Citi Earnings Beat Spurs Optimism (Update2)

The bank shed $2.5 billion, driven by $7.5 billion in writedowns.
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Updated from 2:50 p.m. EDT

It's a long, slow road for troubled

Citigroup

(C) - Get Report

, but as the financial titan on Friday posted second-quarter earnings that were not as bad as some had feared, perhaps there is a crack of light showing through.

Trimming its second-quarter losses in half vs. the first quarter and beating Wall Street's bleak estimates, Citi posted a loss of $2.5 billion, or 54 cents a share. The loss was driven by $6.7 billion in writedowns related to the bank's exposure to subprime, downgraded bond insurers, commercial real estate and alt-A mortgages. Revenue declined 29% to $18.7 billion because of the writedowns.

Citi's loss from continuing operations was $2.2 billion, or 49 cents a share. Both the loss and revenue figures beat the consensus outlook of analysts polled by Thomson Reuters, which expected a loss of 66 cents a share on revenue of $17.72 billion.

"While there is still much to do, we are encouraged by our progress in delivering on our commitment to the re-engineering efforts," CEO Vikram Pandit said in a company statement.

The decent earnings report sparked shares to rally as much as 14% on Friday. Shares closed up 7.7% to $19.35.

Writedowns in the company's securities and banking operations dropped by 42% from the first quarter, Citi said.

In its securities and banking arm, the company had a $3.4 billion writedown on its subprime mortgage-backed securities, downward credit value adjustments of $2.4 billion related to the exposure to the monoline insurers, a $545 million writedown on its commercial real estate-backed securities and $428 million writedown on funded and unfunded leveraged loans.

Separately the company said it recorded a $745 million net mark-to-market loss on the mortgage servicing right and related hedges in its North American consumer banking arm.

As with other banks, higher credit costs in its mortgage business reflected a "weakening of leading credit indicators, including higher delinquencies in first and second mortgages, unsecured personal loans and auto loans," it said. Net charge-offs rose 146 basis points to 2.33%.

The company's firm-wide credit costs totaled $7.2 billion in the second quarter, which included another $2.5 billion addition to reserves and $4.4 billion of charge-offs related to its North American residential real estate portfolio and global card business, it said.

In its credit card business, the higher credit costs reflected "a weakening of leading credit indicators, trends in the macro-economic environment, including the housing market downturn, higher fuel costs, rising unemployment trends and higher bankruptcy filings, as well as the continued acceleration in the rate at which delinquent customers advanced to write-off," Citi said. Its "managed" net credit loss ratio rose 202 basis points to 6.53% in the quarter.

The bank also reported progress in reducing staff, eliminating 6,000 jobs in the quarter and 11,000 so far this year.

Despite the rising problems in its consumer mortgage and card businesses, the company has been improving its capital position as it moves to shed nonstrategic businesses like CitiCapital, Diners Club International and CitiStreet. Just last Friday, the bank announced the sale of its German retail banking operation. Citi's Tier-1 capital level rose to 8.7% in the second quarter.

Citi has reduced its overall assets by $257 billion or 11% to $2.1 trillion since the third quarter, according to Citi's CFO Gary Crittenden, in a conference call this morning.

But the financial titan, which has been rocked in every way by the credit crunch and housing downturn -- including the ouster of its CEO Charles Prince late last year over fumbles the company has made -- still has a ways to go before it can breathe a sigh of relief.

Citi still must deal with "disrupted" fixed-income markets, where "investors continue to be wary," Crittenden said on the call. It has significant exposure to monoline insurers such as

MBIA

(MBI) - Get Report

and

Ambac Financial

(ABK)

and risky mortgages such as subprime and alt-A in its securities and banking arm.

"However, as you have seen, we are aggressively managing our exposures," the CFO said.

Adding to Citi's troubles is the winding down of its Japanese consumer finance arm, as well as credit costs in its consumer business, which are likely to rise the rest of this year. In addition, Citi's year-over-year expense comparison in the second half of the year will be "challenged" by the fact that compensation costs were so low last year because of the shaky markets as the credit crunch roiled, Crittenden said.

Still, analysts seemed fairly pleased with the results.

Deutsche Bank analyst Mike Mayo upgraded Citi's stock on Friday to hold from sell, while Moody's Investors Service affirmed its ratings on the financial titan's debt. Moody's rates Citi's senior debt Aa3, its lead banking subsidiary at B for financial strength and Aa1 for deposits. Still, Moody's has a negative outlook for the firm.

"Citigroup reported results that should help ease concerns of an imminent capital raise, that show run-rate annual earnings of $2

a share and credit quality that is not so different than peers," Mayo writes in a Friday note. "The lingering issue is the degree of additional possible future write downs on remaining high risk exposures, a still negative trend in credit, and how much of this quarter's revenues are one-time. Nevertheless, concerns of an imminent capital shortfall have abated."

Despite its losses, Citi's earnings beat joins

JPMorgan Chase's

(JPM) - Get Report

on Thursday and

Wells Fargo's

(WFC) - Get Report

on Wednesday. Those results helped spur a market rally this week, but

Merrill Lynch

(MER)

disappointed investors with results Thursday after the bell.

"Citi did a little better than expected, thanks to a strong core outcome in fixed income trading (same as JPMorgan)

Thursday," writes David Trone, an analyst at Fox-Pitt, Kelton Cochran Caronia Waller. "We expect the stock to outperform today as the results were bad,

but actually a little better than expected. Writedowns and credit issues were in line with our expectations and could have been far worse."

At least one activist investor remains unhappy with Citi's performance last quarter. In a letter sent Friday to Citi chairman Sir Win Bischoff, the American Federation of State, County and Municipal Employees (AFSCME) renewed calls for a split between Citi's consumer and securities businesses.

"Citigroup lost close to $15 billion in the six months ended March 31, and today Citigroup posted a second-quarter loss of $2.5 billion. How many more losses can our company as currently composed withstand?" AFSCME said in the letter. Through a public pension plan for its members, AFSCME owns roughly 3% of Citi shares.

A move to break up Citi's securities, investment banking and consumer businesses "would clarify Citigroup's financial position, would unlock value and would allow greater focus in each core area, rather than the unwieldy jumble that has jeopardized our company's financial position and led to the loss of so much shareholder value," the letter said.