Rough Going for Citigroup

Fourth-quarter net surges on a big gain but continuing ops are light.
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Updated from 6:53 a.m. EST

Banking behemoth

Citigroup

(C) - Get Report

reported another highly profitable quarter on Friday, but Wall Street's reaction was negative as per-share earnings missed estimates.

The world's biggest financial service firm softened some of the blow by raising its quarterly dividend 11% to 49 cents.

In the quarter, Citigroup earned $6.93 billion, or $1.37 a share, including a gain of $2.1 billion related to the sale of its asset-management business, which added 41 cents to the bottom line. Prior to the gain, earnings were $4.97 billion, or 98 cents a share, down 3% from the $5.15 billion, or $1.02 a share, a year ago.

Analysts were forecasting earnings of $1 a share, according to Thomson Financial.

Net revenue rose 3% in the period to $20.8 billion, but also fell short of the consensus estimate of $21.75 billion.

Overall, it was rough quarter for Citigroup, especially in its U.S. consumer division, a business that had been propelling earnings during the era of low-interest rates. The entire operation reported a 33% decline in net income to $1.4 billion.

The bank's big U.S. credit card division took a huge hit from a wave of bankruptcy filings by consumers looking to beat the deadline for a new and tougher federal bankruptcy law. The spike in bankruptcy filings cost the bank $252 million in losses. Net income from the bank's U.S. card operation fell 60% to $444 million.

Salvaging the quarter for the bank was the strong performance of its investment banking division and strong growth in consumer banking in Asia and Latin America -- a testament to the bank's global reach. Corporate and investment banking net income rose 21% to $2 billion. Income from Citigroup's international consumer operation was up 2% to $1 billion.

Like many lenders, Citigroup is continuing to grapple with the disappearing spread between short- and long-term interest rates, which crimps the profitability of loans. The so-called flattening of the yield curve is hammering margins at many lenders and resulting in only modest gain in net interest income.

Citigroup was not immune to this trend. CFO Sallie Krawcheck said net interest income rose a modest 5%.

Citigroup CEO Charles Prince, repeating a phrase that many bank executives have been muttering this earnings season, said the bank is facing a "challenging interest rate environment.'

Citigroup is optimistic that the yield curve will soon return to a more normal position, with the spread between short- and long-term rates widening. If that happens, the bank expects fatter profits ahead. But just yesterday, officials at

Wachovia

(WB) - Get Report

, a big East Coast regional lender, said they are bracing for a relatively flat yield curve for the duration of 2006.

If that's the case, even Citigroup officials acknowledge it may be a tough year for the bank's non-capital markets businesses.

"There isn't a business that any of us have that benefits from a flat yield curve,'' says Krawcheck, speaking during a morning conference call. "We will not have an opportunity to earn more if the yield curve stays flat.''

The good news for Citigroup and other banks is that -- other than the spike in personal bankruptcy filings in the fourth quarter -- loan losses remain at near record-low levels. Says Krawcheck, "credit remains terrific.''

Other observers accentuated the negative.

"U.S. consumer banking is really dismal for Citi. There card business was atrocious,'' says Michael Stead, manager of River Aire Investment, a hedge fund that invests mainly in financial stocks. "They are having trouble generating earnings and revenue growth from their franchise.'' Stead doesn't currently own any shares of Citigroup.

In the quarter, Citigroup did do a good job on controlling costs. Operating expenses rose just 1% to $11.37 billion.

The bank's return on equity, a measurement of a firm's ability to generate earnings, rose to 25% from 20% in the year earlier period.

Citigroup also booked $600 million of pretax income in the quarter by releasing part of a reserve for payouts in Worldcom-related lawsuits and arbitrations. On an after-tax basis, the release from reserves added $375 million, or 7 cents a share, to the bottom line.

But the income gains from the release were offset by a $354 million after-tax loss due to an accounting change, which reduced earnings by 7 cents.