A key question coming out of Citizens Financial’s (CFG) third-quarter results is whether this bank is going through its credit cycle sooner than other banks, or whether it will see a materially worse credit quality cycle. “Sooner, not worse” is a credible argument, but this wasn’t a well-loved bank going into earnings, and without an upgrade to cost-cutting expectations or other near-term sources of improved results, the bears have a little more ammunition in the short term.

I’m still bullish on Citizens Financial. My argument has never been predicated on Citizens Financial being one of the best banks (it’s not), but rather on the bank being better than what’s reflected in the valuation. Citizens still has a strong middle-market lending franchise, opportunities to grow fee-generating businesses, and opportunities to improve operating leverage. With what I believe is a line of sight to double-digit ROTCE even in a near-zero rate environment, I don’t believe that Citizens should trade at a nearly 20% discount to tangible book.

A Beat On PPOP, Overshadowed By Higher Credit Costs

Not all of the larger banks that have reported have posted better-than-expected pre-provision operating profit, but most have and the large majority of banks have beaten expectations in part due to lower credit costs (lower provisioning expense). Not so for Citizens, and the shares were punished accordingly.

Revenue rose 9% yoy and 2% qoq, beating expectations by about 4%. Net interest income fell 1% yoy and 2% qoq, missing by about 2%, as a weaker NIM (down 29bp yoy and 5bp, missing by about 5bp) and smaller balance sheet both contributed. Fee income was a standout on the positive side, with 33% yoy and 9% qoq core growth, beating expectations by around 13%. Citizens saw double-digit qoq growth in several categories, including deposit, card, letter of credit, and trust fees, and although mortgage banking declined 1% qoq, it was one of the better results seen so far (and up 137% yoy).

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Operating expenses rose 1% and were down fractionally on a sequential basis. That was about 2% or so less than expected, and coupled with the revenue beat, it drove a better than three-point beat on the efficiency ratio. Core adjusted pre-provision profits rose 20% yoy and about 4% qoq, beating expectations by more than 10%.

Unfortunately, provisioning expense came in higher than expected. While provisions fell 8% qoq, they were still almost 30% higher than investors expected, costing the company about $0.27/share on a pre-tax basis.

The Credit Question – Early Or Worse?

The ongoing theme of bank earnings has been a better-than-expected credit cycle, with aggressive government stimulus activities helping to effectively bridge consumers and businesses over the pandemic-related disruptions. By the same token, it’s early to sound the “all clear;” credit losses don’t typically peak until more than a year after a recession begins (sometimes two years). Moreover, there is significant uncertainty about another round of stimulus, how long the pandemic will linger on and so forth.

Citizen’s credit numbers for the third quarter weren’t great. Non-performing loans rose 29% on a sequential basis, with the NPA ratio jumping from an already-high 0.81% in Q2’20 to 1.05%. The charge-off ratio nearly doubled on a year-over-year basis (from 0.37% to 0.7%; rising 24bp qoq), and while it was largely driven by two large loans, that’s how credit losses often work. The reserve ratio of 2.3% (ACL, ex-PPP loans) is still a little light for a bank with a sizable syndicated loan portfolio with relatively weak credit quality, and the 200% reserve coverage of non-performing loans is definitely worse than many peers.

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That’s the bad news, and it does support a bearish argument that Citizens has inferior credit quality. On the other hand, management believes that commercial credit losses are peaking, and there could be reserve releases as soon as the fourth quarter. If Citizens is in fact going through the worst part of its credit cycle earlier than other banks, that would explain the differences in the reported figures. Unfortunately, you really don’t know where you’re at in the credit cycle while you’re still in it. While I find it credible that Citizens is recognizing losses and charging off loans faster than its peers, it can also be true that its overall cumulative losses will be higher.

The Outlook

With a CET 1 ratio below 10%, Citizens isn’t in as strong of a capital position as I might like, but I expect charge-offs to peak at over 1% in 2021 and then improve. Investors were looking for an upsized cost-cutting plan with this quarterly report and they didn’t get it, but they still may in the fourth quarter (when management gives 2021 guidance). What they did get was a modification to the current plan that focuses on increased digitalization to drive improved revenue and profits, with a $100M pre-tax benefit target.

Citizens generates more than 60% of its revenue from spread sources, and that’s not going to be a growth driver in 2021 (possibly not much of one in 2022 either). It also doesn’t help that Citizens’ hedges are rather short-dated, rolling off in about a year (likewise for M&T (MTB), whereas Regions (RF) and Zions (ZION) have meaningfully more breathing room). Without a bigger near-term benefit from cost-cutting, I see a good chance of a double-digit decline in PPOP in 2021 and I can’t rule out a decline in 2022 depending upon how the economy recovers. With that, credit costs will be an important swing factor in core earnings.

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I’m still expecting Citizens to post better core earnings in 2021 and beyond, though I do expect 2024 earnings to be below 2019 earnings (even if just barely). Long term, I’m looking for core earnings growth of around 2%, with Citizens generating low single-digit to mid-single-digit core growth in the years after 2024. Relative to other banks in this size group, that’s not a particularly strong growth rate, and I do see some opportunity for upside, particularly if Citizens can improve its operating leverage in the consumer business (the commercial business already runs pretty efficiently relative to peers).

The Bottom Line

While I do see a path to 10%-plus ROTCE over the next couple of years, I don’t value the stock on that basis. Even so, a nearly 9% ROTCE in 2021 can support a fair value in the mid-$30’s, as can my long-term core earnings assumptions. With low-to-mid-teens annualized return potential on that basis, I still think Citizens is worth a look from more aggressive investors who can, in essence, afford to be wrong about the bank’s full-cycle credit quality and operating leverage potential while betting that the Street is underestimating the core earnings power of the bank.

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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