Justin Sullivan
Citigroup (NYSE:C) is mid-way through its strategic transformation under Jane Fraser.
2023 is a pivotal year where major disposals (e.g. Banamex Mexico) are going to complete and release significant amounts of capital. And returns in 2024, are going to start looking increasingly compelling powered by share buybacks and higher interest rates.
In my previous article, I discuss the capital trajectory and expected resumption of share buybacks. Given the stock trades at ~0.55x tangible book value and the business should deliver >12% ROE in the medium term, this is clearly a very important catalyst. In my prior article, I also highlighted the importance of the Fed’s CCAR stress tests due to be released in June 2023, and how it would impact the resumption and quantum of the buyback program.
However, in this article, I will preview the Q4’2023 earnings that are due to be released on Friday, the 13th of January. In a nutshell, I expect Citi to surprise on the upside as consensus earnings of $1.18 are too low. However, I also expect Jane to potentially book a kitchen sink quarter as well for various reasons (more on this later).
Expectations for Q4
Citi’s CEO provided an update on the quarter on December 7, at the Goldman Sachs US Financial Services Conference. Specifically, on the investment bank, Jane shared the followings:
if we look at the trading side, for example, so October, November were good months in terms of trading activity. So with the caveat of, December is always an interesting month in the markets, particularly one where liquidity is where it is. We would expect to be at sort of the 10% mark in terms of revenue growth for this quarter in markets. Investment banking, they’ve had a tougher go of it and we have not seen the wallet recover in the capital markets the way I think some of us had hoped we might in the fourth quarter. So all eyes will turn to the first. And there we expect to be roughly in-line with where the wallet is, which is down sort of 60% or so, from pretty extraordinary highs last year, it feels a long time ago.
So in early December, Jane was expecting ~10% year-on-year growth in trading income driven by FICC trading. Notably, the rest of December was quite volatile, especially with the Japanese central bank bombshell of adjusting the yield curve controls which reverberated across global bond and currency markets in mid-December 2022. As such, I expect Citi to have done reasonably well given the continued volatility in December and perhaps even beat the 10% guidance provided. On the flip-side investment banking fees will be down materially year-on-year given the frozen capital markets when it comes to IPOs and debt issuance.
The crown jewels of the Services division (Treasury and Trade Solutions (“TTS”) and Security Services (“SS”)) are performing exceptionally well powered by rising rates. I expect TTS to deliver around revenue of $3.2b-$3.4b and SS close to $1 billion (compared with Q4 2021 revenue of $2.45 billion and $668 million respectively). It is important to note that the Services division is much less volatile compared to the trading side and that the revenue growth year-on-year is driven by higher rates as well as Citi winning many mandates given its competitive advantage in these areas. The Services division is truly the crown jewel of the franchise and Citi continues to invest in preserving and extending its moat.
On the lending side, both Corporate and Consumer lending demand is strong. On the Corporate side, given that the capital markets are shut, much of that demand has moved to the large banks whereas Cards outstanding loans are growing strongly year-on-year as consumers have begun to exhaust the pandemic-related savings. Credit costs, whilst still below pre-pandemic levels, are normalizing steadily, especially when it comes to the lower FICO scores end and new vintages. These trends, as Jane describes them, are consistent across what I observed in my coverage universe, albeit I am very cognizant of downside risks when a recession will ensue (I believe it is only a matter of when and not if).
On the cost side, the CEO noted that it will meet its guidance of 7% to 8% year-on-year excluding divestitures. This is a good outcome given the rampant wage inflation that was certainly not factored in when that guidance was provided. Encouragingly, Jane also guided for plateauing costs in 2023 and subsequently beginning to come down as efficiencies begin to kick in. Any positive progress on the cost trajectory will be very bullish for the stock.
So putting this all together, this looks like quite a strong quarter for Citi, so why do I think there is a risk of a kitchen sink quarter?
A Kitchen Sink Quarter
There are two primary reasons why I believe a kitchen sink quarter is possible:
- Citi is preparing for the Fed’s CCAR stress tests which are done based on a 31/12/2022 balance sheet.
- Jane has been at the helm for close to 2 years now, and her grace period is nearly over. This is probably her last chance for a kitchen sink.
Preparing the balance sheet for CCAR
The Fed’s CCAR test is based on the 31/12/2022 balance sheet and the most important criterion determining the CCAR outcome is the maximum drawdown as defined by the Stress Capital Buffer (“SCB”). Citi is clearly incentivized for doing some window-dressing and “manage” the balance sheet to optimize the SCB outcome. There are probably a large number of potential opportunities to optimize CCAR. This could include careful management of risk positions in the trading book as of 31/12/2022, booking certain provisions, and/or taking an extra conservative CECL charge (loan loss provisions) in respect of both its consumer/corporate loan books.
The honeymoon is almost over
Every CEO has a grace or honeymoon period where it has a free pass to out skeletons that may be hiding in the closest and/or book significant restructuring provisions. After all, that new CEO can attribute these to past management mishaps. Once ~2 years have passed in the tenure, that option is usually no longer available. Mr. Market impatiently demands results and sees the new CEO as fully owning the financials.
I sense that this is Jane’s last chance to get away with a kitchen sink quarter. From 2023, tangible improvements in the financials will need to show otherwise investors’ pressure will begin to pile on the management team.
Final thoughts
The upcoming Q4 earnings report is going to be pivotal for Citigroup. I expect a strong performance driven by the Services division and FICC as well as higher interest rates. I think the market is underestimating the fundamental earnings power of the franchise and in my view, the consensus earnings for Q4 are some way off. Having said that, I expect some “noise” in the numbers primarily due to balance sheet window-dressing ahead of CCAR and potentially some other one-offs.
I will cover the earnings release in detail.