Fifth Third Bank - A real Gem among the Financials Rubbles
My previous article on November 30, 2012, touted the financials sector as the sector to enter and listed a group of domestic banks that topped street estimates during the third quarter earnings season. The Dow Jones U.S. Financial Index has since outperformed the S&P 500: see the chart below from Marketwatch's bigcharts website:
Following my own advice, I then went ahead to pick a stock among the many domestic banks with valuations that had been hammered by street pessimism. As I examined detailed financials of these players, I realized that general pessimism is well placed in that it is hard for domestic banks to grow top lines in this low-rate environment. During the current quarter earnings season, one lingering concern with the financials is the continuing shrinking net interest margin, and when this would bottom. Even the best of them all, Wells Fargo, had a net interest margin decline of 18 basis points between 2011 and 2012. Therefore, generating decent loan production is not even a driver for revenue growth in the traditional sense of a growth driver, but an imperative in providing an offset for the eroding net interest margin. Many of the small players who I looked into simply didn't pass this test, and do not have the prospect of growing their top lines enough to absorb an overhead, which doesn't have that much room to be cut other than through further consolidation in the sector. The Fed started QE3 in October 2012, so it is reasonable to expect its effect to continue to weigh on banks' net interest margin for a few more quarters, probably through the first half of 2013.
Even though I like Wells Fargo and U.S. Bankcorp, those Warren Buffett favorites, they are better known, and trading at a multiple of 1.2 and 1.8 of the net book value, they are a little pricier than I would like; in this depressed sector I would like to buy as close to or even below the net book value as possible. I expect the financials to continue to mend steadily in this tortoise-moving economy, but not at any torrid pace, and this should be reflected in the share price movements. With lingering regulatory uncertainty, especially any coordination issues among the various regulatory and national government bodies, the financials would well experience more turbulence, and this would be good in providing entry points for accumulating shares of strong players. I also prefer exposure to domestic banks rather than global ones exactly because of the former's insulation from any messy global regulatory issues, and further as a play on the incipient U.S. economic recovery.
Fifth Third Bankcorp (FITB: Nasdaq) is a diversified financial services holding company with branches in 12 states in the Midwest and Southeast, and $118 billion in assets. I like it because it has at least been able to stabilize its revenue base between 2011 and 2012 even in this environment of shrinking net interest margin, and has a reasonable prospect of growing revenue in the second half of 2013 as the net interest margin bottoms. The bank grew average loan and leases by 5.7% between 2011 and 2012, and a major driver is commercial and industrial (C&I) loans, which grew 6.7%, even as it exited certain businesses such as homebuilder and developer loans because of enforcement of more strict underwriting standards. At the current quarter earnings call, management spoke of the momentum in the manufacturing and healthcare industries in driving the growth in the C&I loans. In my view, this driver looks sustainable, provided that the U.S. economy continues at the current pace.
The bank has many non-operating items each quarter, so it takes some work to exclude these and figure out its true historical underlying operating income. A common operational metric among the financials is efficiency ratio, which is simply the ratio of non-interest expense over the revenue base (that is net interest income after provision for loan losses plus noninterest income). From my calculation Fifth Third's efficiency ratio was in the 65% range in 2012. Wells Fargo's efficiency ration is about 59%. Now Fifth Third's management gave a guidance of bringing the efficiency ratio down to 60% during the second half of 2013. That would give a further boost to the company's bottom line. From reviewing the bank's financials in the past three years, my sense is that this is a conservative management who likes to lowball its guidance.
Management pointed out that seasonally higher FICA and unemployment expenses would weigh down the first quarter, so little could be expected on the bottom line from the expense side. But the marked optimism about the second half of 2013 in providing the annual outlook seems well placed. Assuming a flat revenue base and an efficiency ratio of 63% for the year, I calculated an EPS estimate of $1.91 vs. the street consensus of $1.63. I also assumed a further repurchase of 15 million shares, a similar pace as what happened in the second half of 2012. The street EPS estimate of $0.41 for the first quarter seems fair and probably reflected management's detailed guidance, but in my opinion there is some upside in the estimate for the year. At $16 FITB is trading at an earning multiple of 8 or 9 depending on which estimate you use, and there is room for multiple expansion if the company continues to deliver on the bottom line. The stock currently yields about 2.5%, and there is some investor pressure for the dividend to increase. The company built in extra cushion in submitting the capital plans to the Fed due to regulatory uncertainty. As this gradually clarifies, some of this cushion may be released and this would lead to further dividend increases. My target price for the stock is $19, and I would recommend buying in at below $15.