Citizens Financial Group, Inc. (NYSE:CFG) Q2 2023 Earnings Call Transcript

Citizens Financial Group, Inc. (NYSE:CFG) Q2 2023 Earnings Call Transcript July 19, 2023

Citizens Financial Group, Inc. misses on earnings expectations. Reported EPS is $0.92 EPS, expectations were $1.01.

Operator: Good morning, everyone. And welcome to the Citizens Financial Group Second Quarter 2023 Earnings Conference Call. My name is Alan, and I will be your operator today. Currently, all participants are in a listen-only mode. Following the presentation, we will conduct a brief question-and-answer session. As a reminder, this event is being recorded. Now I will turn the call over to Kristin Silberberg, Executive Vice President, Investor Relations. Kristin, you may begin.

Kristin Silberberg: Thank you, Alan. Good morning, everyone, and thank you for joining us. First, this morning, our Chairman and CEO, Bruce Van Saun; and CFO, John Woods, will provide an overview of our second quarter results. Brendan Coughlin, Head of Consumer Banking; and Don McCree, Head of Commercial Banking, are also here to provide additional color. We will be referencing our second quarter earnings presentation located on our Investor Relations website. After the presentation, we will be happy to take questions. Our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are outlined for your review on Page 2 of the presentation. We also reference non-GAAP financial measures, so it’s important to review our GAAP results on Page 3 of the presentation and the reconciliations in the appendix. And with that, I will hand over to you Bruce.

Bruce Van Saun: Thanks, Kristin, and good morning, everyone. Thanks for joining our call today. The turbulent external environment continued in the second quarter, but we continue to navigate well and we delivered solid financial performance. In particular, we’re pleased with the strong results we achieved around capital, liquidity and funding. Our CET1 ratio grew by 30 basis points to 10.3% in the quarter and we were able to repurchase in excess of $250 million in stock. We grew spot deposits by 3% or $5.5 billion and our spot loan-to-deposit ratio improved to 85%. Our federal home loan bank borrowings dropped by $7 billion to $5 billion and contingent liquidity grew by 20% to $79 billion. For the quarter, we posted underlying earnings per share of $1.04 an ROTCE of 13.9%.

NII was down 3% reflecting higher funding costs, in line with our expectations. Non-interest income grew 4%, slightly less than expected as capital markets saw a few deals pushed to the third quarter. The expenses were broadly stable as expected and credit cost continue to be manageable. One of the highlights of the second quarter was the opportunity to secure a significant influx of talent, largely from the First Republic platform to meaningfully augment our Citizens Private Bank and Wealth Management business. While expense investments will lead revenues in 2023, we project the business to be accretive in 2024 and significantly profitable in the medium term. In our presentation this morning, we will highlight this initiative in more detail.

And we’ll also review several other compelling initiatives that we believe will lead to strong medium-term outperformance. Execution of these initiatives continues to be strong. We’re setting up a non-core run-off portfolio as a centerpiece of intensified balance sheet optimization efforts. We expect around $9 billion of loan run-off, largely in auto by the end of 2025. This capacity will be utilized to fund more strategic loan portfolios, to pay down high-cost debt, and to build cash and securities. In parallel, the Private Bank will grow loans over this period by $9 billion, which will be funded by $11 billion of incremental deposits. The net benefit of all of this is a better deployment of capital, along with the positive impact on earnings per share, ROTCE and liquidity.

We’ve also included more detail on our CRE loan portfolio. Our general office reserve is now at 8%. While we continue to see increases in criticized assets and charge-offs in this particular portfolio, we believe losses are manageable and readily absorbed by reserves and our strong capital position. Looking forward, we anticipate that the environment while stabilizing, will continue to be challenging. Our net interest margin will decline again in Q3, given higher funding costs. We expect our terminal beta to reach 49% to 50% at year end. Our fees to continue to grow sequentially. Expenses will be well-controlled and credit should be broadly stable. We will further build our CET1 ratio while continuing to repurchase shares. Overall, we’re holding in okay on current-period performance with mid-teens ROTCE in 2023, while making the investments to deliver a stronger franchise, attractive growth and returns, and afforded by balance sheet over the medium-term.

We continue to build a great bank and we remain very excited about our future. Our capital strength and our attractive franchise, position us to attract terrific talent and to take advantage of opportunities as they arise. With that, let me turn it over to John to take you through more of the financial details. John?

John Woods: Thanks, Bruce, and good morning everyone. Let me start with the headlines for the second quarter, referencing Slide 5. For the second quarter, we generated underlying net income of $531 million and EPS of $1.04. Our underlying ROTCE for the quarter was 13.9%. Net interest income was down 3% linked-quarter, and our margin was 3.17%, down 13 basis points with funding costs outpacing the increase in asset yields. We delivered very strong deposit growth in the quarter, reflecting the strength of the franchise with spot deposits up 3% or $5.5 billion. Period-end loans and average loans were down 2% quarter-over quarter, reflecting the impact of our balance sheet optimization efforts, including our ongoing run-off of auto.

These dynamics improved our period end LDR to 85% and our liquidity position remains very strong. We reduced FHLB borrowings by about $7 billion to approximately $5 billion outstanding at quarter-end and we increased our available liquidity by 19% to about $79 billion. Our credit metrics and overall position remains solid. Total NCOs of 40 basis points are up 6 basis points linked-quarter as expected, primarily reflecting higher charge-offs, increased general office. We recorded a provision for credit losses of $176 million and a reserve build of $24 million this quarter, increasing our ACL coverage to 1.52% up from 1.47% at the end of the first quarter, with the increase directed to the general office portfolio. We repurchased $256 million of common shares in the second quarter and delivered a strong CET1 ratio of 10.3%, up from 10% in the first quarter.

And our tangible book value per share is down 2% linked-quarter, reflecting AOCI impacts associated with higher rates. On the next few slides, I’ll provide further details related to second quarter results. On Slide 6, net interest income was down 3%, primarily reflecting a lower net interest margin, which was down 13 basis points to 3.17% with the increase in asset yields, more than offset by higher funding costs, given the competitive environment and migration from lower cost categories. With Fed funds increasing 500 basis points since the end of 2021, our cumulative interest-bearing deposit beta is 42% through the second quarter which has been rising in response to the rate and competitive environment and is generally in the pack with peers.

Our asset sensitivity at the end of the second quarter is still approximately 1% which is broadly stable with the prior quarter. Our received fixed cash flow swap position is similar to the prior quarter as we held off on adding further protection as rates continued to rise during the quarter. Moving on to Slide 7, we posted a solid fee performance in a challenging market environment. Fees were up 4% linked-quarter with card fees showing a seasonally strong increase from higher transaction volumes and increases in wealth and mortgage banking fees. FX and derivatives revenue was modestly lower. Capital markets fees were stable with market volatility through the quarter continuing to impact underwriting fees, largely offset by increased syndications and M&A advisory fees, despite a few deals being pushed into the third quarter.

We continue to see good strength in our deal pipelines and are hopeful that deal flow picks up in the second half. Mortgage fees were slightly higher as production fees increased with market volumes, partially offset by lower margins and lower servicing fees. And finally, wealth fees were also up slightly reflecting growth in AUM. On Slide 8, expenses were broadly stable linked-quarter as seasonally lower salaries and employee benefits were offset by higher equipment and software costs, as well as higher advertising and deposit insurance costs. On Slide 9, average and period-end loans were both down 2% linked-quarter, reflecting balance sheet optimization actions in C&I, as well as the impact of planned auto runoff. Education was lower given the rate environment, but this was offset by modest growth in mortgage and from equity.

Commercial utilization was down a bit as clients look to deleverage, given higher rates and we saw less M&A financing activity in the face of an uncertain economic environment. On Slide 10, period-end deposits were up $5.5 billion or 3% linked-quarter with growth led by consumer up $3 billion and commercial up $2 billion. Our interest-bearing deposit costs were up 47 basis points, which translates to a 101% sequential beta and a 42% cumulative beta. Strong deposit flows and a very successful auto loan collateralized borrowing program initiated during the quarter contributed to reducing FHLB levels by about $7 billion. Given our BSO objectives, we grew deposits, which drove a favorable mix-shift away from wholesale funding. As a result, our total cost of funds was relatively well-behaved up 38 basis points.

Next, I’ll move to Slide 11 to highlight the strength of our deposit franchise. With 67% of our deposits skewed toward consumer and highly-diversified across product mix and channels, we are able to efficiently and cost effectively manage our deposits in a rising rate environment. We increased the portion of our insured and secured deposits from 68% to 70% linked-quarter and when combined with our available liquidity of $79 billion, our available liquidity as a percentage of uninsured deposits increased to about 150% from around 120% in the first quarter. As rates grew another 25 basis points in the second quarter, we saw continued migration of lower-cost deposits to higher-yielding categories, primarily in commercial with noninterest bearing now representing about 23% of the book.

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This is back to pre-pandemic levels and should stabilize from here. Moving on to Slide 12. We saw a good credit results in retail again this quarter and higher charge-offs in commercial. Net charge-offs were 40 basis points, up 6 basis points linked-quarter, which reflects an increase in the general office segment of commercial real-estate, partly offset by a slight improvement in retail, primarily due to the strength in used-car values. Nonperforming loans are 79 basis points of total loans, up 15 basis points from the first quarter, reflecting an increase in general office, which tends to be lumpy. It’s also worth noting that overall delinquencies were lower sequentially with retail and commercial both improving slightly. Retail delinquencies continue to remain favorable to historical levels.

Turning to Slide 13, I’ll walk through the drivers of the allowance this quarter. We increased our allowance by $24 million, which includes a $41 million increase in CRE general office, even after covering charge-offs of $56 million. Our overall coverage ratio stands at 1.52%, which is a 5 basis points increase in the second quarter. The runoff of the noncore portfolio primarily auto, facilitated the reallocation of reserves to CRE. The reserve coverage in general office was increased to a strong 8%. On Slide 14, you’ll see some of the key assumptions driving the general office reserve coverage level which we feel represent a fairly adverse scenario that is much worse than we’ve seen in historical downturns. As mentioned, we built our reserve for the general office portfolio to $313 million this quarter which represents coverage of 8%.

In addition to running a number of stress scenarios across the general office portfolio, we continuously perform a detailed loan level analysis that takes into account property-specific details, such as location, building quality, operating performance and maturity. We have a very experienced CRE team more focused on managing the portfolio on a loan-by-loan basis and engaging in ongoing discussions with sponsors to work-through the property and borrower-specific elements to derisk the portfolio and ultimately minimize losses. Our reserves reflect this detailed view of the portfolio as well as the key macro factors we set out on the page. The property value, default rate and loss severity assumptions we are using to set the reserve, are adequate for the risks we currently see and are significantly more conservative than what we’ve seen in previous CRE downturns.

It’s worth noting that the financial impact of any further deterioration behind what we expect would be very manageable, given our strong reserve and capital position. On the following Slide 15, there are some additional disclosures we are providing this quarter to give more detail on the type and location of the general office portfolio. You can see out of the $3.9 billion general office portfolio, 94% is Class A or B with the majority in suburban areas, which seem to be performing better than central business districts. On the bottom left-hand side of the page, it highlights that the portfolio is quite diversified across geographies, as well as the top 10 MSAs, listed on the bottom right-hand side. Broadly for New York MSA, we are starting to see return to office trends picking-up and more than 80% of the portfolio was outside Manhattan where property dynamics tend to be more favorable.

Washington DC is 100% class A&D and 95% suburban. Moving to Slide 16, we maintained excellent balance sheet strength. Our CET1 ratio increased to 10.3% as we look to add capital given the uncertain macro and regulatory environment. We returned a total of $461 million to shareholders through share repurchases and dividends. Turning to Slide 17. You’ll see that our CET1 ratio is among the highest in our regional bank peer group. This strong capital level reflects a relatively conservative approach since the IPO in maintaining robust capital levels. If you incorporate the removal of AOCI opt-out, our adjusted CET1 ratio would be 0.5% and we also expect that this replace us near the top of our peer group again this quarter. We expect to maintain very strong capital levels going forward with the ability to generate roughly 20 basis points of CET1 ratio post-dividend each quarter in 2H ’23 before share buybacks.

So, as you see, we’ve been focused for a while and playing really strong defense with a focus on capital, liquidity, funding and maintaining a prudent credit risk appetite. And that’s the job one. Even long before the turmoil we saw in the first quarter. But we also recognized the need to continue to play offense. We need to be selective, investing in initiatives that will grow the franchise where we have a right to win. Over the next few slides, I’ll spotlight a few of the exciting things we’re doing and ensure that we can deliver growth and strong returns for our shareholders. First, on Slides 19 and 20, we were excited to announce a few weeks back that we hired about 50 senior private bankers and 100 related support professionals who were with First Republic.

As many of you know, for a number of years, we’ve had an interest in growing our wealth business, both organically and inorganically. So we made a number of investments on the organic side, hiring financial advisors and converting that business from a transactional business to a very customer-centric financial planning approach. That’s been a slow and steady build over the years. And then we supplemented that with the Clarfeld acquisition a couple of years ago and that’s gone incredibly well. So, with our customer-centric culture, our financial strength and the full range of products and services we offer, we were the perfect fit for these bankers. We really admire their approach to delivering the bank to their customers in a unique way with white glove service.

This is really a coast-to-coast team with a presence in some of our key markets like New York, Boston, and places where we’d like to do more like, Florida and California. In fact, we think the overlap with JMP in San Francisco is extremely complementary. These bankers serve the types of customers we are seeking to attract to the bank, high and ultra-high-net-worth individuals and families, often the strong connections to middle-market companies with a particular focus on private equity and venture capital firms, serving the innovation economy. We have a great deal of work ahead of us to integrate these teams and ensure that they are positioned to deliver that bank to their clients. We plan to open a few private banking centers in key geographies and build appropriate scale in our wealth business with Clarfeld as the centerpiece of that effort.

We think this is going to be extremely attractive from a financial perspective. These teams and their staff, about 150 people in total, on-boarded late in the second quarter with revenue begin to ramp in the fourth quarter. Financial impact for the second half will be $0.08 to $0.10 of EPS plus an initial notable cost of about $0.03 for 2023. These bankers have hit the ground running and are out-working to build their book of business and we expect the effort to breakeven around the middle of 2024. By 2025, we expect EPS accretion of roughly 5% with 2025 year end projections of about $9 billion in loans, $11 billion of deposits and $10 billion of assets under management. So overall, a very exciting advance for us. Now let’s go to Slide 21, and I’ll walk you through how we’ll be managing our balance sheet over the next few years.

Since the IPO, we’re prudently growing our balance sheet while managing the mix of assets and funding with an eye towards maximizing returns. With the increase in rates since the end of 2021, plus the advent of quantitative tightening and more recently, the heightened competition for deposits, we are entering the next stage of the journey with a plan to focus on attractive relationship lending, while lowering our LDR, which will improve our liquidity profile and benefit returns. In order to make this effort clear and show the benefits we expect, we’ve established a $14 billion non-core portfolio which is comprised of our $10 billion shorter duration indirect auto portfolio and lower relationship purchased customer loans – consumer loans. This portfolio will run down fairly quickly with about $9 billion of run-off expected by the end of 2025.

Moving to Slides 22 and 23, you’ll see that as the non-core loan portfolio runs down, this allows us to pay down higher-cost funding and redeploy capital into more strategic lending and our investment portfolio. We will also be growing relationship-based lending to the private bank and raising deposits to self-fund that growth. Despite the size of the run-off portfolio, we expect to see modest loan growth in 2024, picking up in 2025, driven by opportunities across retail and C&I as well as our private bank effort. The net result of these actions is an improved liquidity profile with a better loan and funding mix and higher returns. Next on Slide 24, a quick update on our entry into New York Metro where some really exciting things are happening.

With the branch conversions behind us, we are full steam ahead working to serve our customers and capitalize on opportunities. We continue to be encouraged by our early success. We’ve seen strong sales in the branches as we leverage our full customer service capabilities to drive some of the highest customer acquisition and sales rates in their network. Most importantly, we have seen a steady improvement in our Net Promoter Scores. On the commercial banking side, we’ve got a strong new leadership team in place with local talent joining from larger firms and we are seeing some early success leveraging our new visibility to build pipelines with middle-market firms. And we are looking forward to what we can do with our new private banking capabilities in the market.

On Slide 25, we have a great opportunity to build on Citizens Access, our national digital platform that has been focused on deposits for the last few years. We moved to a modern fully cloud-based core platform and we are trying to add checking capabilities later this year. Down the road, we plan to converge our legacy core system with this modern platform. We are confident that a single integrated platform will be more cost-efficient and flexible in meeting our client’s needs. We aim for this to be a complete digital bank experience to serve customers nationwide with a focus on the young mass-affluent market segment. And on the right side of the page is CitizensPay where we have been very innovative in creating distinctive ways to serve customers.

CitizensPay has been the top customer acquisition engine for the bank with very high promoter scores and this has been a great performer from a credit perspective. We have some fantastic partners on the platform for a while, such as Apple, Microsoft, Best Buy, BJ’s and Vivint. And we are always very excited to welcome new partners like Peloton, Tre, The Tile Shop and Wisetack to platform. On Slide 26, I’ll highlight how we are positioned to support the significant growth in private capital. Over the last several years, private capital fundraising had led – has led to record deal formation, M&A activity and substantial fees. The activity has been relatively muted recently and many sponsors have not deployed meaningful amounts of capital. So there is a tremendous amount of pent-up demand for M&A and capital markets activity.

We have been executing a consistent strategy to serve the sponsor community with distinctive capabilities for the last 10 years and we’ve done a great job moving up to the top of the sponsor lead tables, particularly in the middle market. We have made significant investments in talent and capabilities, including five advisory acquisitions since 2017. And our new private bankers significantly expand our sponsor relationships and capabilities. Our success supporting private capital has been a large part of our strong capital markets performance over the last few years and we are poised to capitalize on the next wave of sponsor activity as the path of the economy becomes clearer. Let’s move to Slide 27 for an update on our TOP program. Our latest TOP 8 program is well underway and progressing well.

Given the external environment, we have decided to augment the program to protect returns as well as ensure that we can continue to make the important investments in our business to drive future performance. We have increased our targeted benefit by $15 million to $115 million by accelerating some of our other efforts and to further rationalize our branch network and reduce procurement costs. We have also begun planning for our TOP 9 program, looking for efficiency opportunities driven by further automation and the use of AI to better serve our customers. We are also looking at ways to simplify our organization and find even more savings in procurement. Continuous improvement is part of our DNA and I’m very confident that we’ll continue to deliver these benefits to the bank.

Moving to Slide 28, I’ll walk through the outlook for the second quarter for Citizens, which excludes the impact of the Private Bank and I will also provide some comments for the full year. The outlook takes into account another rate increase, followed by Fed on hold for the remainder of this year. For the third quarter, we expect NII to decrease about 4%. Noninterest income to be up by approximately 3%. Net interest expense should be broadly stable. Net charge-offs are expected to be broadly stable to up slightly. Our CET1 is expected to rise modestly from 10.3% with additional share repurchases planned, which will depend upon our ongoing assessment of the external environment. Relating to the full year, our liquidity position is quite strong and given the BSO actions I discussed earlier, we will continue to build on this, targeting an LDR of low-to mid-80s by the end of the year, positioning us well for anticipated regulatory changes.

Worth noting we are already – we already are fully LDR compliant with Category 3 bank requirements. Based on the forward curve, we are expecting a terminal interest-bearing deposit beta of 49% to 50%. Our net interest margin should begin to stabilize in Q4 as the Fed is expected to reach the end of the rate hike cycle. We are off to a great start of drilling up the private bank, and we expect the EPS impact of this to be $0.06 in the third quarter and $0.02 to $0.04 in the fourth quarter. So we really think of this as a capital investment. To wrap up, our results were solid for the quarter as we continue to navigate a turbulent external environment. We are focused on positioning the company with a strong capital, liquidity and funding position, which will serve us well as we continue to navigate a challenging environment ahead.

Our balance sheet strength also positions us very well to focus on our strategic priorities to continue to strengthen the franchise for the future and deliver attractive returns. With that, I’ll hand back over to Bruce.

Bruce Van Saun: Okay. Thanks, John. Alan, let’s open it up for some Q&A.

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Q&A Session

Operator: Thank you. Thank you, Mr. Van Saun, we are now ready for the Q&A portion of the conference call. [Operator Instructions] Your first question will come from Scott Siefers with Piper Sandler. Go ahead.

Scott Siefers: Good morning, everybody. Thank you for taking the question. I guess first question is just on the sort of accretion to the margin from the balance sheet optimization. Do you have a sense for what sort of steady-state margin from Citizens might look like after that is completed. I guess, it doesn’t necessarily have to be a specific number, but just in your view how powerful is that accretion from these activities? And I appreciate that sort of the backdrop of the 4.2% yield versus the 5.5% funding costs.

John Woods: Yes, I’ll go ahead and start off. Thanks for the question. I mean, I think, broadly, we’re seeing the impact of the rate environment on our net interest margin. We’re managing it quite well as the Fed is continuing on its hiking cycle. And as you get into the end of the year, taking into consideration all of the balance sheet optimization activities, we see NIM flattening out and kind of holding it around 3% or so, as you get to the end of the year. The tailwinds from balance sheet optimization are meaningful and will continue to build into ’24 and so those are the big drivers there, I think that also contributing to that NIM stability would be the fact that we think that balance sheet migration is starting to stabilize.

And also you can ignore the fact that the Private Bank itself as you get out into ’24, would start to deliver accretive NIM. So we’re feeling good about the profile after we get through this last hikes from the Fed here in July, watching that NIM starts to stabilize as you get into the end of the year.

Scott Siefers: Okay, perfect. Thank you. And then is it possible to put sort of a finer point on the, I guess 8% to 10% – pardon me, $0.08 to $0.10 of cumulative expected EPS drag from the Private Bank initiatives. Certainly appreciate the sort of the loan and deposit in asset management or assets under management outlooks, but maybe any broad sense dollar value of expected revenues and expenses as we look into the second half.

John Woods: Yes. And it’s a little bit front-end loaded as the expenses will come in and drive probably more in the neighborhood of $0.06 of that $0.08 to $0.10 happening in third quarter with $0.02 to $0.04 really into the fourth quarter. And it’s primarily expenses in the neighborhood of $40 million or so, as you get into the 3Q and 4Q and but the loan book starts to build later this quarter and into 4Q. So that gives you the front-end loaded of that $0.08 to $0.10 into 3Q.

Bruce Van Saun: The one thing I would say to that, Scott, it’s Bruce, is, this is a very sound approach to scaling up the wealth business. We’ve been looking for acquisition ideas and it’s been very expensive with very long tangible book value earn backs, many times would be over five years, which is beyond our appetite. So to actually do this in a kind of de novo build-up basis, you incur some capital expense in the short run, but it’s almost the same as if you kind of equate it to an outlays that ultimately starts to generate revenues. And the nice thing about this is that it’s accretive already in the second year and kind of earn-back on this thing is under two years. So we look at it really less as a driver of how does it affect the near-term EPS.