Description

The Case for Buying U.S. Banks

U.S. Banks have underperformed the market by over 20% YTD, trading down 10% vs the S&P up 11%. This underperformance has been driven by pushed out expectations on rate hikes following weak May jobs number and Brexit, lower 10-yr rates which causes worries on NIM pressure, higher energy provisions in 1Q which surprised investors, and weaker capital markets activity in 1Q. These problems are resolving themselves, at least to various degrees, and the bank sector should at least trade back to flat YTD by year end, offering 10% upside over 6 months.

U.S. Banks Thesis

1. June jobs report showed +280k offset weak May and indicates US employment still healthy. Brexit vote is done. S&P is back to all-time highs and worries on the worst concerns over the economy have eased for now. In turn, the fed may raise rates in Sept or Dec given the ease in concerns.

2. 10-yr rates are starting to rise again.

3. Average oil prices have rebounded by over 30% vs 1Q levels. Banks were provisioning for $20-30 oil in 1Q so we have likely seen peak energy provisions. Capital markets are relatively open so even if there is distressed selling, private equity will likely inject more equity or buy distressed assets, reducing losses taken by banks.

4. Capital markets activity has rebounded in 2Q. JPM’s 2Q earnings were evidence of healthier activity. Shares traded up +1.5% after earnings.

CFG Long Thesis

If you are on board with the long bank thesis, there is a good chance CFG will outperform the banking sector in the next 12 months. Citizens Financial (ticker CFG) is an $11 billion market cap super-regional bank based in New England and the Mid-Atlantic with $103b in deposits and $135b in assets. RBS IPOed CFG in Sept 2014 and has fully exited their position. Under RBS, CFG’s management team was not incentivized to create shareholder value. Since the IPO, CFG has improved ROTCE from 4% to 6.8% with the goal to reach 10% in the future vs peers 12-13%. CFG trades at a large discount vs peers and improving ROTCE will cause the valuation discount to narrow. CFG’s fair value is $29.00 based on 1.2x P/TBV, 14.5x P/E, and private market valuation using a deposit premium of 2.5%, offering over 35% upside potential over the next 12 months. 

• CFG trades at a 0.86x P/TBV and 11.0x P/E, a discount to super-regional bank peers which trade at 1.4x P/TBV and 14.4x P/E. The key to narrowing the valuation gap vs peers is improving the ROTCE.

   

• CFG will improve its return on tangible common equity (ROTCE) through deploying excess capital, cost cutting which will improve the efficiency ratio, increased services which will drive fee growth, and loan growth which will drive net interest income.

   

1. Capital return. CFG has significant excess capital. CET1 ratio is 11.8% vs peers at 10.5%. CFG passed the 2016 CCAR stress test and was approved for $690mm of share repurchases (6.2% of outstanding shares) and increase the dividend to $0.12 in 3Q16 and $0.14 in 1H17, bringing the total payout ratio to 95%. MTB and CMA were allowed to return >100% of net income via dividends and repurchases which effectively lets them shrink their capital ratios for the first time since the financial crisis. This is a very good sign that the fed believes certain U.S. banks are well capitalized and indicates CFG may return >100% of net earnings next year which will shrink its capital base and increase ROTCE.  

    

2. Loan growth. Another way CFG will deploy its excess capital is through growing its loan portfolio which drives higher net interest income and operating leverage. CFG is growing the portfolio broadly across C&I, CRE, student, auto. CFG is also the partner bank with Apple’s iphone financing business. Apple selected CFG because of their good technology platform which is a testament to the investments CFG has been making in growth. 2Q loan growth should be +1.5% q/q for a +6.0% annualized run-rate.

    

3. Fee income. CFG’s fee income is 29% of total revenue vs peers at 35%. CFG’s fee income is underpenetrated compared to peers, giving the opportunity to cross sell customers more products. CFG is working to improve fee income as a part of their Top III efficiency improvement program.

    

4. Efficiency ratio is operating expenses / total revenue – a lower number is better. CFG’s efficiency ratio is 67% vs peers 61%. The company is reducing headcount and consolidating expenses to reduce the efficiency ratio toward peers.

    

• CFG is an asset sensitive bank with a +100 bps increase in rates driving +7.0% increase in net interest income over 12 months. The street is not modeling any rate hikes for 2016 and is modeling 1 rate hike in 2017, so a more hawkish fed into year-end could drive EPS upside. Investors are not paying for rate sensitivity now with multiples significantly de-rated so offers free upside optionality to higher rates.

Catalysts

• Increased expectations that the fed will raise interest rates in September or December 2016. Higher 10-yr treasury yields which often drive sentiment on banks.

• Strong 2Q results which show continued loan growth.

• With shares trading at a large discount to TBV, CFG will aggressively deploy its share repurchase approval because buying shares at a discount to TBV drives TBV/share accretion.

Valuation

• P/TBV. CFG’s tangible book value per share is $24.27. At CFG’s historical average 1.05x P/TBV, fair value is $25.50 today, 21% upside. TBV/share will grow with retained earnings less dividends or about 5-7% annually from today’s level. As CFG narrows the ROTCE gap vs peers, CFG’s P/TBV will expand toward peers, and CFG could trade closer to peers at 1.4x P/TBV. At 1.2x P/TBV, CFG’s’ fair value is $29.12, 39% upside.

• P/E. CFG is expected to earn $2.03 in FY17. At a peer 14.5x P/E multiple, CFG’s fair value is $29.44 over 6-12 months, offering 40% upside potential.

• Deposit Premium. Another way to think about CFG from a private market valuation perspective is to value the tangible book which is $24.27 which is likely worth about 1x in a liquidation. The most significant asset a bank has is a sticky retail deposit franchise. Typically deposit franchises sell for a 2-3% deposit premium. CFG’s $103b of deposits would sell for about $2.5b or $4.76/share. Taking $24.27 TBV + deposit value $4.76 = $29.03 private market valuation, 38% upside. 

Citizens Business Description

Citizens Bank is headquartered in Providence, RI and has $103b in deposits and $135b in assets. The company offers retail and commercial banking products and services to individual, small businesses, middle-market companies, and large corporations. The company has 3200 ATMs and 1200 Citizens branches across its 11 state footprint in the New England, Mid-Atlantic, and Midwest regions. Pennsylvania and Massachusetts are its largest markets. CFG generates 71% of revenue from spread income and 29% from fee income. In Sept, 2014 RBS decided to sell CFG through an IPO of 29% of the bank. Subsequently, RBS has sold down its entire position and 100% of CFG is publicly floated. 

CFG is overcapitalized.

CFG fee income is underpenetrated.

CFG can narrow efficiency ratio gap vs peer. 

Catalyst

• Increased expectations that the fed will raise interest rates in September or December 2016. Higher 10-yr treasury yields which often drive sentiment on banks.

• Strong 2Q results which show continued loan growth.

• With shares trading at a large discount to TBV, CFG will aggressively deploy its share repurchase approval because buying shares at a discount to TBV drives TBV/share accretion.