Citizens Financial: The Turnaround Story

Citizens Financial Bank (CFG 2.60%) was spun off from the Royal Bank of Scotland (NWG 0.29%) in 2014, and the bank is rapidly spreading up and down the East Coast.

In this week's episode of Industry Focus: Financials, Motley Fool analyst Gaby Lapera and senior banking specialist John Maxfield dive into what investors need to know about the company. Find out some of the most exciting prospects the bank has going for it, three of most important risk factors that investors should keep an eye on, how Citizens Financial is responding to the digital revolution with things like mobile apps and robo advisors, and more.

A full transcript follows the video.

This video was recorded on May 26, 2017.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today on Friday, May 26, 2017. My name is Gaby Lapera, and joining me on Skype is John Maxfield, Motley Fool contributor and banking expert. Hey John! How's it going?

John Maxfield: It's going great. How are you doing, Gaby?

Lapera: Really good. Thanks for joining me on a Friday. This is kind of a little bit last minute. Apparently, there's some studio work being done on June 5th, so the studio will be closed. So our excellent producer, Austin Morgan, managed to squeeze me in on this Friday afternoon. I really appreciate you, too, John, because I asked you about this literally yesterday. Listeners, this is my third show of the week, so I am trying to hold it together. [laughs]

Maxfield: You're trying your hardest.

Lapera: I'm trying so hard, guys! But, no, I am excited about this show. I think, potentially, I saved the best for last, in terms of my awesome ideas for the podcast this week. And when I say my awesome ideas, I mean your awesome ideas, John. John really wanted to talk about Citizens Financial Group today, and I was like, sure, whatever, I haven't really heard of them. And then I did a bunch of research and I was like, "Wow, this is so interesting." So, I'm very pleased that we will be taking this opportunity to talk about them.

Maxfield: Yeah, it really is a good story. To give the listeners some context behind it, I had a chance recently to have a conversation with a few different executives at Citizens Financial on a few different occasions. One of them, and the most substantive and overarching conversation that I had was with Bruce Van Saun, who is their CEO. We talked through what it's been going through over the past few years, what its objectives are going forward, and a whole bunch of stuff that I think investors will find interesting, not only investors in Citizens Financial Group in particular, because there's a lot of interesting dynamics with the story, but even more importantly, it further helps to tease out how to think about banks, well-run banks, banks that are going through transitions and things like that, to give more contexts to people who buy bank stocks.

Lapera: Definitely. Let's get straight into the story. Citizens Financial was actually spun off from the Royal Bank of Scotland. The Royal Bank of Scotland is not the most guilt-free financial institution, I guess you could say it that way, going into the financial crisis. Mistakes were made. So, Citizens Financial got spun off.

Maxfield: That's right. Citizens Financial was a relatively small bank when a few decades ago the Royal Bank of Scotland purchased it. They invested in it, boosted it up, it grew and grew. It's now one of the largest banks in New England. That's its stronghold. It's based in Providence, Rhode Island, it has $150 billion in assets now. But Royal Bank of Scotland's, like so many other banks during the financial crisis, got into a whole bunch of trouble, making bad loans, making bad decisions strategically. So they had to, in the immediate wake of the crisis, at the direction of regulators, they basically had to shut down growth and just focus on retreating and retrenching, which is not uncommon for banks in the financial crisis. But the position that put Citizens in is that it put it at a really competitive disadvantage against the company like, well, Wells Fargo (WFC 2.73%) is in kind of a different place now than it was back then, because they have the whole fake account scandal last year, but Wells Fargo, JPMorgan Chase, these guys were able to continue growing and growing and growing. But Citizens, when it was still a subsidiary of the Royal Bank of Scotland, it was watching everybody grow, but because of the restrictions on the Royal Bank of Scotland in terms of having to de-risk its balance sheet and shrink as opposed to grow, Citizens Financial was directly impacted by that. Then in 2014, it spun off in an initial public offering, so, it went public, and it was the biggest IPO of a bank in United States history. I can't remember exactly, don't quote me on this exactly, but I think it had something like $120 [billion]-$130 billion in assets when it went public. So, it was already a large bank when it went on to the market.

Lapera: Yeah. Being a large bank has advantages and disadvantages. One of the main disadvantages is that you're subject to a lot of regulatory stuff. So, they're getting spun out from their parent company and dumped into the world in not a great time for them, because 2014 was when things were starting to turn around and look good for banks. I think a lot of banks were doing OK by then, but Citizens came out in a really tough spot for a bank.

Maxfield: Yeah, it absolutely did. I think you can look at that as a glass-half-full, glass-half-empty perspective. When I was talking to Bruce Van Saun, I got the impression that he looks at it as a glass half full, coming from that perspective, and here's why. In the immediate wake of the financial crisis, one of the main things that really hit the banks, you had the subprime mortgage crisis, that hurt banks. But the banks who that really hurt were the ones who securitized those mortgages, and then sold them in securities to other institutional investors, and then in the process of securitizing those and selling those, there were incorrect things said in those documents, or misrepresentations. And that's what caused the losses at these big banks, like Bank of America and Citigroup. But if you look at a lot of the other banks across the country, the thing that really hit them was commercial real estate loans. These are like development loans, so it's just a piece of land that's priced up when the market is doing really well, and then the bank will loan on that, and if the market falls out, there's nothing on that property to act as effective collateral. So, one of the things that the Royal Bank of Scotland forced throughout this entire organization was, I'm not sure they completely stopped making commercial real estate loans, or if they just throttled it significantly, but when Citizens spun out of the Royal Bank of Scotland, it was way behind in commercial real estate loans, way behind in mortgage loans, way behind in all of these other things, which meant that, to a certain extent, there was only one direction to go, and that was up. And we're starting to see that come through right now in Citizens' performance.

Lapera: Yeah. The other thing that you mentioned earlier was Van Saun, the CEO. He's kind of been an angel for Citizens Financial. He's really the person who seems to be driving this new culture and new ideas that are helping the bank in their turnaround story.

Maxfield: Bruce Van Saun has been an executive at a lot of different major institutions. I talked to Richard Bove, one of the most respected banks analysts in the country. He's a veteran bank analyst, he's been around, he's on CNBC all the time talking about banks, he writes notes to his clients every day and I consider them to be pretty good commentary. When I talked to Richard about this -- he goes by Dick -- when I talked to Dick about this, I asked him what do you think about Bruce Van Saun, and he told me literally that Bruce Van Saun is an excellent banker. Mind you, Dick Bove is someone who doesn't mince words when he doesn't like a bank CEO. So, I consider that to be pretty high praise, and it really did corroborate my thinking, and help to crystallize my thinking on Citizens, and back up what the numbers were saying to me in terms of Citizens' performance.

Lapera: Yeah. So, why don't you talk a little bit about some of the stuff that Van Saun has done to improve Citizens' position? Like their recruitment efforts or their tech investments, or stuff like that.

Maxfield: OK. So, let me paint a picture with some numbers for you. Last year, Citizens grew its loan book by 7.7%, about 8%. Its peer group average, these are other banks that are a few hundred billion in assets, grew their loans last year by 5.4%. So, it outperformed on loan growth. So, that's an important thing to keep in mind. Another is that the revenue, it makes sense that the revenue would grow fast, because the main product that a bank sells is loans, and if you're selling more loans, your revenue is going to go up. Their revenue last year rose by 8.9% versus 5.4% for the average competitor. Then, the efficiency ratio, which we talk about all the time in the context of banking on this show, which tells you the percent of revenue that a bank spends on operating expenses, it fell by 376 basis points, so by 3.76%. I think it's now starting to close in on that 60% threshold that banks strive for. So, if you look at those three metrics, which are probably the most important metrics when you're analyzing a bank's performance, it had a really, really good year. So, the question is, as a general rule, and I think this is a good way to think about things as an investor, and to think about things in general, to think about general rules and exceptions -- this is actually how lawyers are taught to think. The general rule in the case of loan growth is you want loan growth to be robust. But, any time that loan growth outperforms the peer group average, you have to look at that askance. Because the general rule is that loan growth that is too fast is concerning, because it means that you're going out and making loans maybe to people who shouldn't be getting them.

Lapera: And, for listeners who are a little bit newer to banking, every time a bank makes a loan, you have underwriters who check to see, how risky is this person, are they likely to pay back their debt? During the financial crisis of 2008, banks were not very strict at underwriting, and you saw what happened. So, that's the concern when you see super rapid loan growth. Do you think that's what's happening here with Citizens?

Maxfield: To your question, Gaby, your original question was, talk about the things they're doing and investments they've made. I think its rapid loan growth is more a function of not necessarily reducing the underwriting standards, which is what you're referring to, and I was referring to in that general rule. It's more about the fact that it was so under-concentrated in these loan groups relative to other banks that it had a ton of upward momentum that was just waiting for it to take advantage of.

Lapera: Real quick, the loan groups that you're talking about are the commercial real estate and regular home loans, right?

Maxfield: Right. Commercial real estate is one of the main ones, home loans is another one. Basically, what Citizens did is, once it spun off from the Royal Bank of Scotland, and it had more operational flexibility to make investments in the business, and to grow as opposed to contract, what they did is went out and almost doubled their staff of mortgage officers. If you're going to double your staff, the number of people who are your loan officers, then you should expect to grow a lot faster. And, they're going out and recruiting loan officers that deal with larger companies from other banks. And those loan officers from these other banks that have these large accounts are bringing those accounts over. So, when you start to put all those pieces together, you start to say, "Oh, OK, it makes sense now, that its loan book is growing faster than its other book." And it makes sense for reasons other than the fact that whether a bank is or is not manipulating the underwriting standards.

Lapera: Let's talk a little bit about some of the tech investments that they've made.

Maxfield: We talked about tech investments a few shows back, I feel like it was about a month ago. Just to add some context around this, right now the bank industry is going through a very significant shift toward digital banking. So, the banks that are going to survive into the future, 10-50 years down the road, have got to navigate this digital transformation effectively in order to make it. So, keep in mind that that's a really important context. There are a number of different ways and technologies that a bank needs to pursue in order to navigate the digital divide, one of which is just having an effective digital app, a presence online, an effective digital app that provides really good customer experience, that's something that Citizens has invested in. Another thing is cloud computing. Cloud computing reduces the costs of storing customer data and accessing that data and using it for analytical purposes to grow your business in the future. There's also another thing that Citizens Financial has gotten into more recently, in fact, I was just talking to the head of their wealth management recently about this, they are pushing into the robo advisory space, which is basically an algorithmic program that manages your investments, and these things are just blowing up. You have Wealthfront, Betterment, Schwab has gone into the space, Vanguard has gone into the space, Bank of America is coming into the space, everyone is moving into the space because it's such an inexpensive way to serve these customers. It's also getting into big data analytics, that's something that Bruce Van Saun noted in his most recent letter. Big data analytics, what that allows you to do is look across your customer base, determine which customers have the right products and which don't, and then make a tailored pitch to those customers who don't have the right products but maybe need an additional one, and tease out why that would help them financially. It's a multifront war that banks are fighting, and Citizens is on the vanguard of that.

Lapera: Question for you, because, you're right, banks are trying to deal with all these things and update their services to match this digital world. Do you think that Citizens is trying to get into too much at once? Or do you think this really makes sense for them?

Maxfield: I think, as they would say in contract law, time is of the essence. With the millennial generation that has grown up with technology in their pocket, and they expect that experience, to be able to do whatever they want on their phone, and when you add on top of that the high switching costs that have traditionally been in the banking space, now, switching costs could change going forward, but assuming that they don't, if they don't change, if these banks are not providing these top-notch digital products to these millennials, they will just go elsewhere and they'll just stay at those banks forever. So, these investments have to be made right now. It's a non-optional thing for banks. To a certain extent, it would be nice if a bank like Citizens didn't have to throw so much money at these things simultaneously. But I don't think that's an option for them.

Lapera: OK, totally fair. That brings me to my next point, which is, they're investing all this money, they're growing, their story is, in theory, a turnaround story, they're on the upswing. But if someone is thinking about investing in this bank, there are some things they probably want to watch out for. For me, we were talking earlier about the rapid loan growth. That's something that I would want to keep an eye on to make sure that doesn't change from "We have a lot of room to grow in this area" to "Our underwriting processes are slowly getting worse and worse and worse."

Maxfield: Right. And just because I think Citizens Financial is on the right track, and it looks to me like everything is going well, and it looks to me like given the fact that their stock is trading below book value and their trajectory of their earnings and growth, that it looks like a compelling opportunity to me -- I will tell you that the one thing that I learned last year when that Wells Fargo scandal came out is that you're never sure. That really shocked me, that Wells Fargo scandal. I had an immense amount of respect for John Stumpf, and the way they ran that bank, and the way they'd run that bank for 160 years. You can never know for sure with these institutions. So, that should always stay in the back of people's minds, whether it's JPMorgan Chase, even with a guy as incredible as Jamie Dimon, or whether that's Wells Fargo or Citigroup. You should always be suspicious, and innately have that in the back of your head. 

Lapera: Yeah. We should rename this show The Paranoid Investor. [laughs] 

Maxfield: [laughs] Exactly. Only the paranoid investors survive. I think that's what Andy Grove, the former Intel CEO, that was his philosophy.

Lapera: What were you going to say, though, the other thing?

Maxfield: The other thing, Gaby, you and I talked about this earlier, Citizens Financial has had some bumps in the road. The most recent bump in the road concerns its so-called Citizens checkup program. The Citizens checkup program is pretty basic. What Citizens wants its employees to do is reach out to their customers. Citizens is now investing in this data analytics program. Now they want to reach out to these customers whose portfolio of financial products may not be ideal for these individuals. We all accumulate a new account here and a new account there, and then you get to 40 and you're like, "Why do I have all these random accounts? $15 here, $10 here, I thought this was a good idea but I could really use this or that." Basically, what Citizens Financial wants its employees to do is reach out to these customers, set up appointments to either call them on the phone or come into a branch, and have a "financial checkup," kind of like a doctor checkup. The problem that Citizens Financial employees ran into, allegedly, according to an article in The Wall Street Journal from earlier this year, is that they couldn't either get ahold -- because we all know what sales calls are like, because that's basically how someone would interpret these --

Lapera: Yeah, I would definitely hang up on that.

Maxfield: Exactly. Or you wouldn't pick up the phone, right?

Lapera: No, not at all.

Maxfield: So, the problem they ran into was everybody was doing that. So, they're being told, "Make all these appointments," but they were having problems. Again, these are all allegations from The Wall Street Journal, so keep that in mind, these are just allegations. So, what these employees allege, and I think there are roughly a dozen employees that were used as sources for this story, what they alleged is that they would then, to make sure they kept their jobs, they would make up these fake appointments and say someone came in, or hadn't come in, or had cancelled, or whatever it was. So, they were inflating the number of appointments that they actually had. That's not a good thing. So, No. 1, I think we need to be clear, that is not a good thing. But, let me say this. If you compare those allegations at Citizens to what happened at Wells Fargo, which is the natural analogy that anyone is going to draw right now, there's two points to make. No. 1, in the wake of the Wells Fargo scandal, it was a deluge of information in the media from other Wells Fargo employees who came out and said, "Not only were we doing this, and all these other people were doing it and all these other people were doing it," and leak and leak and leak came out about it, but also, Wells Fargo was mistreating its employees at the same time, by firing them, or demoting them, or in some way impacting their employment in a negative way because they tried to bring the scandal to light. That just hasn't been the case at Citizens. After that initial Wall Street Journal article, you haven't seen anything in the media about this. Which leads me to believe that this was not even close to as widespread as the Wells Fargo scandal.

Lapera: Yeah. And honestly, making up that I made a meeting with someone is very different from opening a fake account in their name and having people be potentially charged fees because they don't know this account exists. But, there is something to think about there, and something to keep an eye on. Just keep an eye on the story, A, and B, when stuff like this happens, regulatory bodies tend to start taking more interest in your bank, which can lead to increased cost. The CFPB, the Consumer Financial Protection Bureau, may have a couple tentacles out there looking at Citizens Financial, and that's something that you want to watch in the future. So, the rapid loan growth, the potential for this checkup story to blow up a little bit more, and the regulatory issues that might surround that. And I think that the third thing that you wanted to bring up was the change in the control of executive payment. This is basically a golden parachute. We talked a lot about this during -- I didn't personally, but people talked a lot about this during the financial crisis, which is this idea that CEOs could bail and take a huge package of money with them, even though the company is failing.

Maxfield: Right. That is factually accurate, what you're saying. But it's not so much about if the company is failing so much in itself. I mean, a company could be doing really well, and it could be acquired, and there's going to be a lot more concentration in the banking industry going forward, so there's going to be a lot of acquisitions. And a bank like Citizens is either going to be an acquirer or an acquiree.

Lapera: Those are the two options. [laughs] 

Maxfield: [laughs] Exactly. But, if you're an acquiree, in a case where you have change of control that trigger payments to executives -- let's say Citizens were to be purchased by another bank, that could trigger a large payment for some of its executives. There are reasons that companies put these change of control payments in, and the explanation they provide is that they do so in order to disincentivize hostile takeovers, because it makes a hostile takeover much more expensive to complete. But the fact of the matter is, again, thinking in general rules in the context of general rules and exceptions, as a general rule, change of control payments like this, at least in my opinion, and this is how I've always interpreted it, and I feel like this is consistent with our philosophy at The Motley Fool, it's that those, as a general rule, are not investor-friendly mechanisms through which to protect against a hostile takeover.

Lapera: No. This is exactly why your average citizen thinks of a banker as a fat cat smoking a cigar, and not just a person. And this is something that Citizens has done recently. I believe they addressed it a little bit in a call transcript somewhere. But, it's just something to keep an eye out for, because when stuff like that starts happening, you want to see if anything might come of it. So, I think those are the big three things: the rapid loan growth, the checkup stories, and this golden parachute thing that they have constructed.

Maxfield: That's right. Let me say one thing. You can find this information about any company in their proxy filing, which you can get on the SEC's EDGAR website.

Lapera: If you don't know how to do that, shoot me an email at [email protected] and I will tell you how to do that.

Maxfield: Yeah. Also shoot Gaby an email if you guys are interested in, I wrote a really comprehensive piece on the Citizens' turnaround that walks through all the things that Bruce and I talked about. Send Gaby an email if you're interested in that. And let me close, because I know we're running out of time, with one final thought. Even though we just covered those concerns, and those should be on investors' minds, this comes across as a bank that has a ton of positive potential in the future. And most of the things that I have seen lead me to believe that it's an executive team that has the experience and the integrity to deliver that to shareholders. Now, that doesn't mean it's 100% a winner. But at least in my mind, this looks like a very compelling opportunity.

Lapera: And after having said that, I think it's the perfect time to say, as usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Especially for today's episode. Try and think critically. If you want to keep talking about Citizens, feel free to shoot us an email, like I said, [email protected], or by tweeting us @MFIndustryFocus. Austin, thank you so much for putting up with me three times this week!

Austin Morgan: I got you.

Maxfield: [laughs] It's been a long week for Austin. 

Lapera: [laughs] Austin is a star. I want everyone to know that. I'm going to make him a cake one day. All right, that's it for everyone. I hope everyone has a really great week! I'm out.