Description

CFG is a solid but under-earning regional bank that is being spun-off by the government controlled UK mega-bank RBS.  I think it has 40%+ upside based on its straightforward ROE improvement plan.  The downside is protected because CFG trades at 1.0x tangible book and because the balance sheet is clean and very over-capitalized. 

Overview

·         CFG is the 13th largest bank in the US with $131bn of assets and 1,200 branches.  #2 market share in New England.  Headquartered Providence, RI.

·         Respected new CEO since late 2013.  He was CFO of RBS for 4 years, and CFO of Bank of New York for 10 years before that.

·         RBS sold 29.5% via IPO in September 2014 at $21.50. The divestiture is mandated by the EU as a condition for RBS’s bail-out.  A secondary offering in March 2015 at $23.75 reduced RBS’s stake to 42%.  RBS has to dispose of the rest by the end of 2016.  RBS would like to do another secondary in 2015 to bring its ownership below 35% which would allow it to deconsolidate CFG in 2015.   

·         RBS bought Citizens in 1988 and grew it with a handful of moderately sized acquisitions.  45% of assets came from acquisitions, mostly during 1999-2004.

Background

·         For background, CFG was not managed for growth or profitability when it was under RBS.  RBS is a major $2trn in assets UK bank that was taken over by the government during the financial crisis.  The government still owns 71% of RBS and is heavily involved in management.   The UK government’s main priority has been ensuring RBS’s solvency by shrinking and building capital.  As a result, CFG was somewhat ignored by RBS and RBS’s main objective was for CFG to shrink and build capital.

·         To dimension how much CFG has shrunk vs peers, the average regional bank has grown assets cumulatively by 10% since the end of 2007 vs CFG’s loans are down -14%.  The average regional bank had assets drop -4% to the trough and started growing in Q3’11, versus CFG’s loans dropped -23% to the trough and only started growing in Q3’13, a full two years behind the industry.  So, CFG is sub-scale.

ROE Improvement

·         CFG targets a 10% ROE by the end of 2016, and higher thereafter, versus 6% in 2014.  Peer bank ROEs are 12-13%, so CFG’s target is very reasonable. 

·         Deposit quality is the biggest determinant of bank profitability and the hardest thing for a bank to change (as opposed to loans which are relatively easier to grow).  CFG has good branch-based deposits (e.g. 28% of deposits are non interest bearing, in-line with the average for peers), so there is no structural reason it can’t have a peer-like ROE. 

·         CFG’s ROE bridge from a 5% ROE in 2013 to 10% in 2016 is as follows:

o   0.8-1.0% from scaling-up loans and loosening RBS’s super conservative loan restrictions.

§  RBS has been hiring commercial loan officers from the major banks in all loan areas.  In particular there is a focus on commercial real estate (CRE) where CFG has less exposure than peers because it was only focused on very high quality credits (RBS’s CRE loans yield 2.50-2.75% vs peers at 4.00%).  CFG has been re-investing $200m of expense cuts to staff up for growth while keeping expenses relatively flat.

§  Planning to double mortgage originators from 350 to 700. CFG’s mortgage market share is half of its deposit share, which is an obvious opportunity for growth.

§  CFG is focused on growing higher yielding auto and student loans.  Under the conservative mandate from RBS, CFG only did super-prime, but now it is expanding down to prime.

o   0.8-1.0% from fee income growth.

§  Areas for growth include: (1) mortgage fees from adding originators, (2) treasury management where CFG has new technology and a new team, and half the market share of similar sized peers, (3) adding wealth managers.

o   1.3-1.6% benefit from higher interest rates

§  CFG is asset sensitive.  A 200 bps gradual rise in interest rates over 1 year adds +6.8% to net interest income (vs peers at 3.7%).  85% of interest rate sensitivity is concentrated at the short end of the curve so revenue will benefit right away when the Fed starts raising. 

§  I estimate that a 25 bps change in fed funds impacts EPS by ~6c per share, or ~3%.

§  The timing of rate increases is uncertain, so for conservatism I assume that CFG hits its 10% ROE target in 2017 instead of 2016.  Management has also indicated that they have additional revenue and expense levers they can pull if interest rates don’t cooperate, and they plan to provide more detail about these levers in the next few months.  Regardless, at 1.0x TBV, I think CFG provides a free option on higher rates.

o   0.9-1.0% from cost savings

§  CFG is targeting $200mm of expense saves by 2016, a ~6% expense reduction, (85% in run rate by end of 2015) which it will reinvest in loan originators and technology while keeping overall expenses relatively flat.

o   0.7-0.8% from capital management

CFG is returning capital via buybacks and dividends. It bought back $1bn in 2014 and is targeting $500mm and $250mm in 2015 and 2016, respectively.  CFG recently passed the 2015 Stress Test and was approved for $500mm of buybacks in 2015.

Downside Protection

·         CFG trades at 1.0x tangible book value (TBV) and it is overcapitalized with a Pro Forma Basel 3 Tier 1 common ratio of 12.1% vs peers at 10.5-11.0% ($3.00 per share of excess capital versus peers).  I think it would be hard for CFG to trade below tangible book value for a significant period especially given that we are at a favorable point in the credit cycle. 

·         Non-performing loans have dropped steadily for six years, and CFG has only recently started to grow loans.  Charge-offs are close to cyclical lows, management is guiding to stable loan losses, and losses industry-wide are likely to be low for a few more years.

Take-out optionality

·         CFG has been a rumored take-out since 2012 with articles in the WSJ, Bloomberg and Reuters mentioning possible interest from buyers including TD Bank and BMO in Canada, Itau Unibanco in Brazil, Sumitomo and MUFG in Japan, and PNC, which has a complimentary geography.

·         CFG is an attractive asset because of its large market share in wealthy areas of the northeast.   Bank consolidation is likely to pick up again now that banks are starting to move to the offensive for the first time since the financial crisis.  I think an acquisition by a slightly larger regional bank like PNC, BBT or STI would make excellent sense because the expense saves would be 25%+ and the geographies would be complimentary.

Valuation

·         If you look at the P/TBV vs ROE regression for regional banks that every sell side analyst has, it implies CFG should be worth 1.3x TBV at the end of 2016 when its 1-year forward ROE is 10%.  1.3x TBV of $26 at the end of 2016 is $34, plus you’ll get $1 of dividends in that time, resulting in a 42% return.  On a P/E basis, this is 13x 2017 EPS of $2.60 which is in-line with the historical average for regional banks.

Issues

·         Interest Rate Risk:

o   There is some sensitivity to the pace of Fed increases as discussed above.

·         RBS overhang:

o   There is an ongoing overhang from RBS continuing to exit its 42% stake this year and next.  However, the overhang is a lot lower now, and the pattern from similar situations like the government selling out of Citi, GM and AIG shows that stocks tend to go up as overhangs diminish.

·         Execution risk:

o   The plan implies gaining some market share of loans and fees which is hard to do in a competitive market.  Also, growing loans faster than the market typically entails taking more credit risk which could back-fire in a few years.  However, 1) a lot of the growth is coming from moving into categories where CFG is underweight, such as CRE, and from moving from superprime to prime, and 2) our diligence shows that CFG has been successful hiring loan officers with existing books who are tired of the headaches at the major banks.

·         Over exposure to home equity:

o   Historically CFG’s charge-offs have been in-line with peers, but its loan yield has been below peers, so its risk adjusted yield has been poor.  A major reason is that CFG was over-exposed to home equity loans before the crisis, including $6bn of home equity loans that it bought from third parties like Countrywide.  These loans had low yields and very high charge-offs. 

o   Home equity is still an outsized exposure for CFG at 22% of loans (vs peers at 7%), although the acquired portion of the portfolio is down to $1.9bn, or 1.9% of loans.

o   Credit quality has improved significantly, and I think this is no longer an issue because a significant portion of loans was already charged-off and because the housing market and unemployment have been recovering for a few years already.

·         HELOC payment shock:

o   $4.6bn of HELOCs are at risk for payment shocks from 2015-2017 as the loans become fully amortizing after a 10-yr interest only period. This is 5% of the loan portfolio.  I think the impact should be minimal and should only contribute 5-6 bps to charge-offs on the overall loan book.

o   $0.9bn reset in 2014 with a 1.4% charge-off rate (note they are also offering alternate financing and forbearance which I am sure reduces the loss rate).  $0.7bn reset in 2013 and 3.4% have charged-off over two years.  $1.4bn will reset in 2015.

o   Credit quality of the HELOCs is decent. Most are self-originated.  83% of the payment shock population has a FICO greater than 740 or an LTV of 80% of lower.

·         Fed Stress Test:

o   CFG just passed the 2015 stress test on March 11, 2015 after failing the stress test last year on a qualitative basis.  So, this risk has been averted, at least for another year.

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

Catalyst

ROE improvement, removal of RBS overhang