When talking about any bank, it’s important to remember that current bank sector valuations are far below normal and sentiment is lousy, as investors worry about the impact of the confluence of tight spreads, weak loan demand, rising credit costs, and limited expense leverage. Given all that, it may well not be until late next year before banks start trading on recovery prospects.

Even so, I continue to believe that Citizens Financial (CFG) is just too cheap at a double-digit discount to book value, particularly in the context of upside potential from balance sheet optimization, better operating leverage, and growth in fee-generating businesses. With annualized total return potential in the double digits, I believe this is a name worth considering, and I don’t see much risk to the dividend unless there’s a significant deterioration in the economy beyond what’s already expected.

Credit Looking More Stable

Most banks commented after second quarter earnings that they believed the bulk of their reserve-building was done, and virtually, every bank I’ve seen update their views since has maintained that view – although always with the caveat of “if things don’t get worse from here…” So too with Citizens, where management presented at Barclays’ recent bank conference and confirmed a “reduced need” for future reserve builds. This is perhaps one of the benefits of the new CECL standard in that it leads to earlier reserving ahead of actual losses.

Deferrals are of limited value in predicting credit problems, but evolution here has been positive. Citizens had below-average deferrals exiting the second quarter (6% in the 10-Q), and those have since dropped further to around 4.5%, with commercial loan deferrals at only 1.8% of loan balances at the end of August.

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Exposure in the loan book to industries at “high risk” from COVID-19 is still elevated, though, at around 17% exiting the second quarter (management’s estimate is closer to 10%). On a positive note, the exposures are pretty diverse, with no real concentration across areas like oil/gas, hospitality, and so on. What’s more, even the exposed areas aren’t necessarily at high risk, as the company’s exposure in oil/gas is in less price-sensitive segments, its exposure in food service is largely to fast-food/quick-service, and its exposure to retail is largely to gas stations and convenience stores.

I’d also note that criticized loan balances are accelerating, with criticized C&I loans up 45% qoq between the second and first quarters, and criticized CRE loans up 37%. In both cases, CFG’s criticized loan levels are above-average, though not enough to concern me too much. Citizens also looks a little under-reserved relative to the Fed’s “Severely Adverse” scenario compared to other banks, but I’d also remind investors that Citizens is challenging the Fed’s numbers, given that it doesn’t factor in certain risk-mitigating items like loss-sharing obligations.

Self-Help More Important Than Ever

The general theme shaping for the third quarter on the revenue side of things is pretty similar to the theme from the second quarter. Higher levels of deposits are leaving banks with excess liquidity that they can’t profitably deploy, given weak loan demand and low rates on securities. That’s going to pressure net interest margins. At the same time, though, fee-generating businesses like capital markets and mortgage banking remain healthy, and that should provide a boost to CFG’s non-interest income in the third quarter.

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Looking out a bit, Citizens is going to have to continue working on its self-help initiatives to offset secular pressures from weak rates and weak loan demand. Citizens has shifted toward a much more asset-sensitive position over the last few quarters, giving it meaningful leverage to rate increases, but with the Fed recently saying it intends to maintain low rates into 2023, that’s not going to help much.

Management continues to invest in its fee-generating businesses like wealth management and capital markets, and Citizens has a pretty diverse array of businesses under its umbrella. The company is also pushing hard on its “TOP 6” program, with an increasing focus on fin-tech investments meant to streamline processes, reduce costs, and improve (or at least maintain) customer experiences.

Balance sheet optimization is also still in the mix, with the company looking to make better use of its excess cash, exit low-return commercial relationships, and optimize its funding. On that latter point, $3.5 billion of CDs reprice in the second half of the year – it’s not a huge number relative to the deposit base ($140B-plus), but we’re very much in an “every bit helps” phase of the cycle.

The Outlook

I don’t see much prospect for higher spreads over the next three to five years, and loan growth is likely to be muted over the next few years, though I see Citizens having some market share growth potential. Of course, one of the most commonly-used words in conjunction with models and estimates is “surprise”, so there would be upside if the U.S. economy recovers at a stronger/faster pace, particularly with Citizens’ enhanced rate sensitivity. As is, though, I do believe that cost reductions and fee income growth will help, and I believe Citizens can generate mid-single-digit pre-provision profit growth in 2022-’24, and that should be an above-average level of growth for banks of similar size.

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Long term, I see Citizens growing core earnings at a low single-digit long-term rate. That supports a fair value in the $30s, as does the company’s likely ROTCE over the next two years.

The Bottom Line

There are legitimate (or at least fair) concerns about Citizens’ ability to offset core spread earnings pressure with fee income, operating leverage (lower expenses), and better balance sheet management, but I think today’s double-digit discount to tangible book is still too much. Yes, banks are very much out of favor now and likely to underwhelm on core earnings for a while, but for patient long-term investors willing to collect dividends ahead of the eventual recovery-driven re-rating, this is a name worth considering.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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