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Citigroup Reports Impressive Q2 Earnings, Includes $7B Settlement Impact

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Continuing the positive note, Citigroup Inc. (C - Free Report) reported impressive second-quarter 2014 results. Adjusted earnings per share came in at $1.24, outpacing the Zacks Consensus Estimate of $1.08. However, earnings were below the year-ago figure by a penny.

Notably, prior to the earnings release, Citigroup struck a deal with the U.S. Department of Justice (DOJ), several state attorneys general (State AGs) and the Federal Deposit Insurance Corporation (the FDIC) worth $7 billion. The settlement will resolve the charges imposed on the bank for allegedly selling or underwriting residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) to investors without disclosing the associated risks between 2003 and 2008.

The banking giant will pay $2.5 billion of the total settlement amount to provide consumer relief and the remaining amount will be paid in cash as penalty to the regulatory authorities. Notably, $4 billion will be paid to the DOJ and $500 million as compensation to the state AGs and the FDIC.

Results in the reported quarter were impacted by credit valuation adjustment (CVA) and debt valuation adjustment (DVA). Moreover, results included charges worth $3.8 billion ($3.7 billion after-tax) related to the aforementioned deal. Including these, Citigroup reported net income of $181 million or 3 cents per share in the second quarter compared with $4.2 billion or $1.34 per share in the prior-year quarter.

Following the mortgage settlement, investors have been bullish on the results as shares of Citigroup jumped around 4% in the pre-market session. The price reaction during the trading session will give a better idea whether Citigroup has been able to meet expectations.

Adjusted costs of credit for the second quarter at Citigroup were down 17% year over year to $1.73 billion. The improvement was primarily attributable to a decline in net credit losses and reduced provision for benefits and claims.

Performance in Detail

Revenues came in at $19.3 billion for the quarter, down 6% from the prior-year quarter. Excluding CVA/DVA, Citigroup revenues declined 3% from the prior-year period to $19.4 billion. The revenue decrease was primarily driven by a fall in Citicorp revenues. However, the revenue figure was above the Zacks Consensus Estimate of $18.8 billion.

At Citicorp, revenues came in at $17.8 billion, down 8% year over year. Excluding CVA/DVA, revenues were $17.9 billion, down 5% from the prior-year quarter. Decreased revenues in the Institutional Clients Group and Global Consumer Banking led to this fall.

Yet, Citi Holdings reported revenues of $1.5 billion, up 33% year over year. Revenues were up 35% year over year excluding CVA/DVA. The figure was pulled up primarily due to the absence of repurchase reserve builds for representation and warranty claims in the second quarter of 2014, elevated levels of asset sale gains and reduced funding costs.

Operating expenses at Citigroup were up 28% year over year at $15.5 billion, including charges related to the mortgage settlement. Excluding such charges, expenses were down 3% to $11.8 billion. Efficiency savings along with reduction in Citi Holdings assets and legal expenses led to the fall. These positives were partially mitigated by elevated regulatory and compliance costs along with repositioning charges in the second quarter.

Credit Quality

Citigroup’s credit quality improved in the reported quarter. Total non-accrual assets declined 18% year over year to $8.3 billion. The company reported a 43% fall in corporate non-accrual loans and a decline of 12% was reported in consumer non-accrual loans.

Citigroup’s total allowance for loan losses was $17.9 billion at quarter end, or 2.70% of total loans, down from $21.6 billion, or 3.38%, in the prior-year period.

Capital Position

At the quarter end, Citigroup’s estimated Basel III Tier 1 Common Ratio was 10.6%, up from 10.0% in the prior-year quarter, mainly driven by retained earnings and deferred tax asset (DTA) utilization. The company’s estimated Basel III Supplementary Leverage Ratio for second-quarter 2014 was 5.7%, up from 4.9% in the prior-year quarter.

As of Jun 30, 2014, book value per share was $66.76 and tangible book value per share was $56.89, up 6% and 7%, respectively, from the prior-year period end.

At quarter end, Citicorp’s end of period assets was $1.8 trillion, up 3% year over year while deposits of $947 billion were up 8% year over year. Citi Holdings’ assets decreased 15% from the prior-year quarter level to $111 billion and represented just 6% of the company’s total assets at second-quarter end.

Our Viewpoint

Following the dismal second-half 2013 performance, Citigroup began 2014 on a positive note and reported impressive results in the second quarter as well. Though revenues declined, on the whole, its profit level outpaced expectations.

Citigroup’s underlying franchises of the consumer businesses and revenues have continuously been under pressure for the past several quarters. Considering the tepid economic recovery, we believe that robust top-line expansion will remain elusive in the near term.

Moreover, though Citigroup’s strategy to shrink non-core assets would improve the valuation over time, the trimmed Citi Holdings portfolio would result in revenue challenges, partially restricting the upside potential of the stock. Additionally, with the thrust of new banking regulations, there will be pressure on fees and loan growth.

Higher legal costs drove down profitability in the reported quarter as expected. Yet, such settlements bring relief to affected investors and help resolve the bank’s pre-crisis shoddy mortgage practices to a large extent.

Moreover, reduction in provisions for future losses and improved credit trends are expected to counter the negatives. One can consider a strong brand like Citigroup to be a sound investment option over the long term, given its global footprint and attractive core business. Moreover, Citigroup currently carries a Zacks Rank #3 (Hold).

The second-quarter earnings season kick-started with Wells Fargo & Company (WFC - Free Report) . Driven by prudent expense management, Wells Fargo earned $1.01 per share in second-quarter 2014, thereby surpassing 98 cents earned in the year-ago quarter. However, the reported figure was in line with the Zacks Consensus Estimate.

Among other big Wall Street firms, JPMorgan Chase & Co. (JPM - Free Report) will report on Jul 15, while Morgan Stanley (MS - Free Report) on Jul 17.

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