Citizens Financial Group Lacks Clarity (NYSE:CFG)

Investors should hold shares of Citizens Financial Group (NYSE:CFG).

Down 20% over 2022, Citizens has performed well against the S&P Regional Banking Index over the past decade. Solid dividend payments coupled with strong earnings results have helped the firm distance itself from competitors. However, the regional banking industry seems to be in limbo as mega-cap firms such as JPMorgan Chase (JPM), Wells Fargo (WFC), and Bank of America (BAC) continue growing their market shares. It remains to be seen if this phenomenon will leave smaller firms like Citizens behind.

Company Background

Headquartered in Providence, Rhode Island, Citizens has over 1200 branches across 14 states. The firm, founded in 1828, has amassed over $160 billion in deposits and $225 billion in assets. Bruce Van Saun has led Citizens as its Chief Executive since 2013.

Citizens is 92% owned by institutional shareholders. Vanguard owns 11% of the firm’s outstanding shares, BlackRock (BLK) owns 6%, and State Street (STT) and Capital Group International both own 5%. There are not any other institutional investors who own more than 5% of the firm’s outstanding stock. Notable insider activity includes a small insider purchase by Director Terrance Lillis in April 2022.

Citizens was owned by the Royal Bank of Scotland, now a subsidiary of NatWest Group (NWG), between 1988 and 2015. In fact, Citizens and the Royal Bank of Scotland still use the same logo. The relationship between the two firms proved beneficial as Citizens experienced tremendous growth under the Royal Bank of Scotland’s leadership. However, the 2008 Global Financial Crisis crippled the Scottish firm and led to Citizens being an independent firm once again.

Business Description

Citizens operates through two segments: Commercial Banking and Consumer Banking. As of September 30, 2022, Commercial Banking had accounted for $946 million of consolidated net income while Consumer Banking had accounted for $793 million.

The firm’s operations, and its ability to make profit, are closely tied to market interest rates. Like other commercial banks, Citizens takes in deposits from customers and uses these funds to make loans. The firm is able to charge interest on these loans, but must keep adequate reserves in the event of mass default. Moreover, higher interest rates also mean that Citizens must pay higher fees on customer’s certificates of deposit, checking accounts, and savings accounts. Investors must also bear in mind that poor lending practices can spell disaster for a bank.

Industry Overview

Warren Buffett looks for “economic castles protected by unbreachable moats.” Citizens does not fit the mold of a traditionally strong economic moat. I recently published an article on the custodian bank BNY Mellon (BK). BNY Mellon is the global leader in custodian banking and has established its niche in this area over many decades. Moreover, BNY Mellon has created alternate revenue streams in areas such as wealth management. Citizens, on the other hand, does not have a defined moat due to the intense competition of the consumer banking industry. In addition, the firm has small corporate advisory and wealth management practices, but these do not constitute significant sources of income.

My long-term view on the regional banking industry is an overall consolidation of mega-cap firms as companies like JPMorgan Chase, Bank of America, and Wells Fargo continue to grow in size. Industry competition is fierce. Not only does Citizens compete against its peer group, but it contends with a myriad of larger and smaller firms. Large regional banks such as PNC Bank (PNC) and Truist Financial (TFC) serve as competitors along with smaller regional firms such as WSFS Bank (WSFS) and Fulton Financial (FULT). Non-publicly traded credit unions and banks also pose a competitive threat to Citizens.

The banking industry is characterized by growth through acquisition. Truist’s recent acquisition of SunTrust and BB&T and the remarkable growth story of Bank of America are just a few examples of this phenomenon. In an era where customer loyalty is declining in the face of commoditized banking and insurance products it is hard to identify which firms will outperform.

Peer Group

There are some excellent comparable companies relative to Citizens Bank. Regions Financial (RF), which primarily operates in the Southern United States, has a similar market cap to Citizens as well as a similar number of employees. I also chose KeyBank (KEY) for its slightly lower market cap, but extensive geographic range across the continental United States. KeyBank also directly competes against Citizens in the northeast. Moreover, Huntington Bank (HBAN) was selected for its similar market cap and number of branches. Finally, I feel that M&T Bank (MTB) makes a good comparable because it directly competes with Citizens in the northeast.

Ticker	Founded	Headquarters	Branches	Employees	Market Cap	Fortune 500
RF	1971	Birmingham, AL	1,450	19,950	$20.15B	489
KEY	1849	Cleveland, OH	900	17,477	$16.25B	449
HBAN	1866	Columbus, OH	1,000	19,997	$20.34B	521
MTB	1856	Buffalo, NY	700	22,879	$25.04B	519
CFG	1828	Providence, RI	1,200	17,463	$19.39B	473

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Relative Valuation

Investors should consider the price to tangible book value when valuing a financial services firm. Since these companies carry many of their assets at fair value under U.S. GAAP, book value is a reliable valuation measure. Moreover, it is important to remove intangible assets from a firm’s book value to get a more accurate perception of its revenue-generating assets.

Since 2018, Citizens has traded at a discount to its tangible book value relative to its peers. This appears to reflect the market’s overall perception of the firm’s growth prospects. Noted finance scholar Aswath Damodaran has argued that banks with higher growth potential have higher price/book ratios. Moreover, he believes that a lower price/book value indicates a riskier bank. This can also be viewed as a typical risk vs. reward scenario. Not only can investors buy Citizen’s assets at a cheaper relative value than its competitors, but they can expect a higher return for bearing this risk. Unfortunately, this is all assuming that the market has incorrectly perceived Citizen’s long term growth prospects.

Interest income is a crucial measure of a bank’s profitability. On the surface level, a higher net interest income relative to competitors indicates greater profitability and potential cash flow for a firm. However, it is also crucial to consider that additional interest income can also be generated via risky lending. This can have a tremendously positive impact on profitability and cash flow during economic booms, but can have an equally horrific effect during economic declines. A deeper analysis would indicate that Citizens and its peers are likely engaging in similar lending activities. These regional banks do not have extensive capital markets segments nor are they overly exposed to complex international transactions (theoretically at least). Citizens has been relatively average compared to peers in its annual net interest income since 2019.

Graham’s number is more of an intrinsic valuation than a financial ratio. Developed by noted investor Benjamin Graham, Graham’s number is a measure of a firm’s value based on the relationship between its earnings per share and book value per share. It has limitations, but is useful for valuing financial services firms due to fair value accounting principles. Citizens is quite undervalued based on Graham’s number.

DDM Valuation

I have ceased doing discounted cash flow models for financial services firms. Free cash flows are simply too hard to predict, and much of the intrinsic value of these firms is tied to their dividends. I have become a believer in Aswath Damodaran’s investing philosophy, and I think that keeping things simple with the discounted dividend model is the way to go.

Citizens has paid dividends since late 2014. The firm steadily grew its dividend payments leading into the coronavirus pandemic. As indicated in the chart below, the firm’s dividend yield spiked during the pandemic and has since fallen dramatically before beginning to grow again.

I created a dividend discount model for Citizen’s with a 5 period time horizon. It should be noted that this model is intended to be conservative. Long-term growth may end up being higher than the 1.25% I assumed. Citizens could also have a lower cost of capital than the 9.5% arrived at using the capital asset pricing model. A higher growth rate and lower cost of capital would yield a higher implied value. In terms of the formulas used for the model, I used a formula from an old Goldman Sachs (GS) pitch deck.

Inputs	Values
D1 (2023)	0.42
D2 (2024)	0.42
D3 (2025)	0.42
D4 (2026)	0.44
D5 (2027)	0.46
k	9.52%
g	1.25%
PE (Terminal)	10.68
EPS (Terminal)	5.46
Implied Value	$38.66

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Risk Factors

There are numerous risk factors that investors need to consider regarding Citizens.

Credit Rating: Borrowing is important for many businesses. Citizens is no exception. The firm’s ability to maintain a strong credit rating is crucial to its long term success. Citizens is currently rated BBB+ by both S&P (SPGI) and Fitch.

Provision for losses: It is inevitable for some loans to fall into default. Therefore, it is crucial for banks like Citizens to make a good faith effort in setting aside reserve funds to cover these delinquencies. Throughout 2022, Citizens increased its provision for losses. However, it is still possible that these losses could be underestimated.

Interest Rates: Rising interest rates throughout 2022 have led to a slight increase in net interest income as of September 30, 2022. However, it is much harder to project how Citizens will be affected by lower lending activity as the increased cost of borrowing sets in over the market. My hunch is that net interest income will fall over subsequent periods.

Regulation: Any regulatory changes in capital or liquidity requirements could impact the firm’s profitability. This is hard to predict, but important to consider.

Perhaps most importantly, purchasing any share of common stock is inherently subject to the risk of loss. A company does not have any obligation to buy back its stock or pay dividends. Citizens has demonstrated a decade-long history of shareholder rewards via dividends and share repurchases. However, this does not mean that this trend will continue.

Investment Summary

Citizens is a seemingly above-average firm with solid earnings and sensible rewards for shareholders. I feel that there are better opportunities for investors to employ their capital at the present moment. Should Citizens become more attractively valued from a dividend perspective it will be a great buy. Banking is an incredibly lucrative and profitable business. The world economy would not exist without it, as bankers are wizards with respect to the creation of money through debt. Citizens will continue to be profitable, but will it become more attractively valued in the ensuing months?