- Citigroup hasn't been more cheaper in the past 5 years. Most analysts have Citigroup stock's value pinned at close to $70 a share.
- Revenues from fixed income is undoubtedly falling but equity trading should be able to continue growing at present growth rates.
- Citigroup is more protected than US banks against a recession materializing in the US.
Citigroup (NYSE:C) will announce earnings for its latest fiscal quarter ending December 2015 on the 15th of this month and analysts are expecting an EPS of $1.09 on revenues of $17.87 billion for the fourth quarter. Citigroup was one the few shining lights in the financial sector in 2015 as the company beat earnings estimates in all three quarters. If it continues this trend for the fourth quarter, then a meaningful move in Citigroup stock to the upside should transpire. Why?
Citigroup Is Trading At Attractive Valuations
Well there are a number of things at play here in this sector that are in Citigroup's favor. It doesn't really matter if the company is missing expectations on top line growth. Citigroup demonstrated in 2015 that its focus is on the bottom line and its consistently beating earnings per share consensus by being ruthless in its cost cutting efforts.
Even if revenues continue to decline, if ongoing cost-cutting efforts (asset sales, branch closures, etc) can outpace top line declines, net income will remain buoyant which should move the stock price going forward. The second tailwind Citigroup stock has at present is its valuation (both with respect to its historic valuation and the financial sector).
Citigroup hasn't been as cheap since 2011 (now trading at 10.4 times earnings) and also trades at a discount to the industry average of 11.2. However it is its price to book value or book value per share that has many value investors peeking their interest. The bank's book value per share has now reached almost $70 a share (accounting value of share of each stock in the bank if the company was liquidated today).
Growing Revenue From Equity Trading Desk
The group has been recapitalized, refocused, is under new management and although on a macro level there may be risk to the downside in equity markets, central banks have demonstrated since the great recession that they will not let markets fall. There are some legal risk for the company too but the risk/reward set-up in Citigroup stock appears to be definitely to the upside.
Another factor that should provide a tailwind to Citigroup stock is its equity trading division which should grow meaningfully from here. Why? Well its definitely a growth area as we have seen in the first three quarters 2015. Stock trading revenue on Wall Street increased by 12% whereas fixed income desks fell by 10% in the same time period.
Bears will point to fixed income revenues continuing to fall due to the present low interest rate environment and high regulatory costs. The group reported $2.6 billion in fixed income revenue for its third quarter which was 16% lower than the same quarter of 12 months prior. On the equity side, Citigroup reported $996 million in revenues, with a growth rate much faster than rate of the fixed income decline and I for one thing this trend will continue.
First of all the group's balance sheet is strong which is a requisite for equity trading (Supplemental Leverage ratio at 6.9% is much higher than some of its peers). Secondly, the gap in revenues between the group's bond desk and equity desk presently is more than 200%. All the other major investment banks have equity numbers far closer to their fixed income numbers (average is less than 30%). Therefore Citigroup's gap should close and I'm betting it will come from meaningful growth on the equities side.
Diversification is another advantage this group has. Although it is a US bank, it derives more than half of its income abroad owing to its established presence in Asia and Latin America. The Chinese stock market has been very volatile thus far in 2016 but I'm convinced that emerging markets are far nearer a bottom than the US market. Just look at how emerging markets fund Vanguard FTSE Emerging Markets ETF (NYSEMKT:VWO) have under-performed the US market since the great recession in the chart below.
The US had its credit boom (before 2007) and its weak recovery thus far coupled with tight regulation will ensure that those types of loans will never be made available again. If there is going to be a credit boom once more, I can't see it happening in the west. Just because many US banks have huge deposits on their balance sheets doesn't mean they can loan this capital out indefinitely for profit. New growth will come from emerging economies and Citigroup has the infrastructure to take advantage.
Citigroup Is An Excellent Risk Reward Play
To sum up, I believe Citigroup stock is an excellent risk/reward play to the upside for a number of reasons. Its book value per share is $20+ higher than where the Citigroup stock is currently trading. Its equity trading division is growing by leaps and bounds and over time interest rate hikes should mean more net interest margin for the bank.
Furthermore it is positioned well in emerging markets and is well hedged against a potential US slowdown. If the Citigroup stock reports an EPS beat in its earnings report, expect a violent move to the upside. Alternatively if you believe that the stock could disappoint but want to remain long, consider selling some put options 3 or 4 strikes in the money.
Currently implied volatility is around 40% and IV rank (implied volatility measured against itself) is over 60 on a 52 week basis. This will expand even more going into earnings. By using the elevated premium to get long the stock at a better price, you are improving your basis which will improve the profitability of your investment over the long term.