Prepared by Stephanie, Analyst at BAD BEAT Investing

Banks remain a hot topic among our membership. We have been pretty neutral on Citigroup (C) for a bit and while the stock is off the lows we saw in March, make no mistake this stock has struggled. We have felt that the name was not a top choice in the space well before COVID-19, and is still not a top choice. Does it have upside? Probably, but it is struggling relative to its peer group. Interest rates have been slashed to nothing with unemployment high and many small businesses still reeling. It is just not a good spot for the banks overall, though the best bank stocks can be bought on dips for the long haul. That said, Citi just is not one of them. The financial stocks as a whole sold off extremely hard during the broader market selloff, and frankly, the sector is going to need several quarters, if not years, to rebound. This is where focusing on operational performance becomes paramount. For the most part, our coverage at BAD BEAT Investing suggests that results so far, as a whole, have been better than expected believe it or not, but there are many left to report.

Citigroup is one of the mid-tier names of the biggest banks in terms of quality. We have traded this name many times. We still believe there are several strengths and weaknesses you need to be aware of in the key metrics that we follow for major financial institutions. Overall, we think Citigroup remains a good hold. The most recent quarterly report was rather mixed overall. With performance that is not great but not awful, we just do not see shares as a buy here. That said, Q3 had some strengths and some notable weaknesses to be aware of. Let us discuss.

Headline numbers were much better than expected

The headline numbers were pretty solid. The company beat consensus on the top line and bottom line. Versus last year, there was an expected decline on the top line. We thought it would be worse. We have to say Q4 will likely feel some continued pinch in key metrics we watch. Still there was positive news on this front with revenue of $17.3 billion, down 6.3% year over year, but positive all things considered.

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With the present quarter’s $17.3 billion in revenues, the bank surpassed consensus analyst estimates by $120 million. We thought revenues would come in around $17.2 billion, so this is significant outperformance even against our more liberal expectations.

Factoring in revenue growth, past share repurchases, and expenses that were somewhat well managed, EPS showed solid performance. However, there continue to be high loan loss provisions, though there has been some improvement here which we will discuss later. Still it has led to massive declines in EPS versus last year. While we expected this (and thought it would be worse), the higher provisions demonstrate the pain of government-mandated shutdowns, higher unemployment, and small businesses reeling.

In last year’s Q3, the company saw earnings per share of $2.07 or $4.9 billion in net income. Here, in the present quarter, net income fell to $3.2 billion and earnings per share plummeted to $1.40, which beat consensus by $0.49 and beat our expectations by $0.35. This is a strong decline in net income of 35%. Much of this decline was over credit losses, though they improved sort of here in Q3, but let us look a bit more closely at some of the critical metrics.

Deposit growth continued, loans pulled back

One of the positive points of the quarter was continued deposit growth, though loans declined.

No matter what is happening with interest rates and the economy, the best banks continue to grow loans and deposits, as these activities are what grow a bank’s income over time. The problem, to some degree, is that they cannot make money off these deposits. It is just hard with the yield curve right now.

Overall, there was good news here. Loans were down 4% and came in at $667 billion in the quarter. Keep in mind this is down significantly from Q1’s $721 billion. That is somewhat of an issue. That said, deposits continue to increase at a solid pace as well to help fund potential new loans. Total deposits rose to $1.3 trillion, an 18% increase from last year. This is solid. We project deposits will surpass $1.4 trillion at the end of 2020, but we would really like to see a stabilization in loans.

As we have said before, traditional banking is the bread and butter of the industry, where the bank takes in money and lends it out at a higher rate. However, not only do we have concerns with declining loans, one should check to ensure the loans are of quality. Obviously, we aren’t doing a line by line audit of what is on the loan book, but we will reiterate that ever since the Great Recession, Citigroup has cleaned up its act and significantly tightened its lending criteria to consumers, improving the quality of its loans. As always, we must be on the lookout for increased loan losses, for which, given the current climate, the allowance was dramatically increased in 2020.

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Big move in provisions for credit losses

Changes in provisions for credit losses can be informative, and even the best banks have been increasing these provisions in 2020. Now, in ‘normal times’ if the provisions grow, it could represent more risky debt is being taken on. It could mean simply that more loans are on the books, and the bank is setting aside additional provisions based on historical/anticipated losses. What we had previously liked here is that we saw Citigroup taking on less risky loans since the Great Recession.

Loan loss provisions over time have become a lower percentage of loans until COVID-19 hit. Coming into Q3, there was a massive spike to $26.4 billion, or 3.9% of all loans in Q1. This was a huge increase from Q1 2020, which saw loan loss provisions of $20.8 billion or 2.9% of total loans. Now that said, in Q3, loan loss provisions improved, at least in our opinion. Provisions were not expanded in Q3, and was $26.4 billion once again. We were anticipating an increase in Q3, so that is positive. We will continue to monitor this key metric.

Efficiency was abysmal

Citigroup’s efficiency ratio is another reason we have been in and out of the name over the years, trading swings. The efficiency ratio measures the amount spent to generate a dollar of revenue. We are likely at the best efficiency we will see here. Efficiency was pretty bad in Q3 2020. Over the last few years, Citigroup has seen its efficiency get to and remain below 60%. However, here in Q3, the efficiency ratio worsened to 63.4%. This is an awful shift from the 52.3% operating efficiency ratio for the bank in Q2 and Q1’s 51.5%. It is the highest in years. This is a huge decline in performance for this key metric.

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Final thoughts

You can buy now and hold for years and maybe generate 15-20% returns in the long term. That is not awful, but it is compared to the moves we make week to week in our service. Still, we knew earnings would get nailed. Not just for C, but for all banks. As we move into Q4, we still do not know how bad the defaults on loans will be, but we suspect it gets better. We do expect a high level of credit losses, but seeing the provisions for losses stabilize was a big positive. A big negative was the lack of efficiency. One bullish point is the near 30% discount to tangible book value. In that regard, we think shares have some value. But, if one must buy a bank, stick with the best, and Citigroup does not fit the bill.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.