C) anticipated Q3 earnings (expected pre-market on October 13th). With the U.S. economy playing the Fed’s challenging “higher for longer” game against inflation, Citigroup is at the crossroads of testing its operational mettle.

From significant YoY expenses in the corporate realm and heavily influenced revenue expectations to transformative investments and strategic wind-downs – it’s a whirlwind of numbers and narratives.

C’s positive turnaround developments, combined with its tangible book value per share of $85.47, reaffirm the strong buy for the foreseeable future.

Citigroup Q3 Earnings Spotlight: Navigating Inflation, Elevated Interest, and Transformational Shifts

Upcoming Q3 earnings are critical for Citigroup, as it is the primary test for operational efficiency as the U.S. economy has entered the Fed’s “higher for longer” game against inflation for the midterm. For instance, expenses were 89% YoY in the corporate segment, primarily due to inflation.

For Q3, the street expectations for revenue of $19.23 billion are heavily influenced by elevated interest rates that may lead to nearly $45 billion in annual net interest income. Other revenue-boosting factors are card and fee growth, along with an increase in consumer borrowings. Moreover, revenues, excluding divestitures, may remain stable midterm, aligning with the bank’s revenue guidance of $78-$79 billion for 2023.

Notably, an increase in expenses can be observed due to considerable investments in transformation. Expenses can be further elevated due to divestiture-related impacts along with the FDIC assessment.

Furthermore, Citigroup’s overall growth continues to be in line or flat during 2023 due to several factors. Most important is the fact that during H2 2023, Citigroup may continue to be in phase 1, “execute and invest,” where transformation execution, management of macro factors (like FX headwinds and inflated expenses), structure simplification, and process tracking will eat up the savings or profitability.

Moreover, Citigroup may announce significant organizational and leadership changes, alignment of complete operations with a transformed structure (including financial reporting), and a near-complete exit from consumer markets. One of the most notable wind-downs will be Indonesia and the further acceleration of the wind-down process.

At the bottom line, Citigroup may not deliver a considerable surprise against EPS expectations of $1.23 due to the further investments in transformation, cost of credit (under normalization of net credit losses in cards), and an effective 25% tax rate that set off the savings from transformations.

Finally, on the income side, during 2023, with a stable deposit and average loan growth (1% and -1% YoY in Q2), the continued elevation of the cost of interest-bearing deposits (3.09% as of Q2) will continuously negatively impact the net income margin to some extent as it is in line with the growth of gross loan yield ( 8.63% as of Q2 2023).

Turnaround Story: Charting a Path to Profitability and Growth

At its core, Citigroup may attain long-term growth and benefit from its turnaround progress. One of the central elements of Citigroup’s turnaround strategy is optimizing the relationship between revenue and risk-weighted assets (RWA). This metric is crucial for improving returns and efficiency.

Over the past two years, Citigroup has successfully reduced RWA by approximately $120 billion, with approximately 75% of this reduction driven by balance sheet optimization and strategic decisions against low-margin client activity. This reduction in RWA highlights Citigroup’s focus on enhancing its capital efficiency and focusing on higher-margin business activities. At the top line, Citigroup’s target of a 5% revenue CAGR over the medium term reflects its confidence in growth opportunities.

What sets Citigroup apart is its diversified business model and strong balance sheet, which serve as significant value drivers as they allow Citigroup to adapt to varying economic landscapes. For instance, the bank’s Treasury and Trade Solutions (TTS) segment witnessed robust growth, with revenues up by an impressive 15% YoY. It will continue to be a vital growth driver in Q3, as the overall market growth rate suggests a 12% CAGR (2023–2031).

Both net interest income and non-interest revenue drove this growth. Citigroup’s security services revenues also saw a 15% YoY increase, fueled by higher interest rates across currencies. The data speaks for itself, with approximately $2.4 trillion in new assets under custody and administration acquired last year. This substantial gain reflects the bank’s ability to attract and retain clients, bolstering its market position and revenue streams.

In cards, Citigroup has achieved double-digit revenue growth (+15% YoY), driven by robust customer engagement and the normalization of payment rates, particularly in its retail services segment, which reflects its portfolio profile. However, what’s noteworthy is the bank’s observation that this normalization does not necessarily signal a recession. Instead, it points to a more cautious consumer.

Despite economic uncertainties, consumers in the United States still actively use Citigroup’s card services. It can be observed in a boost of 7% YoY in purchase volume (H1 2023), as per the Nielsen report, where Citigroup stands among the top 3 credit card issuers.

On the expenses side, Citigroup’s focus on managing expenses is evident in its proactive efforts. While expenses were elevated in Q2 (+9% YoY), Citigroup remains on track to meet its cost-saving targets. In detail, higher expenses were derived primarily from investments, volume-related expenses, inflation, and severance. However, savings from closed exits and wind-downs offset these elevated expenses.

In the same direction, Citigroup’s strategic actions to simplify its operations are noteworthy. The planned sale of remaining Asia consumer franchises by year-end and the exit process in Poland align with the bank’s simplification strategy. As the bank winds down legacy franchises and reduces stranded costs, it can allocate resources more efficiently. Also, it is reducing exposure to low-margin or unprofitable business segments, such as subscription credit facility lending. These savings are vital for offsetting the significant investments made in the bank’s transformation efforts.

Looking forward, Citigroup’s expense guidance of approximately $54 billion for 2023 reflects the company’s disciplined approach to cost management. The ongoing efforts to bend the expense curve by the end of 2024 are expected to result in meaningful cost savings and improved margins.

On the capital strength side, Citigroup boasts a robust capital position with a CET1 ratio of 13.3%. Its tangible book value per share reached $85.47, marking a 6% YoY increase (as of Q2, 2023). While the increase in the stress capital buffer of just 0.3% from October 2023 may have disappointed to some extent, Citigroup is actively engaging in a dialogue with regulators to better understand the differences in modeling results, particularly in non-interest revenue. Citigroup can also utilize several levers to manage its capital ratios, such as deferred tax asset (DTA) utilization, G-SIB score, and a management buffer of 1.0%.

Additionally, Citigroup’s strategic investments are directed at crucial growth areas. Notably, the bank is investing in technology and healthcare, recognizing their potential for significant returns. Specifically, the bank’s strategic plan involves diversifying its business mix, simplifying its operations, and reducing risk. The exit from 14 international consumer markets aligns with this strategy.

Lastly, Citigroup’s focus on innovation and client engagement drives growth in various segments. For instance, the launch of CitiDirect Commercial Banking, a digital platform designed to help commercial clients leverage the bank’s global network, is an example of how innovation fosters its expansion.

Citigroup’s ability to deepen relationships with existing clients and acquire new ones is evident in its wealth segment. Referrals from U.S. retail banks are on the rise, and new client acquisition in the private banks and wealth at work has grown significantly. Therefore, these indicators of client engagement bode well for the bank’s future growth.

Takeaway

In conclusion, as Citigroup approaches its Q3 earnings spotlight, it finds itself at the crossroads of navigating a complex financial landscape characterized by inflation, elevated interest rates, and transformational shifts. While challenges persist, the bank’s proactive efforts to optimize its operations, streamline expenses, and adapt to changing economic dynamics indicate its resilience and commitment to long-term growth.