Fifth Third Bancorp (NASDAQ:FITB) Q2 2023 Earnings Call Transcript

Fifth Third Bancorp (NASDAQ:FITB) Q2 2023 Earnings Call Transcript July 20, 2023

Fifth Third Bancorp beats earnings expectations. Reported EPS is $0.87, expectations were $0.83.

Operator: Good morning. My name is Rob and I will be your conference operator today. At this time, I would like to welcome everyone to the Fifth Third Bancorp Second Quarter 2023 Earnings Conference Call. [Operator Instructions] Chris Doll, Head of Investor Relations. You may begin your conference.

Chris Doll: Good morning, everyone. Welcome to the Fifth Third Second Quarter 2023 Earnings Call. This morning, our President and CEO, Tim Spence; and CFO, Jamie Leonard, will provide an overview of our second quarter results and outlook. Our Treasurer, Bryan Preston and Chief Credit Officer, Greg Schroeck, have also joined the Q&A portion of the call. Please review the cautionary statements on our materials, which can be found in our earnings release and presentation. These materials contain information regarding the use of non-GAAP measures, reconciliations to the GAAP results and forward-looking statements about Fifth Third’s performance. These statements speak only as of July 20, 2023, and Fifth Third undertakes no obligation to update them. Following prepared remarks by Tim and Jamie, we will open the call for questions. With that, let me turn it over to Tim.

Timothy Spence: Thanks, Chris, and good morning, everyone. Before we get to the quarter, I’d like to welcome our new Chief Credit Officer, Greg Schroeck to the call. Greg has been a part of Fifth Third for 35 years, and during that time, you see more than a few credit cycles. He previously held leadership roles in both credit risk and the line of business, including serving as our Chief Commercial Credit Officer for several years and is our Head of Leasing, asset-based lending and structured finance. We’re fortunate to have him as part of the Fifth Third executive team. Despite heightened market volatility over the past four months, Fifth Third has delivered consistent top quartile financial results while investing strategically to position the bank for the long term.

Our operating priorities have been and continue to be stability, profitability and growth in that order. Earlier today, we reported second quarter earnings per share of $0.87, excluding items noted in the release, a 10% increase compared to the year ago quarter. Adjusted revenue increased 9%, reflecting our diverse fee sources and resilient balance sheet. Expenses increased 4%, excluding items noted in the release. And credit quality was strong with net charge-offs and early stage delinquencies remaining below normalized levels. Our key return metrics improved even as we increased our capital levels and credit reserves. We generated an adjusted return on assets of over 1.2% and adjusted return on tangible common equity, excluding AOCI, of 15.4% and an efficiency ratio below 55% for the quarter.

These will be important bellwether metrics for all banks as we adapt to impending regulatory changes. Deposits continue to be in focus for the entire sector in the second quarter. Fifth Third’s total period-end deposits increased 1% sequentially and increased 2% year-over-year as compared to a 5% decline for the HA [ph] over the same period. Our commercial banking and commercial banking business segments both generated period-end deposit growth. Given the year-over-year decline in deposit system-wide, it’s reasonable to ask how Fifth Third has continued to outperform. The answers are deliberate multiyear strategies to expand distribution in our Southeast markets to launch innovative operational deposit-oriented solutions like momentum banking and our treasury management offerings and our sustained focus on primary household growth.

We have added over 70 de novo branches in our Southeast footprint since 2019, more than any other bank except JPMorgan. As a portfolio, these branches are outperforming their original business cases on deposit production with several producing at a rate of 200% to 300% of plan. In consumer, we generated year-over-year net household growth of 3% once again this quarter, continuing a strong multiyear trend and punctuated by 7% year-on-year growth in the Southeast and continued success in our Momentum banking product. In commercial, we have added a record number of new quality middle-market relationships this year, up 30% from 2022. Our embedded payments business, Newline, has also been a strong catalyst for deposit growth. We expect the environment in the back half of the year to remain highly competitive for deposits.

While we will continue to protect our house relationships and manage to a strong and stable liquidity profile, we will not match a rational pricing competition in a way that prioritizes headline growth over profitability. Turning to pending regulation. We are taking steps to adapt our balance sheet in anticipation of higher capital and liquidity requirements across the industry. We finished the second quarter with a CET1 ratio of 9.5% having accreted around 90 basis points of capital from retained earnings over the course of the past year. We are balancing three capital priorities, continuing to build capital on an accelerated pace, supporting a dividend increase in the third quarter subject to Board approval and supporting clients to drive organic growth.

We will continue to pause share repurchases until the final capital rules are published and new capital targets are established. We are also taking several actions to boost on balance sheet liquidity and optimize returns. — in reducing our indirect auto lending origination volumes by approximately 15% through the exit of noncore states, trimming outsized lines and closely evaluating select areas of our corporate banking business. While we acknowledge the market’s more optimistic outlook, we remain vigilant on the potential for a recession in 2024. Our commercial clients continue to perform well, but they are being cautious by slowing their growth plans. Many are closely watching the impact that regulation may have on credit availability and pricing.

Consumers have held up well in aggregate, but there has been a divergence between homeowners who were able to lock in historically low mortgage rates and renters who have had to face persistent inflation in their largest monthly expense. Compared to three years ago, homeowners in our deposit base have maintained strong deposit balances, whereas renters deposit balances are down meaningfully. I want to thank our nearly 20,000 employees for their unwavering commitment to serving clients in our communities. Last year, you volunteered more than 117,000 hours to community organizations and you provided leadership to roughly 1,200 not-for-profit boards. Due to your hard work, we have already delivered nearly $30 billion of our 10-year $100 billion commitment to provide affordable housing, access to essential services and renewable energy.

In June, we celebrated Fifth Third’s 165th anniversary. Given the current pace of technological and regulatory change and the logical questions about market structure and competitive model to follow. It was an interesting time to reflect on our history and what it could tell us about this moment. Since Fifth Third’s founding in 1858, the company has withstood a civil war, two World Wars, two global health pandemic and 33 recessions. The company adapted its business model to take advantage of technological innovations including the telephone, electric white bulbs, the automobile and the Internet. We were an early adopter of the wire and ACH Windows, anchored the rollout of the credit card networks in the Midwest, invented the network ATM and were one of the 15 initial launch bankers.

We witnessed the creation of the OCC, the Federal Reserve and the FDIC and have continued to thrive through many different regulatory regimes. I believe that companies that stand the test of time, develop a character of their own that extends beyond the people who work there. Fifth Third’s character is rooted in hard work, ingenuity and insistence on excellence and the sense of responsibility for the communities we serve. I’m as confident as in Fifth Third’s positioning, our ability to outperform through the cycle and to deliver innovations that improve lives for all our stakeholders. And frankly, I’m just thankful to be part of [indiscernible] steward the bank into the future. With that, I’ll now hand it over to Jamie to provide more details on our financial results and outlook.

James Leonard: Thank you, Tim, and thank all of you for joining us today. Our second quarter results were once again strong despite the market headwinds. We achieved an adjusted efficiency ratio of just below 55%, which is a 4-point improvement compared to the prior quarter. Our second quarter adjusted PPNR grew more than 8% compared to both the prior quarter and year ago quarter, driven by the continued diversification and growth of our fee revenue streams combined with disciplined expense management throughout the bank. . Net interest income primate $1.46 billion increased 9% year-over-year, did decline 4% sequentially. Our sequential NII performance was the result of our deliberate actions to grow on balance sheet liquidity to support a defensive balance sheet position, given the uncertain macroeconomic outlook and tightening liquidity conditions.

Interest-bearing deposit costs increased 54 basis points to 2.3%, which represents a cycle-to-date beta of 45% on interest-bearing deposits, which includes the impact of CDs. Adjusted noninterest income increased 2% compared to the year ago quarter, with increases in mortgage fee income and commercial banking revenue partially offset by a decline in deposit service charges due to the impact of earnings credits from higher market rates and the elimination of our consumer NSF fees in July of last year. Adjusted noninterest expense increased 10% compared to the year ago quarter as elevated compensation and benefits expense was driven by nonqualified deferred compensation costs, the minimum wage increase that went into effect in July of 2022 and continued investment in dividend finance.

Additionally, expenses increased from higher technology and communications expense and the impact of the increased FDIC assessment that began in January. Excluding the impacts of nonqualified deferred compensation, which are offset by a gross up in securities gains, the FDIC assessment increase and incremental expense growth from dividend finance, Total underlying expenses increased approximately 4% compared to the year ago quarter. Moving to the balance sheet. Total average portfolio loans and leases were stable sequentially in both commercial and consumer portfolios due to our continued discipline with respect to client selection and optimizing returns and also reflecting softening demand. The period-end commercial revolver utilization rate of 35% decreased 2% compared to last quarter.

C&I balances were flat compared to the prior quarter as strong middle market loan production and muted payoffs were offset by the lower revolver utilization. Corporate banking production was also tempered due to our focus on optimizing returns on capital in this environment and lower customer demand. Average total consumer portfolio loan and lease balances reflected growth from dividend finance, offset by declines in indirect auto and residential mortgage. Average total deposits were flat compared to the prior quarter as increases in CDs and interest checking balances were offset by a decline in demand deposits. By segment, consumer deposits increased 1% and commercial deposits decreased 1%, while wealth and asset management deposits declined 12%, reflecting the impact of tax payments as well as clients’ alternative investment options.

June activity reflected continued momentum such that period-end total deposits were up 1% compared to the prior quarter. Notably, we have grown deposits 2% since the end of last June compared to a 5% decline for the top 25 banks as shown in the Fed’s H8 data. Moving to credit. As Tim mentioned, credit trends were stable with our key credit metrics remaining below normalized levels. The net charge-off ratio of 29 basis points increased three basis points compared to the prior quarter. The NPA ratio of 54 basis points was up three basis points compared to the prior quarter. In consumer, we have focused on lending to homeowners, which represents 85% of our consumer portfolio. We have also maintained one of the lowest overall portfolio concentrations in nonprime consumer borrowers among our peers.

In commercial, we have maintained the lowest overall CRE concentration as a percent of total loans relative to peers for many years. Within CRE, we have limited office exposure with a low and improving criticized asset ratio and almost no delinquencies. We continue to watch office closely and believe the overall impact on Fifth Third will be limited. We had deemphasized office even before the pandemic, and we are not currently pursuing new office CRE originations. From an overall credit management perspective, we have continually improved the granularity and diversification of our loan portfolios through a focus on generating and maintaining high-quality relationships. As many of you know, we have been and remain cautious in our economic outlook.

We tightened underwriting standards during COVID, including stressing credits to an up 200-basis-point scenario off the forward curve, which limited our growth but improved the stability of our balance sheet. Since we began tightening underwriting standards, roughly 90% of our commercial portfolio has been re-underwritten. Our criticized assets have been stable over the past several quarters. Across all loan categories, we continue to closely monitor exposures where inflation and higher rates may cause stress. Moving to the ACL. Our reserves increased $87 million, reflecting the impacts of dividend finance and Moody’s macroeconomic forecast, which eroded slightly. The ACL ratio increased nine basis points sequentially. As you know, we incorporate Moody’s macroeconomic scenarios when evaluating our allowance.

The base economic scenario from Moody’s assumes the unemployment rate reaches 4.3%, while the downside scenario incorporates a peak unemployment rate of 7.8%. We maintained our scenario weightings of 80% to the base and 10% to each of the upside and downside scenarios. Moving to capital. Our CET1 ratio increased 25 basis points sequentially, ending the quarter at over 9.5%. Our capital position reflects our ability to build capital quickly through our strong earnings generation. Our tangible book value per share, excluding AOCI, increased 11% compared to the year ago quarter. We continue to expect a meaningful improvement in our unrealized loss position, assuming the forward curve plays out, resulting in approximately 36% of our current loss position accreting back into equity by the end of 2024 and approximately 50% by the end of 2025.

Looking forward, we expect to build capital at an accelerated pace given our RWA optimization initiatives and by extending our share buyback pause. As Tim mentioned, we will postpone repurchases until we have more clarity on the regulatory environment in order to determine the new level of required capital dollars. Assuming we do not buy back shares through year-end, we would anticipate accreting capital such that our CET1 ratio ends this year at or above 10%. Moving to our current outlook; we expect full year average total loan growth between 1% and 2%, which reflects our cautious outlook on the economic environment and our decision to proactively adapt our balance sheet to the new regulatory regime. We expect total commercial loans to increase in the low single digits area compared to 2022, which implies a decline in the second half of the year relative to the first half.

This outlook assumes the revolver utilization rate of 35% in the second quarter remained stable throughout the remainder of 2023. Our commercial loan outlook also assumes that we meaningfully reduced originations in certain areas of the commercial franchise, predominantly in the corporate bank to meet our higher risk-adjusted return thresholds, while continuing to increase the generation in our core middle market business, we expect total consumer loans to be stable to down slightly from reduced originations of the lower-yielding out-of-footprint auto and specialty lending channels, combined with portfolio residential mortgages, partially offset by growth from dividend finance. We currently expect to need approximately $4 billion in dividend loans for this year, which is a modest decrease from our previous expectations.

We continue to expect to grow deposits in the back half of 2023, assuming stable or even slightly tighter market liquidity conditions Consistent with our track record over the past year of taking market share and maintaining high levels of core operating relationships in both consumer and commercial. Within that, we continue to expect migration from DDA into interest-bearing products throughout the remainder of 2023 with the mix of demand deposits to total core deposits declining from 30% in the second quarter to 27% by year-end as we discussed last month. For the third quarter of 2023, we expect average total loan balances to decline 1% to 2% sequentially with commercial down in the low single digits area and consumer stable to slightly down.

We expect average deposits to be up 1% on a sequential basis, impacted by our strong finish to the second quarter, some seasonal uplift and the benefits of our multiyear investments in the franchise that Tim discussed earlier. Shifting to the income statement; we estimate full year NII will increase 3% to 5%, consistent with comments from the mid-June investor conference. Our AI guidance assumes a cumulative beta of 53% by the fourth quarter, assuming an additional 25 basis point rate hike in July and no further rate movements in 2023. Our outlook translates to total interest-bearing deposit costs increasing around 40 basis points in the third quarter and another 15 basis points or so in the fourth quarter. Our guidance assumes that our securities portfolio balances remained relatively stable between now and year-end.

As a byproduct of strong deposit growth, combined with lower loan growth and stable securities balances, we expect to hold closer to $15 billion in cash and cash equivalents by year-end. We expect our loan-to-core deposit ratio to end the year in the mid-70s area. It will keep Fifth Third in a strong liquidity position in anticipation of more stringent regulatory environments. We expect third quarter NII to be down approximately 2% to 3% sequentially due to the continued impacts of the balance sheet dynamics I mentioned. We expect adjusted noninterest income to be stable in 2023, resulting from continued success, increasing market share due to our investments in talent and capabilities. with stronger gross treasury management, capital markets, wealth and asset management and mortgage servicing revenue to be offset by higher earnings credit rates on treasury management, subdued leasing remarketing revenue and a reduction in other fees due to lower TRA and private equity income this year.

We expect our fourth quarter TRA revenue to decline from $46 million in 2022 to $22 million in 2023. We expect third quarter adjusted noninterest income to be down 3% to 4% compared to the second quarter. We expect to continue generating strong revenue across most fee captions, which we conservatively assume will be more than offset by a slight erosion in debt capital markets and mortgage revenue. reflecting the environmental headwinds as well as lower other noninterest income. We continue to expect full year adjusted noninterest expenses to be up 4% to 5% compared to 2022. If capital markets fees improve relative to our current expectations, we will likely land at the upper end of the range. Our expense outlook incorporates the FDIC insurance assessment rate change that went into effect on January 1, the mark-to-market impact on nonqualified deferred compensation plans which was a reductant in 2022 expenses but an increase in 2023 and full year impact of investments to grow the dividend finance and provide businesses.

Excluding the FDIC assessment and NQDC impacts, we would expect our full year 2023 core expenses to be up 3%. Our guidance reflects continued investment in our digital transformation, which should result in technology expense growth in the low double digits for the year. We also expect marketing expenses to increase in the mid- to high single digits area. Our guidance also factors in the run rate benefits from the severance expense recognized in the first half of the year, which reflected proactive actions taken to reduce ongoing expenses given the operating environment. We expect third quarter adjusted noninterest expenses to decrease 1% to 2% compared to the second quarter. In total, our guide implies full year adjusted revenue growth of 3% to 4%.

This would result in an efficiency ratio of around 56% for the full year. We expect full year total net charge-offs to continue to be in our previously stated 25 basis point to 35 basis point range. However, as you would expect, with normalizing credit costs in this environment from record low levels, there may be a little lumpiness in C&I in the second half such that total Bancorp’s third quarter losses are expected to be 35 to 45 basis points and then fourth quarter losses improving relative to the third quarter. Given our reduced loan growth outlook, we expect a lower quarterly build to the ACL in the $25 million to $75 million range, assuming no significant changes in the underlying Moody’s economic scenarios. This considers strong production from dividend finance of around $750 million in the third quarter, which, as you know, carries a higher reserve level.

In summary, with our proactive balance sheet management, disciplined credit risk management and commitment to delivering strong performance through the cycle, we believe we are well positioned to continue generating long-term sustainable value for our customers, communities, employees and shareholders. With that, let me turn it over to Chris to open the call up for Q&A.

Chris Doll: Thanks, Jamie. Before we start Q&A, given the time we have this morning, we ask that you limit yourself to one question and a follow-up and return to the queue if you have additional questions. Operator, please open the call up for Q&A. .

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Q&A Session

Operator: [Operator Instructions] And your first question comes from the line of Scott Siefers from Piper Sandler.

Scott Siefers: The first question I wanted to ask is — and I think if I’ve done the math correctly, the fourth quarter NII could kind of level out, even at the low end of the range, it could kind of level out or at least really slow the rate of decline. And I guess, in your view, what would allow NII to find a bottom at that point? I guess, I asked specifically in the context of you all having been bought the most conservative out there on your funding cost outlook for the second half of the year.

James Leonard: Yes, Scott, thanks for the question. It really comes down to the rate environment with the Fed in our forecast, the assumption being that the Fed reaches 5.5%, and holds. And therefore, by the end of the fourth quarter, we’ve gotten through all of the repricing lag that would occur. So that right now, the third quarter guide is down 2% to 3% and then the full year guide implies a little bit of a step down from third quarter into fourth quarter, and then we’ll see what 2024 holds when we get there. Implicit in the guide is an increase in our deposit costs so that the terminal beta is 53%. And I guess, coming out of listening to some of the other earned calls, the one comment we would have is that our June, like everyone else’s was quite strong and could — and I think to the point in your head could result in better NII outcomes than what it reflects.

But from our standpoint, spotting one robin doesn’t make it spring. And therefore, we’re going to continue to be cautious in the outlook and play defense in this environment. We’ve got a long way to go from the liquidity conditions tightening with at $80 billion a month, $1.5 trillion or more of trade issuance, the student loan repayments kicking back in, and then the competitive dynamics that we’re seeing across the footprint. So we’re going to play a good defense, and we think defense wins championships in this environment.

Scott Siefers: Perfect. Okay. And then I think I take tack one that you might have addressed towards the end of your prepared comments. But as it relates to the reserving needs, which look less in the second half in aggregate than in the first half is. No change to the reserving needs for dividend, right? I think you mentioned that’s just due to the anticipated commercial growth.

James Leonard: Correct in that the dividend reserve coverage ratio, we’re assuming, remains in that 9% area. The reduction in the guide for the ACL build is driven by all of the loan production changes that we are forecasting with the RWA diet and reducing the balance sheet for the new capital regimes that will be forthcoming.

Operator: And your next question comes from the line of Erika Najarian from UBS.

Erika Najarian: My first question is for Jamie. According to your first quarter Q, we’re down 100 basis points parallel, I believe, your NII would be up 44 basis points over a full year. A lot of investors are now thinking about the potential for a Fed rate cut in 1Q ’24. So I’m wondering, as we think about that 4Q ’23 exit rate in all else equal, do you expect relative stability in NII if in the scenario as the Fed cuts? And how does that play out in terms of deposit costs? In other words, is just — is there an absolute level where deposit costs don’t move that much. Do deposit costs continue to increase even in the first few cuts? You are the most trusted CFOs out there. So it would be interesting to hear your perspective on all of that.