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Citigroup Earnings: Failure is Not an Option


After a dismal fourth quarter and a disappointing result from the Federal Reserve's stress test, Citigroup (C) cannot afford another financial upset when it reports its first quarter results in mid-April.

So far, analysts are optimistic that a rebound in fixed income trading revenues and continuing improvements in credit quality will assure Citigroup an earnings report that bears a close resemblance to the strong first quarter of the previous year.

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According to consensus estimates available on Bloomberg, analysts expect the third largest bank by assets to report an earnings per share of 97 cents on revenues of $19.7 billion.

In the first quarter of 2011, Citi reported earnings per share of $1 on revenues of $19.73 billion.

Analysts will be watching out for any improvements the bank has made in market share in equities trading and investment banking, both of which underperformed significantly in the fourth quarter. Progress in controlling spiraling expenses will also be viewed favorably by investors.

However, management will likely spend a considerable portion of their earnings conference call discussing what they believe went wrong with the Federal Reserve stress tests, undoubtedly the top question on the minds of most analysts.

Citigroup was one of four banks that failed to win approval to return more capital to shareholders in the Fed's annual stress tests, delivering a major blow to CEO Vikram Pandit who had repeatedly said that the bank would reward investors with a higher dividend or buyback starting in 2012.

Some analysts believe Citi may have been too ambitious in its request. Oppenheimer analyst Chris Kotowski estimates that Citigroup must have asked to return $10 billion over the next 9 quarters or about 1% of its $1 trillion risk-weighted asset base, based on the difference between the minimum capital ratios before and after the request. That works to about $4.5 billion per year.

Had Citi asked for half of that, Kotowski calculates, its minimum stressed ratio after all proposed capital actions would have been 5.4%, in line with JPMorgan Chase (JPM) and US Bancorp (USB) which positively surprised.

The bull case for Citigroup then is that management got too optimistic on the proposal and this is a temporary setback. The bank can make a request for a lower capital return program later in the year and could win approval from the regulator.

The stock appears to have held up well since the stress tests, partly because of this reason.

Still, there is likely to be considerable debate on the Fed's harsh view of potential losses at Citigroup in the event of a severe downturn.

Several analysts noted that the Fed seems to have taken a much darker view of Citigroup relative to peers and relative to the bank's own historical loan loss experience.

For instance, projected loan losses as a percent of average loan balances is 11.2% at Citigroup versus 8.3% at Bank of America (BAC).

Its projections even seemed to have taken the bank by surprise. "We plan to engage further with the Federal Reserve to understand their new stress loss models. We strongly encourage the public release of these models and the associated benchmarks and assumptions," the bank said in a statement following the results.

The Fed later issued a correction on some of its loss rate calculations for Citigroup, but said the revisions did not change the estimated capital ratios under the stress scenario.

The gap between Citi's analysis of its potential losses and the Fed's estimate has also raised questions on what level of capital the Fed would consider adequate to allow Citi to buy back shares, if at all, when it re-submits its plan later this year.

Oppenheimer's Kotowski believes Citi is likely to be in the "penalty box" for another year.

Others believe that with Citi missing the target by just a whisker, it is likely that it will be able to win approval for a more modest capital return plan sometime in the second half of 2012, most likely the fourth quarter.

After all, Citi has had more time to build capital in the six months since it submitted its plan. "With the original results only 0.1% away from the minimum Tier 1 Common ratio, we think that simply pulling back just a bit on the capital return proposal along with the six extra months of earnings and RWArisk weighted assets reduction, Citi should get approval," Nomura analyst Glenn Schorr noted in a recent report, following a meeting with senior management.

KBW analyst David Konrad believes that future approval of dividends or buybacks might be dependent upon Citigroup's ability to show that it is well on its way to meeting Basel 3 capital standards.

"Citi still has a lot of heavy lifting to do," Konrad said in an earlier interview with TheStreet. The analyst believes that the bank will have to make headway in winding down some of the riskier assets in Citi Holdings. "As they sell them, there will be a multiplier effect on how they perform on the next stress test."

Already Citigroup has made three sizable asset sales in the first quarter, including its 9.85% stake in India's Housing Development Finance Corporation, its 2.7% stack in Shanghai Pudong Development Bank, and its partial stake sale of Akbank, a Turkish bank it bought into in 2007.

One big potential asset sale that The Street is keeping a watch out for is the scheduled sale of Citi's 14% stake in the Morgan Stanley Smith Barney joint venture to Morgan Stanley (MS) in May. Recent reports suggest that Citigroup might be willing to sell a greater than 14% stake to the investment bank, assuming they could agree on the right price. Doing so will release more capital for Citigroup.

However, Konrad warns that the bank's focus on building capital comes with some tradeoffs. "Taking marks through earnings in order to improve regulatory capital ratios and improve its capital plan may be a trend throughout most of 2012 for Citi," he wrote in a recent note.

With investor emphasis likely to shift to earnings power versus balance sheet strength, that might be a short-term negative for Citi.

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