Citigroup Rising: Why a Mixed Quarter Could Be Good For Investors

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Citigroup Inc. (NYSE:C) is one of the world’s largest global banks. Most everyone is familiar with the company, which came back strong from the brink of death after the market crash in 2008-2009 triggering the Great Recession. The stock caught my eye after releasing a much-anticipated quarterly earnings report. In this article, I will discuss the strengths and weaknesses of the quarter and what this means for shareholders moving forward.

Let us first look at the headline numbers that most traders work of off. Citigroup saw net income for second-quarter 2014 of $181 million, or 3 cents per diluted share, on revenues of $19.3 billion. This compared to net income of $4.2 billion, or $1.34 per diluted share, on revenues of $20.5 billion for second-quarter 2013. You might immediately think that this is incredibly weak and that you should avoid shares at all costs.

Not so fast. Second-quarter 2014 results included the impact of a $3.8 billion charge ($3.7 billion after-tax) to settle residential mortgage-backed securites related claims, which consisted of $3.7 billion in legal expenses and a $55 million loan loss reserve build, each recorded in Citi Holdings, making up for much of the quarter-over-quarter difference.

The company saw credit valuation adjustments to debit valuation adjustment ratios (CVA/DVA) coming in at negative $33 million (negative $20 million after-tax), compared to positive $477 million ($293 million after-tax) in the prior-year period.

Excluding CVA/DVA in both periods, second-quarter revenues of $19.4 billion declined 3 percent from the prior-year period. Excluding CVA/DVA and the impact of the mortgage settlement in the second quarter 2014, earnings were $1.24 per diluted share, a 1 percent decline from prior year earnings of $1.25 per diluted share. Thus, earnings were not nearly as weak as they appeared, but they weren’t very strong, either.

When it’s all said and done, much of the revenue decrease was driven by a 5 percent decline in Citicorp revenues, primarily due to a decline in fixed income markets revenues and lower U.S. mortgage refinancing activity in the North America Global Consumer Banking (GCB) segment.

Here is what is interesting and why investors should not run for the hills: If we exclude the CVA/DVA and the impact of the mortgage securities settlement, Citigroup’s net income of $3.9 billion increased 1 percent versus the prior-year period. Much of this was driven by lower operating expenses and a decline in credit costs. Operating expenses were $15.5 billion compared to $12.1 billion in the prior year period.

Excluding the impact of the mortgage settlement, operating expenses were $11.8 billion, 3 percent lower than the prior-year period, driven by continued efficiency savings, the overall decline in Citi Holdings assets, and lower legal expenses, partially offset by higher regulatory and compliance costs and higher repositioning expenses. Excluding the impact of the mortgage settlement, Citigroup’s cost of credit was $1.7 billion, a decrease of 17 percent from the prior-year period, primarily reflecting a $419 million improvement in net credit losses. Citigroup’s effective tax rate was 33 percent in both the current quarter and prior-year period.

Finally, I want to point out some things about loans in Citigroup’s books. Citigroup’s allowance for loan losses was $17.9 billion at quarter end, or 2.7 percent of total loans, compared to $21.6 billion, or 3.38 percent of total loans, at the end of the prior-year period. Excluding the impact of the mortgage settlement, the $696 million net release of loan loss reserves in the current quarter compared to a $784 million release in the prior-year period.

Citigroup asset quality continued to improve as total non-accrual assets fell to $8.3 billion, an 18 percent reduction compared to last year. Corporate non-accrual loans declined 43 percent to $1.2 billion, while consumer non-accrual loans declined 12 percent to $6.7 billion.

Looking ahead, the stock is in a delicate place. While some metrics improved, others remained stagnant. Citigroup’s capital levels and book value per share increased versus the prior-year period. As of quarter end, book value per share was $66.76, and tangible book value per share was $56.89, 6 percent and 7 percent increases, respectively, versus the prior-year period.

This is strong under-appreciated data that I want to highlight here. It is a strong measure that is indicative of health, in my opinion. With it on the rise, taking into account the risks prevalent in the financial sector and Citigroup’s overall performance, I rate the stock a buy an assign a $56 price target.

Disclosure: Christopher F. Davis holds no position in Citigroup and has no plan to initiate a position in the next 72 hours. He has a buy rating on the stock and a $56 price target.

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