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Fifth Third Bancorp (NASDAQ:FITB) is a large, decentralized Midwestern bank with a strong history of focusing on cost controls. The company operates over 1,100 branches spread across ten different states: Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania, and Missouri. Fifth Third has over $100 billion in assets.

In addition to its banking operations, Fifth Third also operates one of the Midwest’s largest money managers and one of the nation’s largest EFT processors.

Over the last ten years, the company has averaged a 1.68% return on assets and an 18.34% return on equity.

Location

The vast majority of Fifth Third’s total assets are provided by affiliates in five states: Ohio, Michigan, Illinois, Indiana, and Kentucky.

Fifth Third focuses on smaller markets with below average population growth. The company seeks to operate more efficiently than its local competitors and thereby obtain a dominant share of each market.

The unattractive demographics of the largely Midwestern markets in which Fifth Third operates partially insulates the company from the ravages of competition. Many banks seek out pockets of above average population growth and high concentrations of wealth instead of expanding into one of Fifth Third’s markets.

Decentralization

Fifth Third consists of nineteen affiliates operating in ten different states. The company’s three largest affiliates account for approximately a third of the company’s total assets. These three largest affiliates are located in Cincinnati, Chicago, and Western Michigan. None of the other sixteen affiliates accounts for more than 7% of Fifth Third’s total assets.

The company is well-known for its highly decentralized affiliate banking model. Fifth Third’s President and CEO, George Schaefer explained this model in a May 22nd, 2000 interview with The Wall Street Transcript:

All of our lines of business, for example, in Indianapolis, Indiana, report into our CEO in that market. He's in charge of the commercial business, he's in charge of the retail business, he's in charge of the trust business, the investment business and the processing business in his area.

This decentralized approach has helped Fifth Third compete in each local market, despite the very real differences between the various communities in which the company operates.

Fifth Third now has branches in larger markets as well as the small, slow-growing markets the company is normally associated with. Those smaller markets remain an important part of Fifth Third’s business. However, if the company hopes to continue its strong growth, it will need to increase its rather small share of some of these larger markets.

The autonomy granted to the CEOs of the various affiliates should better position Fifth Third for growth in both types of markets. Such autonomy frees local branches from any sort of institutional uniformity imposed upon them by some distant corporate office. This allows for the development of different solutions to similar problems based on the specific circumstances of each particular profit center.

Costs

Despite its decentralized operations, Fifth Third is more efficient than its peers. The company has consistently had a better efficiency ratio than its rivals.

Fifth Third’s management has always stressed low-cost operations. This focus is reinforced by the monthly profit and loss statements issued for even the smallest segments of the business. At Fifth Third, responsibility for expenses rests with those who can best control the expenses.

Incentives

Fifth Third’s cost conscious culture is a direct result of its highly incentivized employees. The company issues thousands of monthly profit and loss statements that allow costs to be tracked at each individual profit center. The widespread use of stock options reinforces Fifth Third’s cost conscious culture. Mr. Schaefer explained the importance of stock options in the same interview with The Wall Street Transcript:

Every one of our branch managers, all of our officers, receive stock options. We give them all options and we give them all profit/loss statements. So each month they know right where they stand. We keep score very well and they understand that the better they do, the higher the value of these options that we've given them.

Acquisitions

Although much of Fifth Third’s past growth has come from organic sources, the company does engage in acquisitions. Some of these acquisitions have allowed the company entry into an otherwise impenetrable local market. As most banks have learned, the easiest way to gain share in some new market is to acquire existing branches within that market.

Within the last few years, Fifth Third has greatly expanded its exposure to new markets. The company has begun to venture beyond the three core states of Ohio, Kentucky, and Indiana. Despite the company’s highly decentralized affiliate banking model, newly acquired branches are not simply assimilated as is. In that same May 2000 interview with The Wall Street Transcript, Fifth Third’s President and CEO explained the company’s approach to new acquisitions:

When we make an acquisition, we buy a set of branches and then bring in our commercial loan people, our trust officers and our merchant processing people and grow the franchise there. We pick up the geography in an acquisition, but then we fill that with our own people.

Recent Results

Fifth Third’s recent results have been disappointing. Wall Street had very high expectations for this fast growing bank. Over the last few years, those expectations have not been met. Fifth Third’s growth has slowed considerably.

Returns on both assets and equity have fallen to levels closer to those achieved by the average U.S. bank. In 2005, Fifth Third’s return on assets fell to 1.50% while its return on equity fell to 16.60%. Both figures are well below the company’s average returns over the past ten years. In fact, judged solely by ROA and ROE, 2005 was one of Fifth Third’s worst performances in over a decade.

Disappointment and dissatisfaction were clearly evident in Mr. Schaefer’s most recent letter to shareholders:

Unfortunately, we have learned that challenges can also increase with size and even the most highly regarded companies and strongest cultures are not immune to difficulties. Our performance over the last two years has not matched our historical success. And while disappointing and below our potential, I believe these results are best understood within the context of the many things we accomplished this year to improve our competitive position and drive revenue and earnings growth in the years to come – progress that will ultimately be reflected in our performance.

This honest assessment is encouraging. Mr. Schaefer is an able and long-serving Chief Executive who deserves much of the credit for Fifth Third’s past success. He has served as President and CEO for over fifteen years. During much of that time, Fifth Third was a Wall Street darling. The company’s recent performance has relegated it to the Street’s dog house.

Mr. Schaefer could easily have dismissed the company’s recent performance as being purely the result of outside factors such as a difficult interest rate environment. The fact that he did not do so, despite clear evidence that Fifth Third’s real problem was a twenty-five basis point contraction in its net interest margin, suggests he is well aware of the very real difficulties facing his company as it seeks to maintain its past record of above-average growth and profitability.

Below the surface, Fifth Third’s 2005 numbers actually remained fairly strong. Total loan growth came in at 18% for the year. Deposit growth was in the low double digits.

The company’s processing solutions division continues to enjoy strong revenue growth that is largely independent of the overall interest rate environment. Americans seem determined to increase their use of plastic and electronic payments of all kinds each year. This powerful trend is unlikely to abate within the next few years.

Valuation

Shares of Fifth Third currently yield just under 4%. The stock trades at a price-to-book ratio of about 2.25. FITB’s price-to-earnings ratio is a little over 14. It’s worth noting that the earnings in the current P/E ratio represent Fifth Third’s lowest return on equity in some time. For most of the past ten years, the company has earned closer to an 18% ROE.

Conclusion

Wall Street has soured on Fifth Third. The once beloved bank is now viewed as nothing special. During the closing years of the second millennium, Fifth Third was awarded high price-to-book and price-to-earnings ratios. The company’s shares regularly traded at 5-6 times book and 30-40 times earnings. Obviously, these lofty multiples assumed future growth would be both fast and profitable.

While the company’s performance was actually quite strong over the past half-decade, Fifth Third has been unable to deliver the kind of results that would justify such multiples. The stock fell victim to irrational expectations. It is a rare bank that can trade at 5-6 times book for any length of time without ultimately disappointing investors in a big way.

Over the last five years, Fifth Third has managed to double in size. Unfortunately, even that was not enough to protect investors who got in at the top. Like many otherwise excellent businesses, Fifth Third’s shares are essentially no higher today than they were at the opening of the great bull market’s final stage.

The bank’s shares had already been climbing (justifiably) throughout most of the 1990s. By 1997, a logical ascent based on strong operating results had become an irrational surge based on little more than hope, faith, and a pretty looking stock chart.

A great business became a god awful stock and the inevitable result of all the excessive enthusiasm came shortly after the overall market crested. In the five years since, shares of FITB have steadily decreased as the value of the business has steadily increased. Since 2000, the bank’s earnings per share have compounded at 8.64% annually; book value per share has compounded at 10.09% a year.

The recent decline in Fifth Third’s shares gives long-term investors the opportunity to seriously consider an investment in this first-rate bank. At the moment, Fifth Third is perhaps the most attractive of the five banks profiled this week.

Investors who believe in Fifth Third’s decentralized, cost conscious culture should seriously consider acquiring shares at the current market price of less than $40 a share.

FITB 5-yr chart:

FITB 5-yr chart

This post is the fourth in a week long series of five posts on specific banks earning above average returns. The idea is to look at the bank’s business and ask why it is capable of earning above average returns. For a discussion of why banks, on average, earn returns above those of many other public companies, see my earlier post: “On Banks”. The fact that any particular bank is profiled this week should not be viewed as an indication that the bank’s shares are attractive at the current price.

Source: Attractive Valuation for Fifth Third Bancorp (FITB)