Shrinking Legal Backlog, Improving Cost Efficiency Justifies $58 Value For Citigroup
Citigroup (NYSE:C) managed to avoid a loss for the second quarter of the year despite its $7 billion settlement with federal and state regulators over its mortgage-related misgivings thanks to a better-than-anticipated performance by its debt trading desk. ((Q2 2014 Earnings Release, Citigroup Press Releases, Jul 14 2014)) The globally diversified banking group announced the settlement just a few hours before reporting its Q2 results on Monday, July 14. [1] The resulting $3.7 billion after-tax charge reduced the bank’s Q2 net income figure to $181 million. In comparison, the bank reported earnings of $4.2 billion in Q2 2013 and $3.9 billion in Q1 2014. However, adjusting results for one-time charges presents a good picture, with net income coming in at a strong $3.9 billion for the period.
There are other positive trends to note in Citigroup’s Q2 results. The bank’s non-interest expenses (adjusted for one-time inclusions) fell to under $11.8 billion from almost $12.2 billion in the previous as well as year-ago quarters. Also, the provision figure of $1.7 billion for Q2 2014 was the lowest recorded by Citigroup in any quarter since Q1 2006, highlighting the marked improvement in credit quality over recent years. The bank also strengthened its capital structure further, with its Basel III common equity tier 1 ration increasing to 10.6% at the end of Q2.
In view of Citigroup’s better-than-expected performance in Q2 2014 as well as its substantially reduced legal liability from the announced settlement, we have increased our price estimate for the bank’s stock from $53 to $58. The new price target is roughly 10% ahead of the current market price.
See our full analysis for Citigroup
Settlement Resolves “Substantially All” of Citigroup’s Mortgage-Related Litigation
Citigroup’s $7 billion mortgage settlement will see the bank pay $4 billion to the U.S. Department of Justice (DoJ) and $500 million to the several state attorneys general in addition to setting aside $2.5 billion to provide relief to customers affected by the improper mortgage practices. [2] Although the final settlement figure was nearly double what the bank had provisioned for (largely estimated based on JPMorgan’s $13-billion settlement for originating far more residential mortgage-backed securities before the downturn), it is a huge burden off the bank’s back. Also, with roughly half the settlement amount qualifying for tax deduction, the net impact on Citigroup’s bottom line was cushioned to a great extent.
The charge applies to Citigroup’s legacy mortgage business, which is housed under its Citi Holdings division. So the umbrella division created for Citigroup’s for-sale units will definitely not be reporting a net profit this year – something that was expected for 2014 in view of the division’s improving profitability over recent quarters. The chart below shows the operating margin for Citi Holdings, and you can see how this affects the bank’s total share value by making changes here.
Debt Trading Activity Finally Shows Recovery In June
Citigroup and rival JPMorgan raised concerns among investors this May when they issued warnings about a marked decline in trading revenues for the second quarter. [3] Citigroup estimated a 25% decline in trading revenues for Q2 2014 compared to Q2 2013. As the bank generated $4.3 billion through its trading operations (fixed-income and equities taken together, adjusted for CVA/DVA) for the second quarter of last year, this pointed to revenues of $3.2 billion this quarter.
But a recovery in debt trading activity over the last month of the period helped Citigroup bulk up these revenues to almost $3.7 billion. The debt trading desk was responsible for nearly 82% of these revenues – raking in $3 billion for the quarter. This is just 10% below the adjusted debt trading revenues for Q2 2013 instead of the expected 25%.
The importance of trading to Citigroup’s operating results can be understood by the fact that these operations contribute roughly 20-25% of the bank’s total revenues and as much as 40% of total earnings in any given period. This is why Sales and Trading figures as the most valuable business segment in our analysis for the bank as shown in the chart above – making up almost one-third of its total share value, according to our estimates.
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Notes:- Citigroup Announces Comprehensive Settlement with Residential Mortgage-Backed Securities Working Group, Citigroup Press Releases, July 14 2014 [↩]
- ref:2 [↩]
- Citigroup Trading Revenue Will Likely Drop Further, CFO Says, The Wall Street Journal, May 27 2014 [↩]