Citigroup Faces a Crucial Test

When Citigroup(C) closed 2011 with a big earnings miss, many investors and analysts gave the bank a pass and focused on its growing emerging market operations in Latin American, Eastern Europe and Asia.

While a similar dynamic of investment banking weakness and emerging market excitement is likely to be key to Citigroup's second quarter earnings due on Monday, it's time for investors to scrutinize whether the bank's multi-year runoff of U.S. businesses and its focus on global lending is as promising as some expect.As emerging market economies cool on an escalating European debt crisis and a developed markets slowdown, Citigroup's strategy to expand lending and businesses in countries with higher-than-trend gross domesting product (GDP) growth outlooks may face its biggest post-crisis test starting this quarter. At once, the strategy is appealing amid a 2012 outlook for sub 2% developed market GDP growth and a Eurozone recession, according to the International Monetary Fund; however, it doesn't come without risk."The big story for Citigroup is the emerging market piece of its earnings," says Jim Sinegal, a director of bank equity research at Morningstar. While Citigroup has stomached large earnings drains as it shrinks its CitiHoldings portfolio of non-core assets from over $800 billion to just over $200 billion, the bank has been reinvesting sale proceeds in its U.S. and emerging market lending operations and its global corporate banking unit. The result is that while Citigroup's balance sheet is far smaller than pre-crisis levels, its growth prospects versus peers JPMorgan and Bank of America(BAC) may be particularly strong. But the second quarter could test of whether emerging market growth expectations match reality. "If Citigroup can manage to grow without having major credit problems, I think people will look pretty favorably on that," says Sinegal, who notes that this quarter may mark the biggest recent test of the banks' credit quality outside of the U.S. - where its prospects are bright. Citigroup's test comes at a time when investors and economists are yet to fully gauge the spillover effects of developed market weakness on emerging market growth."We are now looking all over the world for the next bust," adds Sinegal. He's concerned about whether mortgage and credit card lending quality will hold steady in Latin American, Eastern European and Asia where Citigroup is particularly active, and which may show signs of weakening in the second quarter. "Credit quality should continue to improve, but at a moderating pace," writes Sandler O'Neill analyst Jeffrey Harte, who calculates that non-performing loans and charge-offs will fall by 5% and 4% respectively, on a quarter-over-quarter basis, even as loan loss reserve releases fall to $848 million from above $1 billion in the first quarter. Harte expects reserve ratios should hold steady at 4.3% of total loans.

Notably, Portales Partners analyst Charles Peabody wrote in a June 20 report that Citigroup could face a second quarter earnings hit of between $3 billion and $5 billion on the strengthening of the U.S. dollar relative to emerging market currencies.

In the quarter, currencies like the Brazilian Real, Mexican Peso, Czech Koruna, Polish Zloty, South African Rand and Indian Rupee fell sharply against the dollar, raising the prospect that economic uncertainty and a flow from risk assets cuts at Citigroup's strategy. "We know that the extreme volatility that was experienced in several key Citigroup currencies during the month of May 2012 will likely produce a multibillion hit to Citigroup's book value," Peabody wrote in the June note, which recommended selling Citigroup's shares. Peabody called the bank - the third largest by assets in the U.S. -- a "value trap" and emphasized that dollar strengthening could be a lasting problem for Citigroup. In a statement sent to Bloomberg, a Citigroup spokesperson refuted the notion that emerging market exposure is a negative for the bank's book value growth.Wells Fargo Earnings Ride Mortgage Wave>>Analysts and investors are likely able to anticipate the impact of currency movements on Citigroup's finances; what may be harder to assess is the impact of emerging market investor outflows on actual asset quality. Were currency adjustments, diminished inflation expectations and stock fund outflows to be a leading indicator of economic weakness and mortgage and consumer credit quality, Citigroup's non-U.S. strategy could backfire.Nevertheless, amid setbacks including a two notch ratings downgrade by Moody's, a botched attempt to get the Federal Reserve to approve a dividend boost and weak investment banking earnings, Citigroup's non-U.S. lending may look increasingly attractive for bank investors if asset quality holds up. Over 70% of Citigroup's 2011 profit comes outside of the U.S, with significant earnings from Mexico, Brazil, Turkey and other countries with GDP growth expectations above 3%.

Exposure to emerging markets may be even more acute for Citigroup as its U.S. headquartered investment bank provides the biggest weight on earnings.

"Capital markets will remain a key driver of [second quarter] results," wrote Deutsche Bank analyst Matthew O'Connor, who's expectation of 78 cents in adjusted second quarter earnings per share is below consensus of 89 cents on expectations that the banks' investment banking unit will underperform expectations. Like investment banking peers JPMorgan, Bank of America, Goldman Sachs(GS) and Morgan Stanley(MS), Citigroup's earnings are expected to fall on a year-over-year and sequential basis on falling trading and underwriting revenue.According to analysts polled by Bloomberg, Citigroup's adjusted net income is set to fall to $2.75 billion, a 17%-plus drop from 2011 levels. Revenue is expected to fall nearly 8% to $19 billion for the quarter. Analysts also expect an accounting gain of between $700 million and $800 million on the widening of the banks' credit spreads, and a $250 million after tax loss on its sale of a 10.1% stake in Turkish lender Akbank, which will cloud earnings."Fitch expects a recent widening of credit spreads for a few large institutions -- notably JP Morgan, Citigroup, Bank of America, and Morgan Stanley -- to drive debt valuation adjustment (DVA) gains that may distort headline earnings," wrote the ratings agency, in a Thursday note to investors that emphasizes such adjustments that have little to do with the fundamental earnings of large-cap banks as earning season kicks off.Citing weak investment banking revenue and particularly a near 50% drop in fixed income, currency and commodity trading, KBW bank analyst David Konrad expects Citigroup's revenue to fall to $18.2 billion, adding in a July note to clients. "Offsetting part of this revenue pressure may be lower expenses."Progress on the wind down of CitiHoldings, the bank's non-core asset arm, will be another key earnings event notes Oppenheimer analyst Chris Kotkowski. While the unit is expecte to subtract from earnings, a slowing of losses and relatively normal trading revenue may help Citigroup earn U.S. taxable income to cut at it's multi-billion dollar deferred tax asset, adds the analyst in a July note.In fact, amid a muted investment banking outlook and continued accounting noise, Citigroup may be among the sector's best performers after a near 30% second quarter stock drop. RBC Capital Markets analyst Gerard Cassidy calls Citigroup a 'favorite name' heading into earnings. Watch for signs that Citigroup's emerging market strategy can withstand macroeconomic weakness as a key to a recovery in the banks' shares.For more on bank earnings, see 10 banks you need to watch during second quarter earnings season. See why Warren Buffet shuns investment banks. For more on Barclays' Libor scandal, see why Diamond's departure was born out of a derivatives bet. >To order reprints of this article, click here: Reprints