Fifth Third (NASDAQ:FITB) has been a relatively strong name this year within the group of banks I follow closely, with the shares outperforming the likes of BB&T (NYSE:BBT), U.S. Bancorp (NYSE:USB), Wells Fargo (NYSE:WFC), and PNC (NYSE:PNC) since my last update on this Cincinnati bank. While this probably sounds like sour grapes, I wonder if this has been part of a "flight from quality" as names like Comerica (NYSE:CMA) and Regions (NYSE:RF) have also been doing better in part on less fear about energy credits and more optimism regarding the opportunities down the road from cost cuts and higher rates.
I struggle to make the valuation really work now. Even assuming that Fifth Third is on the higher end of the range in terms of ROE improvements over the next five to 10 years, I still don't see it being up there with the likes of U.S. Bancorp or Wells Fargo. I think Fifth Third is more likely to generate mid single-digit earnings growth, and that supports a fair value around $21 to $23.
Some Familiar Notes
Most of these larger regional/super-regional banks are facing pretty similar operating environments and making broadly similar strategic decisions. Loan demand and rates remain muted, and that's no less true in Fifth Third's core Midwest operating region. With that, there are a lot of familiar notes in Fifth Third's financials.
Revenue ticked up a bit both year over year and sequentially on a core basis, with net interest income up slightly as both net interest margin and earning asset balances were pretty stable. Fee income was up a bit more, with strength in service charges offsetting weakness in corporate banking and investment advisory. All told, the fee income was weaker than expected, while the net interest income was just a bit better.
That makes Fifth Third a modest outperformer relative to Regions, Comerica, U.S. Bancorp, and Wells Fargo, while sluggish fee (to weak) performance was a challenge at U.S. Bancorp, PNC, and BB&T. Fifth Third did do well on costs, though, with core adjusted expenses basically flat on an adjusted basis.
Fifth Third also saw pretty lackluster loan growth, with period-end loans down slightly on declines in C&I, home equity, and auto lending. Cue the broken record again, as this was a challenge for BB&T, PNC, and U.S. Bancorp as well this quarter, though U.S. Bancorp at least reported some momentum to start off the fourth quarter.
Credit Still Something Of A Concern, As Is The CRA
I'm not entirely comfortable with Fifth Third's credit situation, or at least not as comfortable as I am with names like BB&T, PNC, and U.S. Bancorp. The NPA ratio is still pretty high at over 0.7% (excluding loans held for sale), the charge-off ratio increased for both consumer and commercial loans, and the bank's level of criticized loans has been trending high compared to BB&T, PNC, and U.S. Bancorp.
Fifth Third also still has to see its way through to the end of a downgrade with its compliance with the Community Reinvestment Act. This cropped up back in the summer, and although the company already remediated the issue, it will likely freeze any prospects of bank M&A until the next review cycle rolls through.
Aggressive Goals Are Fine… But You Have To Execute
I was a little surprised when Fifth Third laid out some new targets for long-term performance back in September. With this new "North Star" initiative, management is looking to get ROA to 1.1% to 1.3% and return on tangible common equity to 12% to 14% by 2019. Those are ambitious goals given the performance Fifth Third has shown in recent years absent the period sales of Vantiv (NYSE:VNTV) shares, and I wouldn't assume that hitting it is any guarantee.
One of the three roads to achieving those goals is further expense reduction, largely through more branch reductions, process improvements, and better control of discretionary spending. Fifth Third has already done a pretty good job here, so I wonder just how much more spending reduction and process improvement is really attainable.
Another road is balance sheet optimization through a greater focus on higher-return businesses like specialty lending, small business lending, middle-market lending, and cards. That all sounds great, but it also sounds like what almost every other bank is also trying to do. In particular, U.S. Bancorp is already strong in middle-market and small business lending, and its September investor day gave no hint that it intends to let up. Likewise with cards and specialty lending; BB&T's forays into specialty lending are likely only a limited risk to Fifth Third given the geographic overlap, but there are many other banks targeting these same opportunities.
Last and not least is more revenue growth. In addition to expanding the bank's capital market capabilities, areas like mortgage banking, wealth management, and insurance are also on the docket. There's also cross-selling to consider. Fifth Third has been a transactions-focused bank that has made a point in recent years of paying more attention to cross-selling opportunities. At least insofar as it concerns the retail channel, I have to wonder whether the scandal around Wells Fargo could force Fifth Third to be a little more cautious and judicious with this approach.
Fifth Third's tangible book value per share has been growing nicely, but the near-term outlook for return on equity (and earnings growth) is still pretty lackluster. I think single-digit ROEs will likely stick around for at least another three or four years before a steeper yield curve helps expand margins again. I'm looking for long-term ROEs in the neighborhood of 10% to 12%, which is more or less in line with what I expect from BB&T and PNC and less than I expect from U.S. Bancorp and Wells Fargo.
Discounted back, the adjusted cash earnings lead to a fair value of around $21, while the near-term outlook for return on tangible capital argues for a tangible book value-based fair value of around $22.50. These targets seem to be above where most of the sell-side is, which is a little strange to me given that I'm still not a huge fan of this business.
The Bottom Line
Fifth Third does seem a little undervalued (and as with BB&T, U.S. Bancorp, et al, that's with a double-digit discount rate) and priced to generate at least okay total market returns. It's also worth noting that selling more of Vantiv (a when, not if) can free up more capital to reinvest in the business (M&A, for instance) or return to shareholders. If management can hit those North Star targets, this could be a much more interesting story in a couple of years. For now, though, it's still "okay" bank in my book trading at a modest but not compelling discount to fair value.
Disclosure: I am/we are long BBT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.