Investors, it seems, have mixed feelings on Citizens Financial Group (NYSE:CFG).
The regional bank went public last month as a spinoff from The Royal Bank of Scotland (LSE:RBS); the now former parent hoped to price the bank between $23 and $25, but was only able to sell its shares at $21.50 when the IPO priced. Since that disappointing placement, though, the stock has jumped an impressive 9%.
To see the bullish argument, read here. Today we'll look at the other side of the argument: three reasons why Citizens Financial Group could fall.
1. The Royal Bank of Scotland still owns 75% of the bank
RBS is selling Citizens Financial to raise capital to boost the U.K.-based bank's balance sheet. That means none of the funds raised in the IPO will be available to Citizens Financial. From a capital standpoint this point is moot, as Citizens currently is quite well capitalized: the bank's Tier 1 capital ratio is above 13%.
The issue is that RBS will likely continue to sell shares of Citizens Financial over time, creating downward pressure on the stock as its present 75% position declines. Estimates have put RBS' capital needs at north of $8 billion; the Citizens IPO raised about $3 billion.
RBS has stated that it does not intend to sell off its entire position in Citizens Financial. However, after the disappointing $21.50 pricing per share, it seems reasonable that the bank would sell more shares than originally planned.
This selling is by no means an assurance of a price drop, but it certainly wouldn't help long-term investors.
2. Citizens Financial doesn't meet Warren Buffett's definition of a high-performing bank
In a 2013 interview on CNBC, Warren Buffett described how he evaluates banks. To paraphrase the Oracle of Omaha, it's all about return on assets. A quick review of Buffett's favorite banks shows he puts his money where his mouth is. Wells Fargo (NYSE:WFC) sports a 1.5% return on assets and US Bancorp (NYSE:USB) reports an even better 1.58%. The following chart includes Citigroup (NYSE:C) to demonstrate a bank that produced a weaker ROA over the past five years.
Where does Citizens Financial fall in this comparison? According the company's S-1 filing with the SEC, the bank produced a weak 0.58% return on assets in 2013. (This excludes some one-time, noncash expenses. Actual ROA was considerably worse.)
According to the FDIC's Quarterly Banking Profile, the average bank with total assets in excess of $10 billion returned 1.08% on assets in the second quarter of this year.
Return on assets is one of the purest ways to evaluate a bank's earnings power. Many banks use excess leverage and risky assets to boost return on equity. By looking just at the assets, you can cut through the clever accounting and see a representation of the bank's income power, expense control, and efficiency all in one number.
Unfortunately for Citizens Financial Group investors, that one critical number is currently pretty ugly at the bank.
3. Citizens Financial is an inefficient bank
Another critical metric when analyzing a bank stock is the bank's efficiency ratio. Fellow Fool John Maxfield does an exceptional job explaining this ratio's importance. The short version is that an efficient bank doesn't need to take on high risks to boost profit. Inefficient banks, conversely, will oftentimes make up for their inefficiency by chasing yield in the types of risky assets that tend to blow up in recessions.
According to the FDIC, the average efficiency ratio of banks with total assets greater than $10 billion was 59.5% in the second quarter. Citizens Financial reported a ratio of 66.6% for the same quarter end. Unfortunately for Citizens Financial investors, lower is better when it comes to the efficiency ratio.
For comparison, US Bancorp and Wells Fargo both reported better than average efficiency ratios of 53.1% and 57.9%, respectively in the second quarter of 2014.
Citizens Financial's inefficient operations means two things.
First, there is less money available for every dollar of revenue to pay dividends, buy back stock, or fund growth than at the average U.S. bank. That result is diametrically opposed to the goal of shareholders.
Second, that inefficiency means the bank must turn to other places to boost returns. That could mean excess leverage (a temptation Citizens Financial has thus far avoided), or it could mean focusing the bank on riskier, higher-yielding assets. Looking at the bank's loan portfolio, there is evidence of some excess risk-taking relative to other regional banks.
The bank's largest concentration of loans are home equity lines of credit. These loans are typically in second lien position behind traditional mortgages and are therefore much more exposed to fluctuations in the real estate market. If prices drop, the home equity loans are wiped out well before the first lien mortgages.
The second largest concentration? Auto loans, a high-yielding asset class that carries a correspondingly higher risk profile.
Management has stated an intent to diversify the retail portfolio and thereby reduce this risk, but it's too early to say if that effort will succeed.
Only time will tell how Citizens Financial Group's stock performs. There are valid reasons why the stock could rise or fall. In my view, the key to the bank's future is how the management team execute its turnaround strategy.
If the bank can successfully grow its commercial business unit (a business that's doing quite well) and diversify the retail portfolio, then the stock could very well rise. However, in its current condition, Citizens Financial Group is an underperforming bank in need of a turnaround.