Citigroup: A Strong Result Protects The Preferred Dividends

Introduction

Citigroup (NYSE:C) one of the largest financial institutions in the United States. The bank has had to deal with a series of issues ever since the Global Financial Crisis but seems to have turned a corner. The financial performance is improving and the increasing interest rates make the fixed income securities more appealing as well. Banks report pretty early in the results season and I wanted to have a closer look at Citigroup’s FY 2022 performance and highlight a specific series of preferred shares.

Citigroup’s performance in 2022 was strong and the preferred dividends should be safe

Citigroup saw its net interest income increase throughout 2022 and that’s what ultimately fueled the strong Q4 and FY 2022 performance. In the final quarter of last year, Citigroup’s net interest income increased by approximately 6% compared to the third quarter of the year, and by approximately 23% compared to the final quarter of the preceding financial year.

Loan loss provisions also increased, both on a QoQ as well as on a YoY basis: In the fourth quarter of 2022, Citigroup recorded a $1.77B credit loss provision (consisting of $1.18B in net credit losses and $593M in credit reserve increases). The higher loan loss provisions and the lower non-interest revenue (which decreased by about $1.2B on a QoQ basis) resulted in a net income of approximately $2.5B for the quarter. The full-year results were still good as Citigroup reported a net income of $14.8B for FY 2022. The EPS in the final quarter of last year was $1.16, the full-year EPS was approximately $7 per share.

And as Citigroup retained quite a bit of capital on its balance sheet, its CET1 ratio increased from 12.3% to 13.0%. As you can see on the image below, the total amount of capital that qualifies for the CET1-status increased from less than $145B to almost $149B while the total amount of risk-weighted assets decreased from almost $1.18T to just over$1.14T.

A closer look at the K-Series of the preferred shares

I wanted to have a closer look at the K-Series of the preferred shares issued by Citigroup. These shares are trading with (NYSE:C.PK) as ticker symbol and offer a fixed-to-floating preferred dividend. This series of the preferred shares are paying an annual preferred dividend of $1.71875 per share (payable in four equal quarterly installments of just under $0.43) until November 2023. From November on, the dividend will be floating based on the 3M LIBOR plus a mark-up of 413 basis points.

In the comment section of a previous article on preferred shares issued by Citigroup, someone commented that according to the literal interpretation of the IPO documents, Citigroup has the right to just reset the interest rate at a very low level rather than using the SOFR interest rate as benchmark rate instead of the LIBOR.

While that’s indeed a correct literal interpretation of the document, Citigroup has already indicated it plans to “do the right thing” and in the same comment section another reader posted the exchange he had with Citigroup’s investor relations team. Based on what the IR team told the reader, the bank does not want its reputation to be further tarnished by not doing the right thing.

The same clause is also included in the IPO prospectus of the K-Series of preferred shares. On page S-9 you can read this:

However, if fewer than three banks selected by the calculation agent to provide quotations are quoting as described above, three-month LIBOR for that dividend period will be the same as three-month LIBOR as determined for the previous dividend period or, in the case of the dividend period beginning on November 15, 2023, 0.2381%.

So in theory, Citigroup has the right to just reset the K-series to 0.2381% + the 4.13% markup and pay just 4.37% in preferred dividends on this security but I remain convinced the bank will do the right thing and use a SOFR-based interest rate rather than just defaulting to the ultra-low fallback-rate.

Investment thesis

The strong capital ratio will likely be a relief to some investors as Citigroup can head into 2023 without too much of a head ache. Don’t expect the EPS this year to increase from the $7 posted for 2022 as higher loan loss provisions are quite likely. Additionally, there were some non-recurring items as well so perhaps aiming for an EPS of $5.5-5.75 for 2023 would be a more conservative approach. Of course, I’d be happy to revisit this once we are a few quarters into the current year but I remain a little bit cautious given the sharp increase in interest rates which could increase the amount of defaults in the loan portfolio.

The preferred shares remain an interesting option for Citigroup and it would be good to get more details on how the bank expects to deal with the switch from LIBOR to SOFR and how this will impact the preferred dividends.