Citigroup Pays for Rally With a Downgrade

NEW YORK ( TheStreet) -- Sterne Agee analyst Toddd Hagerman on Monday downgraded Citigroup ( C) to a "Neutral" rating from a "Buy" rating, saying "we see increasing potential downside risk vs. a meaningful upside catalyst, at least in the near/intermediate term."

"C shares have rallied 30% since the July lows, fueled by renewed optimism tied to the global economy and a meaningful global liquidity infusion" the analyst said, adding that the expected earnings and boost from a significant release of loan loss reserves from Citi Holdings -- the subsidiary into which runoff assets have been placed, as part of Citigroup CEO Vikram Pandit's continuing "good bank/bad bank" strategy of right-sizing the company's balance sheet -- and "a more meaningful reduction in the disallowed deferred tax assets" seem "a ways off."

Citi's shares are the cheapest to book value or forward earnings estimates, among the 24 components of the KBW Bank Index ( I:BKX).

The shares closed at $32.97 Friday, returning 24.5% year-to-date, following a 44% decline during 2011. The shares traded for 0.6 times their reported June 30 tangible book value of $51.81, and for 7.3 times the consensus 2013 EPS estimate of $4.54, among analysts polled by Thomson Reuters. The consensus 2012 EPS estimate is $4.09.

While agreeing that Citigroup's shares are cheap to book value, Hagerman said that "potential upside from current levels is limited in our view given our fair value estimate of ~$36/share."

The company will announce its third-quarter results before the market opens on Oct. 15, with the consensus among analysts being a profit of 98 cents, compared to 95 cents the previous quarter, and $1.23 a year earlier.

Hagerman cited a litany of challenges for Citigroup. "C's international growth (~60% of revs) began to show signs of slowing in 2Q12, particularly Asia. In addition, with the recent concerted effort around the globe to actively supply seemingly endless liquidity, we are already beginning to see trade forecasts lowered, expected pressure on global currencies, concerns for rising inflation, and ongoing volume in the Euro-zone with the most troubled debtor nations."

The analyst added that "the overhang tied to persistent regulatory/political uncertainty in the U.S. and emerging geopolitical risks challenge identical catalysts to drive the shares much higher."

Citigroup's reported return on common equity was 6.5% during the second quarter, matching the company's first-quarter performance, but declining from 7.7% a year earlier. Hagerman said that "our projected ROTCE through '14 continues to lag peers ( excluding Bank of America ( BAC)) - again challenging the potential for multiple expansion in the new regulatory environment, particularly given the sheer size of C's balance sheet, particularly the potential volatility surrounding the company's market-sensitive revenues."

A continuing theme for Citigroup -- and for most large banks as the industry continues to recover from the credit crisis -- is the release of loan loss reserves. The company's second-quarter earnings were boosted by a $984 million reduction in loan loss reserves, which was half the size of the release a year earlier.

"While there has been a growing sense of optimism surrounding the potential accelerating reserve release from Holdings and improved margins, our sensitivity analysis suggests any near-term reserve release would likely fall short of expectations," Hagerman said, adding that "in 2Q12, the rate of credit quality improvement in the company's local consumer lending segment continued to moderate as redefault rates on previously modified mortgages continued to trend higher, asset sales moderated, and the rate of improvement in total delinquencies slowed."

Hagerman said "we are tempering our expectations for Citigroup's total reserve release over the coming quarters to approximately $700-800mm/quarter through 2H13 (from $1.0B/quarter) reflecting a more conservative approach in reserve methodology amid persistent global economic weakness and expectations for some additional loan growth--particularly in large corporate."

Moving back to the seemingly eternal headline risk for large banks and the current "Wall Street as enemy" theme of many politicians during election season, Hagerman said "at the end of the day, policy change in Washington is the game changer for these stocks as opposed to the seemingly unstoppable printing press."

C Chart C data by YCharts

Interested in more on Citigroup? See TheStreet Ratings' report card for this stock.

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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