CFG - Citizens Financial Group: Better Than Most Banks But Core Issues Remain

2023-11-28 20:42:02 ET

Summary

• I expect continued deterioration in most financial stocks next year due to a lack of solvency from off-balance sheet losses and growing NIM compression.
• Citizens Financial Group may appear undervalued with low valuation metrics, but its risks are often under-discussed.
• CFG faces potentially significant unrealized off-balance sheet loan losses and NIM compression, impacting its earnings and value.
• Compared to most banks, Citizens Financial Group has more minor solvency issues than some larger banks and lower NIM compression than its smaller peers.
• I could be bullish on CFG if it were not for a negative macroeconomic outlook that may increase its loan losses dramatically.

As detailed in " XLF: The 2024 Financials Sector Outlook Is Concerning," I believe there is a strong possibility that we see continued deterioration in most financials stocks next year. A few key reasons for my sentiment include the fundamental lack of solvency in most banks and some insurers and capital markets firms if assets are accounted for at fair value. Last year, almost all financial institutions suffered tremendous off-balance sheet losses due to rising long-term interest rates that lowered the market value of held-to-maturity bonds and loans.

As discussed, total unrealized losses are nearly equal to bank equity, meaning banks fundamentally lack equity in the event of a continued decline in total deposits, which is likely given the Fed's QT program and the dwindling supply of reverse repurchase agreements (a major "backup" liquidity source for banks). The statistically high probability of a recession complicates the situation by potentially improving the major interest rate challenges while adding potentially significant loan losses. Of course, if inflation remains relatively high in a recession, as I suspect, then I believe many at-risk banks could fail, depending on government intervention, which, thus far, has been minimal.

Of course, many investors are aware of these issues. The more at-risk banks, such as Citizens Financial Group ( CFG ), trade at low valuations with a forward "P/E" of around 6.8X and a decent dividend yield of 6.3%. Most analysts are bullish on Citizens Financial Group and believe it to be a discounted opportunity after losing over a third of its value this year. Indeed, while there are many qualities of CFG that point toward undervaluation, I believe risks facing the bank are under-discussed by most analysts.

Value Potential in Citizens Financial Group

On the surface, CFG appears to be a solid discount opportunity. The bank is currently trading at a price-to-tangible book value of ~0.98X, giving it a very slight discount on its book value. Historically, the bank has usually traded around 1.2X, indicating a potential 20% discount. The bank also has substantial intangible assets, as its price-to-book is below 0.60X; however, most intangibles provide little core value to banks. CFG trades at a historically low "P/E" of 6.5X and a historically high dividend yield. See below:

CFG's valuation is about as low as it was during the COVID fear crash in 2020. Its dividend yield, earnings valuation, and price-to-tangible book are all close to the levels reached during the 2020 spring crash, indicating the bank is currently priced for a steep fundamental correction.

Of course, we must keep in mind that banks operate fundamentally differently than non-financial companies. Banks use high leverage and depend on economic cycles and Federal Reserve policies. Accordingly, in certain instances, a small change to macroeconomic circumstances can have significant negative consequences on banks, particularly small-to-medium-sized ones like CFG. Further, due to high leverage, banks naturally have very high negative tail risk , which means they can lose value much faster than they gain.

Citizens Financial Group faces risks similar to some banks that failed earlier this year. At the end of Q3 , the bank's held-to-maturity debt securities had an amortized cost of $9.32B but a fair value of $8.05B, indicating an unrealized loss of $1.27B off-balance sheet. Subtracting that from its tangible book value, its "market value adjusted" tangible book would be closer to $11.24B, erasing much of its theoretical price-to-book discount. That said, this is not a massive issue for CFG because most of its securities losses are in its available-for-sale segment, which is counted in its balance sheet figures. Its overall securities losses are less significant than I've seen in many other banks.

That said, many analysts are not considering unrealized off-balance sheet loan losses. Loans with shorter maturities are not a massive issue because the bank can expect to hold them to maturity and receive a full payment; however, there has been a sharp increase in non-agency mortgage loans in recent years, usually being fixed-rate with 15 to 30-year maturities just like typical agency mortgages.

CFG last reported its loan maturity data in its last annual report , with no significant changes in its total loan book occurring by Q3, making that data highly relevant. At the end of 2022, CFG had a total of ~$17.26B in fixed-rate residential mortgages with maturities over 15 years, most yielding around 3 to 3.5%, similar to mortgage rates before 2022. The bank also had ~$3.19B in fixed-rate education loans with > 15-year maturities with yields in the 5% range. It also had around $530M in other > 15-year fixed-rate loans of varying maturities. The largest segment of its fixed-rate commercial real estate loans ($7.13B) had 5 to 15-year maturities, giving it some duration risk on those as well.

What would these assets be worth if they were sold today? It is difficult to say for certainty without more data, but fair-value losses on fixed-rate residential loans are likely similar to those on fixed-rate securities due to their similar yields. Most of its securities (~85% of the total, including AFS and HTM) are agency-backed MBS assets, which generally have similar maturities to residential loans of >15 years. The difference between fair value and amortized cost of all its securities (HTM and AFS MBS assets, Treasuries, and others) is $4.4B, pointing to an ~11.75% loss ($37.5B amortized cost). The total loss specifically from MBS securities, was ~$4.12B or ~13% of its costs (~$31.9B amortized cost). Due to their higher maturities and lower yields (or greater duration risk), the significant culprit for its securities value losses is its MBS assets.

Assuming a similar level of losses on its fixed-rate loans with maturities over 15 years, about $21B at amortized cost, we come to a fair value estimate of almost ~18.5B, or around $2.5B lower (12% drawdown estimate). I would also add an estimated $350M off-balance sheet loss from its five to fifteen-year fixed-rate loans, with a lower loss rate due to their shorter maturity. Importantly, these figures are rough estimates based on my loan duration estimate. Still, I believe the total unrealized loan losses facing CFG are likely around $2.9B due to the rise in long-term rates. Offsetting that, the bank has around $15B in fixed-rate long-term borrowed funds with maturities ranging from just over one year to over fifteen years with an average rate of 4.75%. It is challenging to say the exact "fair value" of these liabilities. Still, I estimate that total gains from the devaluation of liabilities for CFG should offset its total unrealized off-balance sheet loss to around $2B.

Adding these known ($1.27B from HTM securities) and estimated figures ($2B net from fixed-rate loans offset by liabilities devaluation) together, I arrive at a tangible net asset value estimate for CFG at about $9.3B. CFG's market capitalization is currently $12.3B, which may be trading at a ~32% premium to its tangible NAV. While this shows how CFG is likely, not undervalued , this figure is not necessarily a high premium compared to many banks today, as many larger banks would be hardly solvent if assets were accounted at fair value in the manner I've done above. Still, CFG's estimated tangible core equity NAV-to-asset ratio is just around 4.3%, giving it ample risk in a negative market event.

Citizens Financial Group Earnings Compression

Unrealized off-balance sheet losses are only an issue if a bank requires liquidity. Without liquidity needs, the bank could easily assume assets will be held to maturity, in which case they would not lose any value. Like many small-to-medium banks, CFG faces strains in maintaining its deposit base. That said, it has not seen as significant of a deposit loss as small banks. See below:

Overall, CFG's deposits have been stable compared to small banks and are more typical of its large bank peers. Citizens are technically at the low end of the "large bank" spectrum but do not necessarily benefit from the "sticky depositor" phenomenon in the largest banks. The largest segment of CFG's liabilities are deposits, of which $33.5B are checking (1.49% rate in Q3), $29.5B savings (1.65%), $52B money market (3.17%), and $21.6B in term (4.3%). Importantly, in 2022, almost all these rates were meager at <1%, indicating a greater rate sensitivity than many banks.

As we're seeing an acceleration in savings account rates , indicating a growing depositor competition, I expect CFG's NIM compression will accelerate over the next year. Its net interest margin slipped to 3.03% in Q3 from 3.24% in 2022, and I would not be surprised to see a continued decline to ~2.5% to 2.75% by the end of 2024 as CFG continues to pay higher rates on its various short-term liabilities. Accordingly, I expect its 2024 net interest income to be closer to $5.62B or $1.4B quarterly. The bank typically earns around $500M in noninterest income (primarily fees) with $1.3B in noninterest expenses. Thus, I project its pre-tax quarterly income by the end of 2024 at ~$600M, or ~$470M post-tax, and ~$450M for common equity.

The Bottom Line

The above estimate gives CFG an EPS outlook of ~$0.96 per quarter or $3.86 per year. That said, CFG has also seen an increase in projected loan losses due to the systemic rise in defaults, now above pre-COVID levels in consumer credit. Given that, its true EPS will likely be only $3.86 given steady credit quality conditions, which currently appear unlikely. Problematically, due to its low tangible common NAV estimate compared to its loans, it would not necessarily take a considerable "surprise" increase find defaults to harm CFG's value substantially.

If not for high recession risks, I may be slightly bullish on CFG due to its low forward "P/E" valuation. However, I am somewhat bearish on CFG today because of my broader macro view that we will likely see a continued rise in defaults through 2025 due to a recession. Further, I expect that inflation will not fall sufficiently over this period to allow for a reversal of Federal Reserve policies, meaning CFG will not necessarily benefit from a decline in long-term rates. More information on that point can be found in my previous two articles ( 1 , 2 ).

Still, compared to many banks I've analyzed, I do not believe Citizens Financial Group is in a very high-risk category. Indeed, its size position is a benefit as some larger banks have greater solvency issues related to off-balance sheet losses. In comparison, the smaller banks typically have greater NIM compression due to deposit competition. Thus, although I am slightly bearish on CFG, I view it as safer than most banks today. Still, Citizens does have ample exposure to commercial real estate and other segments that can result in negative surprises, so it remains possible that CFG could underperform other banks.

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