Special situation: Citizens Financial Group (CFG) – Another interesting “forced IPO” ?

Summary:
The recently IPOed US bank Citizens Financial Group looks like a typical “forced IPO” from a troubled regulated financial conglomerate, similar to Voya & NN Group /ING. The current valuation shortly after the IPO would imply a decent upside (~50%) even if Citizens only manages to become an “average” US regional bank.

Citizen Financial Group went public on September 24th . The story of the US-based lender is similar to the NN Group IPO in which I have already invested.

In this case, parent company Royal Bank of Scotland (RBS), which has been bailed out by the UK government following the financial crisis, is forced to concentrate on its UK business. RBS then decided to ged rid of its US business via an IPO instead of a direct sale to another buyer. It seems to be that there were quite some interested buyers.

Very similar to ING and NN Group, RBS has time until 2016 to sell down the whole stake. That this is not easy was clearly shown as RBS had to price the IPO at 21,50 USD per share, below the inital range of 23-25 USD.

Compared to other regional US banks, the valuation based on book value (and tangible book value) looks attractive:

Name Price/ Book Price/ Tangible Book ROE Current
CITIZENS FINANCIAL GROUP 0,65 1,00 -15,82
REGIONS FINANCIAL CORP 0,79 1,14 7,19
ZIONS BANCORPORATION 0,87 1,05 5,66
SUNTRUST BANKS INC 0,91 1,41 6,38
HUDSON CITY BANCORP INC 0,98 1,01 3,92
KEYCORP 1,07 1,21 8,87
COMERICA INC 1,08 1,19 7,56
FIFTH THIRD BANCORP 1,12 1,35 13,39
NEW YORK COMMUNITY BANCORP 1,17 2,02 8,35
BB&T CORP 1,20 1,82 8,00
HUNTINGTON BANCSHARES INC 1,29 1,44 10,92
M & T BANK CORP 1,37 2,02 10,76
FIRST REPUBLIC BANK/CA 1,73 1,84 13,66
CULLEN/FROST BANKERS INC 1,82 2,43 9,66
SVB FINANCIAL GROUP 1,98 1,98 11,37
SIGNATURE BANK 2,43 2,43 13,26
Average 1,28 1,58 7,70

If we just assume an average multiple, there would be a 50% upside based on tangible book and a 100% upside based on total book value. The problem is of course: in order to reach this multiple you have to earn the average return on equity.

Looking into the IPO filings, we can clearly see that things didn’t work that well in the past. “Normalized” earnings were around 650 mn USD in the past or ~2-3% ROE which clearly would not justify a valuation at book value. Due to the low-interest rate environment, revenues decreased and in 2013, most likely to prepare the IPO, they made a massive goodwill impairment of around 4 bn USD in 2013.

Banks as investments

As there is no shortage of material against banking and the associated risks and evil spirit, I want to outline instead what I do like about banking and this situation:

– Traditional banking in my opinion is a solid and good business if run conservatively and responsibly. Many value investors would never invest in a bank, but I have no problem with this (Mr. Buffet neither as we all know)
– Traditional banking (and Citizens is a traditional bank) profits from higher interest rates. It is easier to put margins on the loan if the nominal rate is higher. So owning a bank is quite a good interest rate hedge
– mid size banks used to have a disadvantage over the large banks, especially with regard to funding. With all the new regulation aimed at the mega banks, I think there is a much better “equal level” playing field. I like good & cheap mid-sized banks.
– I could imagine that being on its own feet, Citizen’s management can react better to local challenges and develop its business than being part of a nationalized UK banking group under constant pressure. The “spin-off effect” could be at work here. Many of the directors have purchased shares directly after the IPO. The CEO owns shares in the amount of 6 mn USD.
– Citizen does have scale on a regional level which in my opinion is quite important (see page 152 of the S1 document) in order to achieve good ROEs
– the region where they are active (North east, New England) had less issues with the housing bubble, so theoretically loan quality should be OK. Most of their business is by the way in so called “recourse states” which adds to the incentive of actually paying back personal loans

Stock overhang

RBS still owns ~66% after the IPO and a subsequent share repurchase. 2016 is not that far in the future and placing another 10 bn of shares will not be a walk in the park, but on the other hand a lot of this could be reflected already in the share price. For me it is always interesting to see when typically sell-side analysts apply a discount due to “stock overhang”. As an “intrinsic” value investor, those situations are one of the clearest situations for market inefficiencies as the intrinsic value of a company does not change because of this.

Similar to ING, I think RBS did sell the first part cheaply in order to then (hopefully) sell into positive momentum. ING for instance managed to sell Voya down from over 60% to now 32% within 1 year and the stock still outperformed the indices.

My assumption is that RBS will not sell below tangible book value which is around the current stock price. If they sell below, they will lose available capital at RBS and therefore weaken their capital base and ratios. So a scenario where RBS sells down to very low levels far below the IPO price is in my opinion not realistic.

Valuation

I am clearly not in the position to judge if CFG is an “above average” bank. However, I think one can attach a high probability to the outcome that CFG will be an average bank. The nice thing about this is that there is significant upside already to the “average case”.

Therefore I would make the following, simplified case:

I assume that there is a 50% probability that within 3 years, CFG will be an “average” bank and trade at an average valuation. Conservatively I ignore goodwill and assume a target price of 1,6x current tangible book value in 3 years which would be ~ 40 USD per share.

To keep things simple, I further assume that there is a 25% chance that they will do really well and a 25% chance that they screw up. In the downside case, I will assume a 50% loss, in the upside case I will assume a valuation at 2x tangible book or around 50 USD.

So my “expected” value in 3 years time would be (0,5*40)+(0,25*11,5)+(0,25*50)= 35,4 USD. Based on the current price of around 22,80 USD, this gives me a potential annual return of ~15,4% which looks attractive to me for such a “special situation” investment.

Summary:

Citizens Financial “forced IPO” looks very similar to ING’s NN Group and Voya IPOs. I think this could be very attractive as even the assumption of Citizens becoming an “average ROE US regional bank” has significant upside. Despite or because of the assumed “stock overhang”, the mid-term risk/relationship looks attractive although, but similar to NN Group, one should not expect a quick win here.

I will therefore invest 2,5% of the portfolio into Citizens at current prices of around 22,80 USD.

P.S.: This will be my first US stock since a long time. I don’t have anything against US stocks, but often I do not find any kind of “edge”. In this case, I do have the feeling that banks are still highly unpopular as investments in general and that there is a good chance for some market inefficiency, even in the highly efficient US market.

17 comments

  • Sold second half at ~28,4 USD or 26 EUR per share,

  • Sold half of my position into today’s “Donald rally”

    Edit: At 28,10 USD.

  • Pingback: Citizens Financial Bank (CFG) and Valuing Banks

  • Thanks for the write-up. I have a very limited understanding of banks but have heard the argument of higher interest rates being good for banks’ net interest margins numerous times.

    It is clear that interest paid on deposits cannot go below zero (leaving aside the possibility of neg. interest rates). Therefore NIM gets squeezed if interest rates are approaching zeroe (as currently).
    However, lower interest rates should stimulate demand for loans (if economic sentiment is not really depressed), compensating for the lower NIM (its a basic price-volume cobination question).

    Secondly, I would assume that most banks have a missmatch in the duration of their liabilities and assets. If interest rates rose tomorrow, I would assume that deposit rates reacted rather swiftly (pushing funding costs up), while the assets being held by the banks (in the most simple case loans) would deliver a rather stable return (determined by the low interest rates that existed at the time the loans were given out). As a result, I would imagine the greates spread in funding costs and asset (loan) returns right after a decline in interest rates.

    Is this correct?

    • Rod,

      normally banks “neutralize” their duration mismatch with IR swaps. Most commercial loans are done on a floating basis anyway. Citizens has a section in their S-1 which shows the sensitivity to interest rates on page 130 (http://secfilings.nasdaq.com/filingFrameset.asp?FileName=0001193125-14-195201.txt&FilePath=\20145\12\&CoName=CITIZENS+FINANCIAL+GROUP+INC%2FRI&FormType=S-1&RcvdDate=5%2F12%2F2014&pdf=). You can see that net interest income is estimated for instance to grow between 6-16% for a 2% interest rate increase, depending on the speed of the change. Those are the direct effects. The indirect effects (more or less loans) come on top.

      As you might now, deposit rates usually rise slower than loan rates, so that might be one of the factors.

      But in general, higher interest rates should be positive.

      mmi

  • I like your blog. However, this text is not my favourite.

    I’d never buy shares of a bank because I really don’t understand them. I cannot read a bank’s balance sheet.
    This juggling with price/book ratios does not help in putting a reliable value label on the subject. You really have to look at the bank’s assets. That’s absolutely crucial when dealing with banks.

    • #richard,

      clearly not every post will be the favourite post for everyone.

      Maybe just for clarification: This is a special situation investment for me.

      As I tried to lay out, I like banks and do have some experience with them. Personally, I understand “traditional” banks better than 90% of other businesses, maybe I should do a post about that.

      Clearly, book vlaue and tangible book value is a very rough proxy. Asset quality is always an issue with banks but in my opinion asset quality at banks is a function of the character of the management and incentives. I didn’t find any red flags here and the fact that they do business in “recourse” states should be a plus.

      So although I don’t know if they really make it, the risk/return relationship still looks good to me.

      mmi

  • Few points that crossed my mind reading your analysis …

    – I think banks care less about the level of interest rates, it’s much more about how steep the interest rate curve is.

    – I might be comparing apples with pears, but look at the large, well known US-banks’ px/tangible book value:
    Bank of America: 1,18
    Citigoup: 0,88
    JP-Morgan: 1,33

    Do you really think 1.6x px/tbv is a reasonable goal for a bank that historically has a 2-3% ROE?

    On the other hand, BNY Mellon has 2.79 and Wells Fargo 1.9 so the 1.6x target might be reasonable.

    – On one hand you say RBS has to divest until 2016, on the other hand you say they won’t sell below tangible book value.
    One or the other might not work out, and I fear it’s the latter.

    • FK,

      thanks for the comment. 2 points form my side:

      BoA(Merril), Citi and JPM are in my opinion not the right peers. Investment banking and the Mega-Bank business model is in my opninion under threat. Many of the regulations will result in a restrictions of growth potential for those players. Small and mid-size players on the other hand will have less issues, so I would rather compare them with other regional banks.

      Second: Points: You clearly point out an issue. If Citizens doesn’t make the ROE targets, then clearly there is an issue. I have weighted this scenario with a 25% probability.

      mmi

    • Take a look at the regional banks. The P/B on the KBW Banking index is 1.2x right now.

      You’d want to compare with PNC, Regions, US Bank, BB&T, SunTrust, Fifth Third etc.

  • Great writeup, I agree and own shares myself. I also live in one of their markets, they have a well regarded brand.

    I’d reinforce the point that the opportunity here lies in two things:
    That the business will improve now that they’re on their own. I think most investors are straight lining the past results into the future. They were owned by RBS, a conservative bank. They have been slow to adapt and adjust. They have local scale and in my view can work to turn on the growth.

    I don’t remember if it was in the S-1, or an interview, but the CEO has a plan to get to a normalized ROE that’s equal to peers. If they can get to the same level as peers this will trade at 1-1.5x BV.

    • Nate,

      thanks for the comment. In one of the amended S1s, the CEO said that they target 10% Return on tangible book within 3 years. That was the basis for my case.

      The CEO by the way seems to know his stuff.

      mmi

    • Huitzilopochtli

      Nate, I like your blog and think Citizen might be a good investment, but…

      Your statement: “They were owned by RBS, a conservative bank.” sounds doubtful to me.

      We either have very different definitions of conservative or you don´t know the recent history of RBS.
      Besides the usal (Libor, fx rigging; misselling of products) and their ill fated takeover of ABN Amro at the worst time, they were basically a mess prior to fin. crisis (very weak risk management, low capital ratios, incompetent management).
      What was your reason for calling RBS a conservative bank?

      • Good points, but in the past six years RBS has been owned by the UK government, and any growth taking or risk taking action is frowned on. I agree the bank has a bad history, but that bad history has constrained recently growth at Citizens.

        Prior to the crisis Citizens was doing a lot of things to gain market share. It was almost as if you could see the day RBS was taken over. Citizens cut back advertising, product innovation stopped, it was as if the bank went silent. This has been true for the past six years. They’ve missed out on the recovery from the crash, but I don’t think it’s too late for them to take advantage.

        • Huitzilopochtli

          Thanks for your reply.

          One follow up question: “product innovation stopped”, what do you mean by that? What useful products were devolped by banks in recent years? (Mobile banking? Better online security?) Genuine question. I generally like my banks boring and not too creative.

          Volkers famous quote (“the only useful banking innovation was the invention of the ATM”) is an exaggeration, but many “innovations ” in banking are neither good for bank stockholders nor the economy in general.

          Has Citizens already changed their “silent” policy? Increased advertisment, etc?

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