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Background

Fifth Third Bancorp (FITB), based in Cincinnati, Ohio, is one of the larger regional banks in the United States. At mid-2013, it had $123 billion in assets and 1,326 offices, including 104 located in grocery stores, in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania, Missouri, Georgia, and North Carolina. The company also has a 25% interest in Vantiv Holding, a payments processing business, and is among the largest money management companies in the Midwest, with over $300 billion of assets under administration and $27 billion of assets under management. Fifth has over 20,500 employees.

The company traces its roots to a bank founded in 1858. In 1908, the Third National Bank merged with the Fifth National Bank, to form the Fifth Third National Bank of Cincinnati, hence its unusual name. Over the years, acquisitions of banks, bank branches, and financial service firms contributed significantly to the company’s growth. Fifth has four main businesses: Commercial banking, Branch banking, Consumer lending, and Investment Advisors. It is organized under 18 affiliates, each with its own board of directors, which Fifth believes gives it a local touch while enabling it to enjoy the economies of scale of a large bank.

The Recession And Subsequent Progress

Prior to the financial downturn, Fifth had avoided the riskiest types of lending. Nonetheless, falling home prices and rising foreclosures hurt, and the company saw its problem loans soar in 2008. In that year, Michigan and Florida, states with severely stressed housing markets, accounted for 65% of Fifth’s mortgage portfolio. The recession also took its toll on other types of loans. Like other banks, Fifth made sizable (over $4.5 billion of) provisions to its reserve for loan losses in 2008, which caused the company to report a large loss in that year.

The company  bolstered its equity capital in 2008 by issuing $3.4 billion in preferred stock and warrants to the U.S. Treasury under the Trouble Assets Relief Program’s Capital Purchase Program (TARP CPP). It also slashed the dividend on its common stock that year, to a nominal quarterly rate of a penny a share, and raised additional capital by selling another $1.1 billion of preferred stock and a $1.3 billion controlling interest in its payments processing business to Advent International in 2009.

Since 2008, the company has staged a partial earnings recovery. When the financial crisis broke, Fifth restructured problem loans and ended brokered home equity production, tightened consumer underwriting standards, and suspended lending for residential development and non-owner occupied commercial property. Loan loss provisions remained relatively high in 2009, but fell sharply thereafter, allowing earnings to recover some of the ground lost in 2008.

In February of 2011, Fifth was able to redeem the TARP preferred sold to the government back in 2008, which reduced preferred dividends (which enter into the earnings per share computation and were a drag on share net). Fifth was also able to increase the dividend on its common stock, and has been buying back stock and ramping up the payout since 2011.

Challenges

Despite its progress in recent years, Fifth still faces a number of headwinds. The uneven economic recovery is limiting the improvement in loan demand and in the housing markets in Florida and Michigan. Historically, low interest rates make it hard to earn money on the spread between the yields on the bank’s loans and investments and the interest rates on the bank’s deposits and borrowed funds. A slowdown in mortgage refinancing activity, higher mortgage interest rates, competitive pressure, and lower volumes of loans refinanced under the TARP program are likely to result in lower gains on mortgage sales, which accounted for a large share of the company’s mortgage revenues in the past few years.

Too, as one of the biggest regional banks in the United States, Fifth is subject to the additional regulation and stress tests imposed on the largest banks in the nation, like Bank of America (BAC) and JPMorgan Chase (JPM - Free JPMorgan Stock Report). Moreover, litigation costs related to the mortgage mess of the past few years remain high.

Opportunities

Despite the challenges, Fifth has room to grow.  Like most banks, Fifth should enjoy better loan growth when economic activity in its mostly Midwestern area strengthens. It has hired lenders and underwriters to expand lending to the energy sector, and expects the growth of selected commercial real estate credits underwritten according to today’s tougher standards to soon offset the effect of  the dwindling volume of pre-2008 crisis credits, supporting renewed growth in commercial real estate loans. It has expanded its indirect auto lending footprint to 45 states. Meanwhile, the company believes it is positioned to benefit from higher interest rates over time which, along with better loan growth, should help support faster growth in net interest income.  Too, an effort in 2012 to simplify deposit products and service charges may well foster an increase in the number of products per customer, which should lead to stronger growth in fee-based revenues.

Potential problem loans are still rather high, but further improvement in the housing market should help the company reduce problem real estate loans in Michigan and Florida, and Fifth’s credit costs. (At mid-2013, the two states still accounted for 20% of Fifth’s loans and 40% of its problem credits.)

Fifth also has room to lower its expense-to-revenue ratio, which (excluding unusual items) hovered near 61% in the June quarter. As mortgage revenues moderate, so should related compensation expenses. Foreclosed real estate and other credit costs that are typically included in operating expenses also ought to fall as problem assets decline. And the company is mulling replacing about a third of its traditional branches with cost-effective self-service micro-branches, which ought to lower compensation costs.

In all, we think Fifth’s earnings will regain some of their past luster within our 3- to 5-year investment time frame, but long-term investors will need to be patient. The stock’s decent dividend yield eases the wait, however.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.