Fifth Third’s Valuation Reflects Overly Bearish Expectations (NASDAQ:FITB)

Likely due in no small part to worries about its large, long-duration securities portfolio, Fifth Third Bancorp (NASDAQ:FITB) has been hit pretty hard since I last wrote about this large super-regional bank. Down 35% since my last update, these shares have largely tracked the larger bank sub-group and trailed the regional bank group (I see Fifth Third as on the border of both), despite the fact that management has been proactive in managing the balance sheet, including reducing risk-weighted assets in a measured fashion ahead of new capital requirements.

I think the Street is making too much of the unrealized losses on the securities portfolio (if that is, in fact, what’s pressuring the shares) and giving too little credit for what Fifth Third has going for it – including quite competitive deposit costs and a generally attractive loan mix. And I say this as someone who hasn’t historically liked this bank all that much. If 2% to 2.5% long-term core earnings growth is a reasonable estimate, these shares are undervalued below the low-$30s.

A Decent Core Beat

So far banks are running about 50/50 in terms of beating core pre-provision profit expectations, and Fifth Third goes on the good side this quarter with a modest core beat that was further boosted by lower-than-expected provisioning expenses.

Revenue fell more than 3% year over year and quarter over quarter, beating by about 1% or $0.02/share. Net interest income fell 4% yoy and 1% qoq, beating by about $0.02/share. Net interest margin was slightly worse than expected (down 2bp to 2.98%), which is relatively unusual for this quarter so far, while average earning asset performance (up 2% qoq), was better than expected (by about 2%), which is even more unusual for this quarter so far.

Core adjusted non-interest income fell 3% yoy and 7% qoq, with strength in commercial banking (up 5.5% qoq) offset by a sizable decline in “other.” Non-interest income came in as expected this quarter.

Core adjusted operating expenses rose about 2% yoy and fell 2.5% qoq, beating expectations by about $0.01/share, with an efficiency ratio a point lower than expected (54.8%). Pre-provision profits fell about 9% yoy and 4% qoq, but did still beat expectations by about 3% (or a little over $0.03/share).

Provisioning expense was meaningfully lower than expected (about $0.065/share), but tangible book value did decline 12% qoq to $13.76.

Reducing RWAs In An Intelligent Way, But Loan Growth Is Weak

Loan growth performance was not impressive this quarter, as slight year-over-year growth (up 0.1%) and a 1.5% sequential contraction were weaker than what large banks as a group produced, as well as the banking sector as a whole. Yields did improve by about 24bp qoq to 6.18%.

Commercial (C&I) lending declined almost 2% sequentially, while the sector as a whole was about flat for the quarter, and commercial real estate (or CRE) lending declined 0.5% versus 0.8% sector growth. Within CRE, office lending declined 6% sequentially and now sits at only around 1% of total loans. Consumer lending was likewise weaker, with weaker mortgage and indirect consumer (auto, et al) loan balances.

This isn’t an accidental process or necessarily a sign of unwanted share loss. Instead, management is pulling back on lending and actively reducing its risk-weighted assets (or RWAs) but doing so with an eye to value. In particular, the bank is getting more stringent with its one-product customers and enforcing stricter hurdle rates and requirements; in doing so the bank has already seen some corporate customers increase their deposits with the bank to stay on the right side of those requirements.

Deposits rose 2% qoq, making Fifth Third one of the only large banks to show meaningful deposit growth, and non-interest-bearing deposits declined at a lower-than-average rate of 3% in the quarter. Deposit costs remain quite competitive, 2% for total deposit costs and 2.76% for interest-bearing deposits, but the beta is a little high at 50% (compared to 43% for PNC (PNC), 46% for U.S. Bancorp (USB), 48% for Citizens (CFG), and 49% for Truist (TFC)). While deposit costs likely have further to rise, loan repricing will help offset this and management thinks that NIM could bottom in Q1’24.

Risks Seem Manageable

There are two major risk items getting a lot of attention these days (maybe three if you include higher capital requirements) – unrealized losses on securities and office CRE portfolios – and both are relevant to Fifth Third.

Taking the office issue first, at only around 1% of loans, it’s just not that big of an issue. Particularly when the office portfolio currently has had no charge-offs and no delinquencies and the criticized loan ratio is only around 5% (down from 7% last quarter). Even if there is widespread carnage in banking from office loans going bad, it won’t hurt Fifth Third that much.

The second issue is certainly more relevant. Fifth Third has a very large securities book (around 30% of earning assets) and these securities have a relatively long duration at 4.9 years. With rates shooting higher, the value of this portfolio has been decimated, driving unrealized losses of almost $6B.

That’s an ugly number, but I don’t think it’s cause for panic or constitutes a reason to completely avoid Fifth Third shares. First, the Fed has made it clear that they will backstop large banks as needed, and that includes the option to borrow against securities at par if need be. Second, the bank has been building cash (up 61% qoq) and it’s now at almost 7% of earning assets. As I don’t think the bank needs to worry about funding loan growth (a loan/deposit ratio of under 72%) and is likely paused on major buybacks ahead of more clarity on capital rules, I think the situation is manageable.

The Outlook

Management has made little secret of its intention to continue growing by focusing on building its Southeastern operations and its treasury management products, as well as continuing to leverage opportunities in its C&I-heavy loan business. From about 20% of branches five years ago, the Southeast has grown to 30% of branches today and management expects it to reach 50% in five years. With management also now focused on improving customer attachment as a condition for loans, I expect growth in branches to help support growth in C&I lending which in turn should support growth in higher-margin service offerings.

I am looking for a double-digit decline in earnings next year, and my 2024 EPS estimate is about 5% below the current sell-side average (I expect the average will decline as more revised estimates are captured in the average). I do expect a recovery across 2025 and 2026, but I’m only looking for around 1.5% core earnings growth from ’22 to ’27 and close to 2.5% over the next decade.

Discounted back, those core earnings support a fair value of $32.50 today. A 9.9x multiple on my ’24 EPS estimate gets me to $29.75, and I’d note that 9.9x is well below what these shares (and others in its weight class) have typically traded. ROTCE-driven P/TBV suggests a fair value in the mid-$30s. Working backward (to estimate what the Street may be expecting in terms of securities-driven TBV erosion), $2B of TBV erosion (one-third of unrealized losses) would reduce TBV to a point where Fifth Third would trade more or less in line with where peers are trading (almost all banks are trading at apparent ROTCE-P/TBV discounts, the $2B accounts for the “extra” discount at Fifth Third).

The Bottom Line

If you’re concerned that the securities portfolio will cause major problems for Fifth Third, you should avoid the shares. I don’t think that will be the case, though, and I think the current valuation reflects too much concern about that issue, as well as the bank’s growth prospects and loan book. Investors have no shortage of choices when it comes to undervalued bank stocks today, but this is a name to look at all the same.