Citizens Financial Stock: Undervalued With Work To Do (NYSE:CFG)

Citizens Financial (NYSE:CFG) deserves credit for management-led efforts aimed at self-improvement. The TOP programs continue to deliver revenue and cost improvements, the company continues to invest in long-term fee-generating businesses like capital markets and wealth management, and acquisitions (Investors Bancorp and HSBC‘s (HSBC) East Coast branches) should improve the balance sheet over time. Still, there is work to be done on core profitability, and the company’s loan mix and funding situation aren’t optimal for the near term.

Citizens’ shares have disappointed since my last update, falling about 17%. As either one of the largest of the smaller banks (relative to the top 10) or the smallest of the larger banks, Citizens’ relative performance has been mixed – it’s done about average for a larger bank (though lagging peers like Huntington (HBAN) and M&T Bank (MTB)) while lagging smaller regional banks.

I do still believe that Citizens is undervalued, and the bank should be one of the better performers in 2023 in terms of pre-provision profit growth and capital returns to shareholders. Longer term, the company still has a fair bit to prove and would do well to improve its customer satisfaction metrics and operating efficiency.

A Fourth Quarter Miss Driven By Weaker Revenue

Citizens didn’t report a particularly impressive fourth quarter, with a miss at the revenue lines bleeding through to a miss at the pre-provision line, while below-the-line items lifted the final EPS number.

Revenue rose 28% year over year and 1% quarter over quarter, missing by about 1% or a little more than $0.04/share. Net interest income rose 51% yoy and 2% qoq, missing by about $0.025/share and coming in below the 6% qoq growth average for its peer group. Net interest margin was weaker than expected (up 64bp yoy and 5bp qoq to 3.30%), while average earning assets (up 0.5%) also came in a little short.

Fee-based non-interest income fell 16% yoy and 2% qoq, with ongoing pressure in mortgage banking and capital markets. Citizens missed by almost $0.02/share here, but the company continues to invest in growth (including hiring more revenue-producing employees for wealth management).

Operating expenses rose almost 19% yoy but were basically flat sequentially, coming in slightly better than expected on an absolute basis, but missing by about 60bp in efficiency ratio terms. At 54.4%, Citizens’ fourth quarter efficiency ratio continues to be a bit below average (by about two points).

Pre-provision profits rose 41% yoy and 2% qoq, missing by more than 2% or around $0.04/share. Lower provisioning and a lower tax rate recouped most of that, with bottom line results meeting expectations.

Not Ideally Positioned For What Comes Next

These are interesting times for banks like Citizens. The Fed is probably near the end of its rate hikes and net interest income (and net interest margin) is peaking for the cycle – and for most banks peaking below the 2018/2019 levels (Regions (RF) being a notable exception). At the same time, credit costs are going to head higher, the yield curve is likely to invert further, and operating leverage opportunities are more limited after years of branch closures and other expense reduction efforts.

Within those general issues and trends, I see some specific challenges for Citizens stock.

First, the best source of loan growth over the next year or two is likely to be credit card loans, and Citizens’ presence here is quite small (around 1% of loans). C&I lending is likely to be the next-best category, but here too Citizens is less leveraged than its peer group (though only slightly less, at around 32% versus 36%), and a lot of its C&I lending is in lower-rated syndicated lending that could see more pressure if the economy slows more than expected.

Citizens is also a little more exposed than average to mortgage lending, which is likely to be weak through 2023, and has a large consumer lending operation. Citizens is one of the biggest student loan lenders and one of the biggest auto lenders (up there with Fifth Third (FITB) and Huntingtons), as a percentage of loans, though management is actively shrinking this business (which will create more loan growth headwinds, though improving credit losses).

There are also challenges on the funding side. The bank did better than most in retaining non-interest-bearing deposits (a 5% decline versus 7% to 10% for many of its comps), but deposit costs still rose 48bp qoq to 0.88% and the cumulative deposit beta of 23% is not superior on a peer comparison. While relatively modest loan growth expectations for next year (4% to 5%) will help some, the loan/deposit ratio of almost 87% is quite high in both absolute terms and relative to its peer group (closer to 80%).

Credit is also a watch item, with non-performing loans growing 11% sequentially, and the charge-off ratio rising 4bp to 0.22% (about double the peer average rate).

There Are Some Positives, Though…

I admit that was a pretty negative run-down on Citizens’ positioning for the next year, but it’s not all bad news. The company is launching its next TOP program (TOP 8), with a target of $100M in run-rate pre-tax earnings improvement by the end of 2023, and the prior program achieved about $115M of improvements. Management also continues to work on customer-facing initiatives like its digital banking in an effort to improve satisfaction and drive improved customer retention and deposit costs over time.

I mentioned the company’s efforts to grow non-interest income, and while that won’t be a huge near-term contributor, it can be a positive driver over time. I also see more scope for reorienting the balance sheet toward longer-term direct lending opportunities in commercial lending, and particularly in CRE lending, where Citizens has historically lagged. I’d also note that M&A activity in their footprint could create opportunities to lure away dissatisfied, revenue-producing loan officers and banking customers.

The Outlook

I’m expecting mid-teens pre-provision growth from Citizens in FY’23, and that should stack up better than most of its peers, though I do see a deceleration in 2024 as a risk. I would note as well that management has been locking in hedges to limit its downside risk if rates were to fall more quickly than currently expected.

Longer term, I think Citizens can generate around 4% core earnings growth (5% over the next five years) and benefit from an ongoing squeeze on smaller, less competitive regional and community banks in its core footprint.

Long-term discounted core earnings support a fair value in the mid-$50s, as does a ROTCE-driven P/TBV approach (ROTCE in the 16%s drives a nearly 2x forward multiple). I give Citizens a slight penalty on P/E due to its lower profitability metrics, but a forward P/E of 10x on my ’23 EPS gives me a fair value of $50 all the same.

The Bottom Line

Citizens is an interesting investment proposition now. I don’t think the bank is necessarily best-placed for the current environment, but it doesn’t take much in the way of loan growth or spread leverage to drive above-average pre-provision profit growth. Likewise, I see ample room for improvement in the balance sheet and in operating efficiency, but “room to improve” and “successfully improved” are far from the same thing.

Given some of those challenges, Citizens probably should trade at a discount, but I think the current discount is excessive. I don’t expect Citizens to appeal to investors who favor best-of-breed stocks in their portfolio, but investors more interested in relative value calls might find something of interest here.