Citizens Financial Group, Inc. (CFG) Earnings Call Transcript & Summary

Welcome back, everyone. Hopefully, everyone had a chance to grab some lunch. Next up on the schedule is Citizens Financial Group. Representing the company are John Woods, Vice Chairman and CFO of the company; as well as Malcolm Griggs, who's the Chief Risk Officer. At the end of last quarter, Citizens had assets of almost $180 billion with 1,000 branches in 11 states. The plan today is for John and Malcolm to discuss the presentation that was filed right about an hour ago. After that, we will transition to a Q&A period. And also for those that would like to ask a question, you can submit one at the bottom of the screen. So with that, let me pass it over to John and Malcolm.

Thanks, Terry, and good afternoon, everyone. It's great to be here virtually. That's fine, but I am looking forward to a real life conference at some point down the line. In particular, with the [ BAB ], the lobster is great, for those of you that have never been to the lunch at the [ BAB ]. So looking forward to seeing that next year. But let's start off on Page 2. This really is just an overview of the remarks that we're going to cover through the first half of this presentation. The first 3 categories that you see on the page, I'll go through. And the last one, Malcolm will cover. So just the highlights. Basically, we'll talk about our recent financial performance in the third quarter. With all of the disruption from COVID-19, we thought that was helpful to do a recap. I'll also cover the levers we have at our disposal to manage through this serve environment and including how we're going to grow EPS and ROTCE. And this includes more room to run on TOP 6, and we'll be talking about the upsizing of our TOP 6 program. And finally, Malcolm will close it out with covering a number of slides on credit trends and how we're proactively monitoring the credit book. So with that, let's get started on Page 3. Like I said, this is a recap of our metrics from the third quarter. There's a lot to like on this page, but let me point to a couple of highlights. First, I think I'd call out our excellent PPNR resilience that you see in the middle part of the page, $834 million, PPNR up 22% year-over-year. This is another record for us. We've set a couple of them in 2020. A lot of that was driven by the strength in fees, which you see in the upper right, 37% of fees to total revenues, very strong. That also has been a record. And it's driving 9% operating leverage year-over-year. And all of that building up to a 9% ROTCE in the third quarter, which is nearing our expectation of generating double-digit ROTCE considering the fact that there was 5 percentage points of ROTCE reserve build in the quarter. So feeling quite good about the financial performance in the third quarter. And finally, making lots of progress, if you look at some of our commentary on the left part of this page, on strategic initiatives and prioritizing where we're going to create momentum as we come out of this crisis. Let's move on to the next slide, Slide 4. This is basically a key up for all of the slides that follow and basically focusing on all of the levers that we have to pull to grow EPS and ROTCE. So the first 2 blocks that you see is basically net interest margin and NII. I'll jump to one of the headlines, which is that we believe that NIM is stabilizing and currently projected to bottom in 2022 in the 270 to 280 basis point range. And much of that is driven by the fact that offsets many of the headwinds is our balance sheet optimization program, which has been contributing over the years and continues to contribute in managing and optimizing the loan and deposit portfolio. We expect some curve steepening as well, and I'll touch on that a bit further as I get into some of the slides. The third block here is in fees. We do expect continuing benefit from all of the investments we've made in our fee income businesses over the years, both organic and inorganic. And as I mentioned before, further expense opportunity. We expect to deliver at least $100 million of additional pretax in this area, which is another example of self-help that continues to contribute. In Credit, strong reserves and credit trends appear to be stabilizing. More from Malcolm on that later. And then finally, with respect to capital, we're at 9.8% at the end of the quarter. And considering we started the year at 10%. This is basically a full round trip back to our target range of 9.75% to 10%, while more than doubling our ACL and protecting our dividend along the way. So let's move over to Page 5. A couple of comments about net interest margin. If you look on the left side of the page, we've highlighted some of the headwinds that we are facing. And you start off, of course, with the REIT environment itself, which is much worse than even the last SERP environment that ended in 2015, given what's going on in the long end. That said, over the last month or so, we have seen some steepening in the yield curve, and we do expect that to continue as you get out over the next year or 2. And so that will, of course, contribute given the fact that we have meaningful amounts of asset sensitivity to the long end of the curve. The second bullet here on the left talks about our earning assets and how balanced we are. We're in a 50% fixed, 50% variable rate profile with respect to earning assets. Now on the variable side, the rate impact has basically been fully baked in by the time you get to the third quarter. On the fixed side, that will take a while to burn in. But the magnitude diminishes over time, and most of this gets baked in by the end of 2022, given prepayments, et cetera. And then if you look at the bottom part of the page, we do talk about the fact that we've been -- we've had very effective hedging strategies to date. And if you assume current rates are in place throughout 2021. That said, our hedges do begin to run off. And so we see a $75 million decline in benefit in 2021 compared with 2020. Now the offset to that, of course, is the fact that -- and I'll talk about this in a second, that we're executing on a number of BSO actions most prominently in the deposit pricing space. But as I mentioned before, all of this rolls up to an expectation that we're going to see NIM bottoming in 2022 in this range of 2.70% to 2.80% compared with where we are today at 2.83%. So another couple of comments on that on Page 6. As I mentioned, deposits are a big part of the story. And on the left side of the page, we've made a lot of progress over the last year. If you look back a year ago, interest-bearing deposit costs being at 124 basis points and bringing them down to 35 basis points has been very good. And frankly, that 35 basis points loosely connects with where we ended the last SERP. But given all the investments that we've made over the years, we can now indicate that we're targeting mid-teens interest-bearing deposit costs by the end of 2021, which is a significant improvement over where we've been, where we ended last SERP and from where we are today. So that's a really important mitigant, if you will, to some of the -- to the environment that we're dealing with. And some of that -- and a lot of that is being driven by the fact that not only just solid analytics and pricing, but our mix shifts are improving significantly, not just in the interest-bearing space where term deposits, they're going to fall by half to maybe something in the 8% to 10% territory by the end of 2021, but also strong DDA growth where we've been a leader over the last several years. So a lot of that will help us in the NIM side of things. And on NII, we still endeavor to try to drive strong loan growth, both in the retail and consumer space -- I'm sorry, retail and commercial space. So let's turn to fees. As I mentioned, we've been -- we've had great performance in fees, up 33% year-over-year in the third quarter. And we do expect continued benefits given all of the investments we've made over the years. When you think in consumer, I mean, it's hard to ignore that mortgage has been a huge story. We -- and we think there are going to be meaningful contributions going forward given the fact that we have an expectation that 2021 may end up being the second largest mortgage market, second to 2020, given where rates are and the fact that a majority of the U.S. mortgages are still eligible for a meaningful refi benefit. There are -- but it's not just mortgage. There are other few categories that are expected to return to pre-COVID or better performance, and I'd say that Wealth and Capital Markets are chief among them. Moving over to Page 8. As I mentioned, I'll finish up my section in the expense area. We had a 2-year TOP 6 program that we can now say is projecting a $400 million to $425 million benefit by the year-end of 2021. This includes $100 million upsizing driven by our digitization initiatives. And really, what we're talking about there is on the loan and deposit side of things, we have a lot of manual processing still within the organization, and we're going to be automating that over this time frame. And not only that, but also driving self-serve capabilities to reduce the need for call center resources, et cetera. So that's the top part of the page, but it's not just about efficiencies. There are also revenue opportunities as well. And so some -- I mean some examples of that are listed in the bottom part of the page. In mortgage where we're adopting digital tools and both in mortgage and wealth where we're increasing our virtual investments to expand the efficiencies there. Closing it out, our annual TOP 6 programs are emblematic of our culture of continuous improvement. It helps us self-fund our investments that are incredibly important and helps us contribute to the bottom line. So with that, let me turn it over to Malcolm.

Good. Thanks, John. Appreciate being with all of you today. On Slide 9, this is just a brief overview of the topics that I'll go into in a little bit more detail. But we -- I think we've got a very disciplined credit risk appetite approach. We have made adjustments, of course, during the course of the pandemic and the economic downturn to ensure that assets that we're bringing on to the sheet and new originations meet our expectations for credit criteria. And we're also taking actions on the back book in light of the stresses in the environment right now. I'm going to talk a little bit about both the retail portfolio and the commercial portfolio. On the retail side, we have a prime and super prime focused portfolio that has served us well during the pandemic. On the commercial side, we've got a very granular and diversified commercial portfolio, and we'll go into more detail around that. We've also helped our customers quite a bit through the COVID crisis. We've been working with retail and commercial customers to help them over the economic hump with forbearance and with commercial loan modifications all of which have been declining substantially recently. We originated 50,000 PPP loans with average size of under $100,000. So the money was really targeted to our small business customers as the program was intended. Reserve levels are strong. Net charge-offs are stabilizing, and we think that nonperforming assets and criticized and classified trends are also stable to improving. If we go over to Slide 10, this just gives a bit of a background on what we have done in terms of the downturn playbook for both commercial and consumer. On the commercial side, we do a quarterly bottoms-up cash burn analysis for 1,900 commercial customers representing 70% of loan balances in the commercial book. So this is a substantial exercise that's engaged in by both the second line of defense credit functions in my world as well as the portfolio management functions in Don McCree's world. What this does is allow us to be more precise in forecasting losses and forecasting nonperforming assets and in identifying customers in need of more attention so that we can help them through the process. We do sector reviews based on the cash burn analysis that incorporate input from weekly and biweekly in some cases, interactions with our customers. So we're in constant contact with our customers so that we understand their financial situation and the challenges that they're facing. In the higher risk sectors, we are running down balances as part of portfolio repositioning. And as I mentioned earlier, we've got disciplined underwriting for new credits. On the consumer side, we've rapidly implemented our credit downturn playbook. We've had credit tightening actions determined by loss expectations across portfolios. So less severe tightening in auto, property, student, more severe tightening for business banking, our PERL product and credit cards. So if you just think about it that way, we're really -- the collateral values are holding up quite well, both in homes as well as automobiles. So the degree of tightening -- we've got tightening across the board, but the degree of tightening has been somewhat less in the collateral secured book, which is far and away most of the book on the retail side. So we've also had a delinquency tracking for loans in forbearance. I'm going to talk about forbearance in a little more detail momentarily. So in terms of forbearance, let's go to Slide 11. That's a good segue. You can see that from the end of June through the end of October, the balances in retail forbearance have dropped from 6% to 2.8%. So that's a fairly substantial drop. Deferrals of either principal or interest in the commercial side have dropped from 5.2% to around 1% by the end of last month. So substantial decreases. But here's the real story. So on the retail side of the house, of the customers who have exited forbearance, 95% are current. I think that's a pretty good statistic. And then overall, the delinquency rates in the consumer book for customers that have been in forbearance or never were in forbearance has remained fairly stable throughout the economic crisis. On the commercial side, I mentioned some of the work that we're doing there. Much of what's been done there this very small percentage, as I indicated, that is actually in deferral of payments. There's a somewhat larger percentage where we've had some form of modification, usually a covenant waiver of some kind, if it's not deleterious to the bank's position. An example of that is that with the PPP loans that were available, often there may have been a covenant that said that the customer could not take on additional debt. Well, technically, even though it's a forgivable loan, PPP is additional debt. That was an easy one to wave, but it counts into our statistics, and we measure that and then we monitor performance relative to the covenant waivers that we've granted to our customers. Let's talk about reserves for a moment. So if we go over Slide 12. We feel that our reserve builds were prudent. And based on current macroeconomic outlooks and the granular portfolio data that we have, including what we've garnered from the cash burn analysis, we don't see the need for additional builds because of deterioration in the back book. We know what we've got. We've already built reserves to address it. We believe that we are adequately reserved. And going forward, we believe that we can take our net charge-offs against the reserve account without adding to provision expense in order to either build or to match net charge-offs. So that will draw down our overall reserves. We'll talk about that in a moment. But we think that we're adequately reserved at this point, and we're able to move forward on that basis. A couple of other quick points. John had talked earlier about some of the metrics coming out of Q3. And I think just to remind folks that despite the sizable build that we have had in our reserves, the CET1 ratio improved 20 basis points to 9.8% given the PPNR growth that John mentioned earlier. The areas that we have of continued concern, the sectors that we have that would pose a continued concern and none of these are surprising to anyone, I think, who's paying attention to the environment. Hospitality is certainly under stress. People are reluctant to travel. They're reluctant to book hotel rooms. We've got some of the retail trade is under stress, although that's come back a bit, including brick-and-mortar retail. Retail sales have ticked up in September and October. And -- but the number of sectors that we're concerned about have started to decrease a bit as the economy has reopened. Nonetheless, of the sectors that remain of concern to us, we have 3x the level of reserves stacked against those sectors as we do the rest of the commercial book. So I think that's important to note. Again, it just emphasizes the fact that we believe that we're appropriately reserved. If we go on to Slide 13, this is what I was mentioning earlier about provisions. We think the provision expense in the fourth quarter will be down. We have given guidance that we're reiterating today on fourth quarter net charge-offs in the range of 60 to 80 basis points on an annualized net charge-off ratio basis. And again, the provision in 3Q of $428 million included a build of $209 million, we don't see the need for a build going forward. On 14. Nonaccrual loans are expected to decline a bit. We don't usually show a month-end column in these presentations. Usually, it's all to do with quarter end. But this is simply illustrative of the fact that as of the end of October, our nonaccrual loans had declined. And we expect that to be the case overall for Q4 as well. So this is simply illustrating what we're seeing and what has actually happened at least in the first month of the quarter. The nonaccruals that increased in Q3 were largely driven by a couple of mall REIT credits that have made their way through the pipe. If we shift over to criticize now, the same kind of concept there. So we've got some data as of the end of October, and you're seeing a decline as of the end of October from 9.06% criticized as of the end of 3Q to 8.65% as of the end of the month of October. Now 1 month does not a trend make. So -- but we overall have an expectation that this is evidence of criticized assets stabilizing with perhaps a downward trend. The caveat that I'll give you on that is that, and just as a reminder, I think most of you are aware of this, within criticized, you have special mentioned loans, substandard and doubtful. Special mention loans tend to have the very broadest possible definition. And as a result, it lends itself to much more judgmental calls. So the definition of a special mention loan has to do with whether a loan has a potential weakness that if uncorrected could increase the likelihood of an inability to repay fully a principal and interest. Well, a potential weakness can describe a lot of things in an economic downturn. So that number is going to bounce around a little bit depending on the quarter we're in, depending on a number of external factors such as when is the next stimulus package going to be passed? How will it be directed? How easy will it be to access? All of those things will factor into the criticized asset ratios as we go forward. But for now, we believe that the trend is a positive trend compared to the third quarter, certainly. So at this point, I'm going to turn it back over to John.

Great. Thank you, Malcolm. Just to wrap it up on this page briefly. I think the main messages that we're looking to have here as takeaways are there are many tools to achieve EPS growth and ROTCE growth that we've highlighted. Within revenues, it's balance sheet optimization, loan growth and diversification benefit in rate protection and fees, further upside on managing expenses. And just closing it out, we have a very strong balance sheet with -- we're seeing positive trends in credit after already having a strong credit reserve level and very strong capital, which positions us well as we fund strategic initiatives over time. So with that, I'm going to turn it back to you, Terry, and we'll take it from here in terms of questions.

Great. Thank you both. Most of the questions, really, I would say expand on the topics that both you and Malcolm just addressed over the last 20 minutes. Maybe, John, let's start with you in keeping with the theme of the conference, which is how will banks combat the structural challenge of low rates, assuming the Fed kind of sticks to its strategy of keeping short-term rates unchanged combined with the slope of the yield curve. What strategies can be employed to counter the negative effect of this interest rate environment? And then I believe in your prepared remarks, you did talk about within that 2022 margin outlook that you talked about, some sort of steepening of the curve. And I was hoping you could expand on that as well.

Yes, sure. I mean I think some broad strokes here. I mean I'd say that underpinning all of this is that we've had an underlying benefit from balance sheet optimization that's been contributing every year for the past couple of years, and we expect that that will continue over time. And it takes the form of targeting strong risk return, loan originations. It takes the form of improving our pricing analytics to expand our spreads on the loan side as well as, when I flip over to deposits, we've made a multiyear investment in analytics and product design and really delivering the entire bank to be able to make the case that we are going to reduce our interest-bearing deposit costs to mid-teens by the end of 2021, which is a significant transformation of our ability to fund the bank and how strong the franchise is. So those are very important, I would say, offsets and mitigants to what is a very difficult environment. Let's not forget the diversification on the fee side as well. We have massive rate protection that has expressed itself in our mortgage business. The refi portion of that business is highly rate sensitive. And there's a significant amount of hedge that existed in 2020 and that we believe will extend into 2021 based on some of the points that I've made. And then maybe just to close it out with a couple of other comments. We're pretty balanced on the fixed floating side of things. So we have about half of our earning assets are fixed. So that's been providing some protection. Sure that will reprice over time, just like our hedges have provided great protection. Those will mature over time. But those have all been the ways that we've combated net interest margin decline. And I think that just coming back to our expectation that, when you put it all together, we do see that NIM is stabilizing and that the range of 2.70% to 2.80% is our best outlook for 2022 at this point. Now the other part of your question was about yield curve, which I would hasten to add that it's our view that once you get past 2021, we believe that yield curve turns into a little bit of a tailwind. We do think that there's some steepening. That could happen earlier in the second half of 2021, you could start to see some of that flip over to being a positive. Even in the last month, we've seen some steepening in the yield curve. We just believe that's going to continue. And we have a view that maybe as you get out to the end of 2021 and into the end of 2022 that we're going to see a 10-year rather than being double digit would be somewhere mid triple digits, if you will. So somewhere around 140 to 150 basis points. And so that will provide some underpinning for the NIM as we move forward.

And then Malcolm since we've got you this afternoon, a couple of questions. You talked about reserve releasing that the banking industry has seen throughout 2020. What do you think banks will need to see before reserves begin to be released on a more sustainable level? I know your comments were just on the fourth quarter. If you look beyond the fourth quarter, what do you think banks will need to see?

Yes. I think that's a great question, Terry. I think the trigger is going to be how well their crystal ball works on where peak charge-offs are going to land. So just from an industry standpoint, as we look out and we take into consideration the macroeconomic forecast that we're using and how reliable we believe they are and how reliable the inputs to those are. If we have a pretty good idea of when charge-offs will peak and then start to go down, if the banks have already built enough reserves to handle that loss content in their reserve account, then you'll start seeing releases even before the peak. So probably a quarter or 2 before the peak hits, you should start seeing releases at that point.

Yes. I might add to that, too, Terry, that I think Malcolm mentioned this earlier, that it's about the scenario, right? If the scenario doesn't worsen, and if you've faithfully consumed that scenario and you've been focused on how your back book would perform in that kind of scenario. As you know, the accounting -- as the scenario started to stabilize, the accounting really intends for you to build it all upfront and then charge off against it over time. I just think that in 2020, there was so much uncertainty with respect to scenarios, it wasn't something that was possible to do as we caught up to how our portfolios would perform in this sometimes worsening environment. Now we've had several quarters under our belt. Our models are tuned a little better. And at the same time, the scenario seems to be stabilizing. So that's what went into our outlook for the fourth quarter, and frankly, even beyond, as long as the scenario doesn't worsen.

And then Malcolm you talked about loan forbearance. What have the trends been for commercial loans coming off forbearance? I know you talked about the retail portfolio. How are you approaching just commercial credits that are still in forbearance? And have most of them been re-rated?

Yes. So the forbearance, the putting of a loan in forbearance doesn't automatically trigger a re-rating, but it is -- it does raise a question about whether it should be. And all of those that should be re-rated have been. So that's a constant process. That doesn't stop. I mean, obviously, we get in quarterly financial statements from our customers. We spread those, and we determine whether or not a re-rating, either in terms of our internal probability or default ratings or in terms of the regulatory ratings, should be changed. So the loans that have been in deferral, we use a different term just to keep it straight. We talk about forbearance on the consumer side of the house, and we talk about deferrals and loan modifications on the commercial side of the house. Those that have been in deferral, as they're coming out, as you noted on the chart, there's been a substantial decrease on those. Most of those customers are actually performing quite well coming out of deferral. They have not needed a second round. They've told us that. They said, okay, look, we got over the hump through the partial economic reopening that we've had in a number of states in which we do business. They said they've regained their footing and they don't need a second round of deferrals. So those customers are doing fine. The ones that aren't, if the ones that are in the elevated risk sectors that we talked about earlier, we're working with them to figure out what the strategy is. Do they have a viable plan? Do they have liquidity? Do they have sources of liquidity that they can tap to inject more equity into a deal? And if they don't, then our workout team works with them as best they can to find an appropriate solution. But for the most part, I would say that the customers on the commercial side that are coming out of any kind of deferral -- payment deferral that we've had are in better shape than they were.