Fifth Third Bancorp's Risk-Reward Ratio Of 1:3 Makes It A Perfect Long

| About: Fifth Third (FITB)

Fifth Third Bancorp proves perfect candidate for long position

We believe that Fifth Third Bancorp (FITB) has strong liquidity and attractive valuations. Investors, on average, can expected approximately 21% total returns by buying the stock, which has a very attractive 1-to-3 risk to reward ratio. Therefore, we recommend our investors to long the stock.

Headquartered in Ohio, FITB is a provider of diversified financial products, and has $118 billion of assets under its belt. The company, with a total market cap of around $13 billion, operates as a regional bank in the U.S. financial sector, and caters largely to the Southeast and Midwest populations.

Second Quarter Earnings Review

The bank was able to post results above estimates for the past two quarters. As illustrated by the table given above, the trend continued this time around as well when the bank announced its second quarter results on July 19. This happened in the back drop of a sluggish U.S. economy. The bank earned 40 cents, against the estimated 35 cents, on revenues of $1.58 billion, against the anticipated $1.54 billion. Revenues exceeded estimates by about 3%, while earnings advanced by a good 14%. The strength in the results could largely be associated to solid growth in mortgages, an increase in leases and loans, and the effective management and control of operating expenses. However, the results were partially offset by a declining net interest margin.

The reported adjusted bottom line remained $349 million on a turnover of $1.58 billion. The bottom line remained largely flat when compared sequentially, however, it surged by 10% when compared to the same quarter of the prior year. Net interest income, which accounts for 54% of the bank's total revenues, remained largely flat at $869 million, primarily due to the fact that the bank was not able to improve its net interest margin of 3.62%. This is against 3.16% earned by Regions Financials (RF) during the same quarter. The decline in net interest margin for FITB was mainly due to a significant decline in the yields on auto loans and residential mortgage loans of 105bps and 42bps YoY. The bank's non-interest income dipped $91 million or 12% sequentially to reach $656 million at the end of the second quarter of the current year. The dip was largely due to fewer securities gains, and a decline in other non-interest income and mortgage banking net revenues.

The bank benefited from increased mortgage originations and a gain on sales margins that were wider.

Loan and Deposit Growth

Essentially, the loan book for the bank remained flat when compared to the first quarter of the current year. However, the bank witnessed a surge in commercial & industrial loans and residential mortgages. Compared to the same quarter of the previous year, the overall loan book of the bank improved 6%. The improvement was largely due to both commercial & industrial loans, and residential mortgages, which were up 4% when compared YoY. The bank's commercial & industrial loans have a large geographical concentration in the Ohio region, followed by Illinois. Mortgage loans represented 14% of the total loans portfolio, and were largely geographically concentrated in Ohio, followed by Florida. Residential mortgage loans increased 4% sequentially on a 14% surge in residential loans from the Florida region. The bank has 8% of its entire loans portfolio exposed to Florida, with 21% of the entire non-performing assets coming from that region. This could be a potential concern for investors, considering the fact that Florida's weather conditions are famous for all the wrong reasons.

Core deposits of $78 billion for the second quarter of the current year remained flat when compared sequentially, however, they showed a 5% improvement when compared to the previous year.

On a sequential basis, operating expenses for the bank declined by 4%. This was largely due to a 25% decline in employee benefits, partially offset by expenses made in technology and communications.

Asset Credit Quality

Credit quality for the bank's assets improved, as demonstrated by the trend in its net charge-offs and non-performing assets. Net charge-offs and non-performing assets declined 18% and 3% respectively when compared to the previous quarter.

Capital & Liquidity Position

FITB's capital position is very much in line with its rivals and safely above the regulatory requirements. Tier 1 common ratio and Tier 1 capital ratio for the second quarter improved and stood at 9.77% and 12.31%, respectively, when compared to 9.64% for the first quarter's Tier 1 common ratio. This is comparable to 9.3% and 10% Tier 1 common ratios for PNC Financial Services Group (PNC) and Regions Financials , the other two regional banking rivals.

The bank's liquidity position is strong. Looking at the debt maturities for the bank, we see that $340 million of debt needs to be serviced by the end of 2012, and $500 million during 2013. Other cash obligations that need to be taken care of within the next 24 months include dividends on common shares amounting to $600 million, dividends on G-series preferred stocks amounting to $70 million, and another $900 million in interest payments and other expenses. The bank currently has $2.9 billion of cash at hand, which is sufficient to cover requirements for the next 24 months.

Dividends

The stock offers an added advantage of a dividend yield of 2.26%, which is sustainable. The sustainability of dividends is analyzed in the liquidity section above.

Valuations

Shares of the bank trade at a moderate 3% discount to its book value, compared to a 22% premium for BBT Corp (BBT) and a 25% discount for PNC Financial Services . The stock is already trading in proximity to its 52-week high, however, our target price is still 20% above the current stock price. With a book value estimate of $15 for 2012, and a book value multiple of 1.13, we have a target price of $16.95. During the financial meltdown, the stock was trading at a 30% discount to its book value, while at its peak; the stock was trading at a 95% premium to its book value. We think as economy recovers, the stock can trade at a price to book ratio of 1.95x which represents a 100% upside. On the other hand, in a bearish scenario the valuations can come off by 30%. This gives investors a very attractive 1-to-3 risk to reward ratio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.