Citizens Financial: Solid Dividend And Discount

seekingalpha04-19

Citizens Financial Group is a bank holding company that offers banking products and services in 14 states.This is a profitable business managed by a company with adequate liquidity and conservative ...

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JHVEPhoto Citizens Financial Group, Inc. (NYSE:CFG), incorporated in 1984 and headquartered in Providence, Rhode Island, is a bank holding company that through its subsidiaries offers banking products and services to individuals and businesses in 14 states. This business has been profitable for a long time and has also been steadily growing over the years. Given its capital position and the attractive but safe dividend yield, I believe that one can practically get paid to wait until the market better appreciates it as the current discount to book value greatly underestimates the credit quality of the loan portfolio and potentially exaggerates the risks associated with it. Business & Portfolio The company's current market cap of $15.19 billion downplays the size of its business, as it owns assets that are worth $222 billion and its deposits totaled $177.3 billion per the last annual report. Moreover, it operates through 1,100 branches across 14 states and D.C., as well as 105 non-branch offices. Though a significant revenue source is its non-interest income that comes from offering various banking services (16.3% of total revenue), Citizens' primary source of revenue is its loan portfolio: 10-K As you can see from the chart above, the portfolio is almost equally split between commercial and retail loans. Additionally, real estate loans (commercial and retail) also account for about half of the portfolio. On the one hand, the office exposure is significant: 10-K On the other, we need to also note that the RE loans are very well-diversified geographically: 10-K So, investors should understand that Citizens differs significantly risk-wise from banks that primarily operate in New York, for instance, or even only in one city. This is important to keep in mind as we move forward. Performance By first looking at the long-term operating performance and how tangible book value grew over the years, one can see that though growth has been slow, it also has been steady, except for the last couple of years: Data by YCharts Similarly, the deposit base experienced its first decline in the last decade in 2023, albeit minor: Seeking Alpha The same happened to the size of the loan portfolio in the same year: Seeking Alpha But this seems a minor setback after you zoom out and see that the portfolio has been steadily increasing throughout the years as well. I think we should also appreciate that during a year when interest rates peaked, the net interest spread experienced a relatively small decrease. Also, the net interest margin held its ground:          2023 YoY Change   Loan Portfolio Yield 5.53% 156 bps   Net Interest Spread 2.39% -44 bps   Net Interest Margin 3.1% 0 bps   Click to enlarge But while interest revenue increased by 45% in 2023, net interest income was flat because of swaps that mature this year (also reflected in the NII staying flat). Because of this, NII could have been higher as the business is asset-sensitive and EPS would probably not have declined by as much as 22%:          2023 YoY Change   Interest Revenue $10,204,000,000 45%   Net Interest Income $5,554,000,000 0%   Non-Interest Income $1,983,000,000 -1%   Net Income $1,608,000,000 -22%   EPS Diluted $3.13 -24%   Tangible Book Value $33.55 5%   Click to enlarge This decreased profitability is also evident in the efficiency ratio increasing by almost 600 bps. As a result, efficiency and profitability suffered as also reflected in metrics like ROAA and ROAE:          2023 YoY Change   Efficiency Ratio 66.97% 598 bps   Return On Average Assets 0.72% -24 bps   Return On Average Equity 10.92% -299 bps   Click to enlarge Zooming in more, the company has released its earnings results for the first quarter of 2024 and the YoY changes also reflect the worsening conditions, albeit more intensely. First, NIM dropped by 39 bps to 2.9% from the first quarter of 2023. Net interest income saw a decrease of 12% YoY, while non-interest income experienced a YoY 7% growth. However, net income and diluted EPS declined by 35% YoY. I think this was to be expected given the fact that we still have some way before the Fed starts cutting the rate and it will most probably get worse from here before it starts to get better. Speaking of cuts, management has revealed its expectations for the year 2024 based on a Fed Funds rate of 4.25% and the forward curve from January data. First, net interest income is forecast to decline by 6% to 9% and NIM to bottom out at around 2.8% before it increases by 5 bps by the end of the year. Additionally, non-interest income is forecast to increase by 6% to 9%. Last, management stated that it intended to buy back shares worth around $300 million in the first quarter of 2024. So even though it was held back by the swaps and rising interest rates, management seems confident in a reversal by the end of the year. I too believe that we will see at least one rate cut in 2024, but I am not as confident regarding how fast this will translate into a tailwind. Long-term-wise, I am not as worried, but I think investors should be ready for some more volatility in the short term. Solvency & Liquidity Citizens' capital position appears to be strong as indicated by its capital ratios at year-end 2023, surpassing the minimum regulatory requirements and increasing since 2022 except for the Tier 1 Leverage Ratio that didn't change:           2023 YoY Change Regulatory Requirement   CET 1 Ratio 10.6% 60 bps 8.5%   Tier 1 Capital Ratio 11.8% 70 bps 10%   Total Capital Ratio 13.7% 90 bps 12%   Tier 1 Leverage Ratio 9.3% 0 bps 4%   Click to enlarge We should note, however, that the cost of borrowed funds including deposits increased from 2.88% in 2022 to 4.89% in 2023. That being said, non-interest liabilities constituted 24.3% of total liabilities, making the overall cost less severe than it appears to be. Impressively, the LDR was about 81% at year-end 2023, reflecting a great margin of safety. Last, let's have a look at how the credit quality of its loan portfolio looks. When it comes to the commercial side, loans with a Special Mention and Substandard rating were 4.28% and 6% of the total loans, respectively, and the NPL ratio was 1.04%. Considering that about 50% of the portfolio is commercial loans, I believe these percentages to be high enough to represent a considerable risk for investors. That being said, I could also argue that some hedging is being offered by the retail side, where the average FICO is 772 and the NPL ratio is lower at 0.83% When it comes to all of the loans together, a reserve coverage ratio of 1.59% (up from 1.43% YoY) and a net charge-off ratio of 0.4% (up from 0.18% YoY) are at the very least concerning. But this should be expected within the current macro context, and it actually may provide us with an answer as to why the shares are cheap. It's up to the investor to gauge if the discount is reasonable given the data we have available above. More on that in a minute. Dividend & Valuation CFG currently pays a quarterly dividend of $0.42 per share, resulting in a forward yield of 5.07%. With a payout ratio of 43.3% and such a payment track record, I think this looks safe: Seeking Alpha The decent yield is also a byproduct of two significant drawdowns in 2022 and 2023, the first starting around the time that the Fed aggressively started raising the Fed Funds rate: Data by YCharts As a result, the earnings multiple of CFG is very low right now at 9.8x, a bit below its 5-year mean: Data by YCharts But more impressively, the market has assigned a very generous 32% discount on its book value: Data by YCharts Though its 5-year P/B ratio is at 0.77x, the 2020 drawdown probably played a huge role here and there's no reason for the market to not close the gap as it did back in 2021 once interest rates fall back down to a similar level to what we saw in 2020-2021. Again, each of us needs to ask if the current discount is justified based on the data we have related to the credit quality of its portfolio and if the dividend yield is attractive enough to help us wait more comfortably. I personally find the yield decent enough to wait for things to turn around, but you may have a different risk tolerance. Speaking of which... Risks The most significant risk here is the credit risk as presented by the commercial loan portfolio. Given the exaggerated discount that is present here, I think shareholders should simply monitor this risk, and it doesn't constitute a reason to liquidate a potential position or hold back from buying shares. Another risk has to do with the scenario that interest rates are kept at the current level for longer than management anticipates, as it has based its forecasts for this year on a lower Fed Funds rate in 2024. Also, because this is a fast-growing and big bank, regulatory changes may impact its business more immediately than much smaller regional banks, which can often enjoy exceptions to capital requirements. Verdict All in all, I think that the current discount is unjustified, as this is an overall profitable business with a strong capital position and an overly well-diversified portfolio. Therefore, I am rating CFG a buy.  What do you think? Please, leave a comment below and I'll get back to you soon. 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