Fifth Third Bancorp (FITB) — Q3 2015 Earnings Call Transcript

Thanks, Sean, and good morning. Today we'll be talking with you about our third quarter 2015 results. This discussion may contain certain forward-looking statements about Fifth Third, pertaining to our financial condition, results of operations, plans, and objectives. These statements involve certain risks and uncertainties, and we encourage you to review them. There are a number of factors that could cause results to differ materially from historical performance and these statements. We've identified some of these factors in our forward-looking cautionary statement at the end of our earnings release and in other materials. Fifth Third undertakes no obligation and would not expect to update any such forward-looking statements after the date of this call. I'm joined on the call today by several people, our President, Greg Carmichael; and CFO, Tayfun Tuzun; Frank Forrest, Chief Risk Officer; and Treasurer, Jamie Leonard. During the question-and-answer period please provide your name and that of your firm to the operator. With that I'll turn the call over to Greg.

Thanks, Jim, and thank all of you for joining us this morning. On November 1 I will officially start my tenure as the Chief Executive Officer of our company. Today we thank Kevin Kabat for his 33 years of service to this institution, the last nine years as CEO. We are grateful for his leadership during a difficult period in our company's history. His contributions will continue to build value for our shareholders. I am looking forward to building upon Kevin's accomplishments and leading our company to become a top through-the-cycle performer in our industry. In September I had the opportunity to meet some of you. And I look forward to having frequent dialogue in the coming quarters to share my team's priorities. We have a number of new faces who joined our senior leadership team over the last 60 days. Lars Anderson, Heather Koenig, and Tim Spence are great additions to an already strong team and have hit the ground running. By all accounts we have had a very active quarter. During the last 30 days we've resolved three significant regulatory and compliance items. Importantly, these items were already reserved for. We are pleased to have solved these matters as we continue to focus on improving our operations, efficiency, and customer experience, which in turn will generate better returns for our shareholders. Driving better efficiency through technology and improving our ability to serve has been a priority for Fifth Third. Over the last few years we've done just that, focused on improving customer service and driving operational improvements. These changes over the past couple of years have resulted in approximately $60 million of annual savings. In June we announced plans to sell or consolidate 105 branches across our footprint, and we expect to generate another $65 million in annual savings once complete. We are well on our way to executing our branch plans with the two announcements regarding the sale of our branches in St. Louis and Pittsburgh. As disclosed, we will maintain our commercial activity in both markets. The first phase of our remaining retail branch consolidations is underway. And we are on track to have this project completed by the middle of 2016 as originally planned. So now a few comments about the quarter. We reported third quarter net income to common shareholders of $366 million and earnings per diluted share of $0.45, including $0.06 of volumes that Tayfun will go over shortly. The operating environment continues to be challenging, but our focused strategies have resulted in continued loan and net interest income growth. The structure and composition of our balance sheet continues to produce current period earnings with balanced exposures to alternative rate environments. Our strategic partnership and ownership stake in Vantiv continues to produce substantial earnings. As you can see we recognized $130 million on the Vantiv warrant in the quarter, bringing our earnings year-to-date on the mark to $214 million. We have benefited greatly from this relationship. And our ownership stake leaves us with significant future revenue potential. Our core business performance is strong. For the third quarter, positive balance sheet trends continued with average loan growth led by C&I, which was up 1% sequentially and 4% from a year ago. Core deposits were up $5.6 billion from a year ago, but down $1.8 billion sequentially, the majority of which was due to intentionally reducing deposits that are unfavorable from an LCR perspective. The income results continue to show momentum, highlighted by corporate banking revenue that was up 4% from the prior year on continued strength in capital markets. And mortgage banking that was up 16% from a year ago. We continue to closely manage our expenses with a sharp focus on extracting efficiencies from our day-to-day operations. Our non-interest expense in the third quarter was flat with the prior period. We will remain focused on cost containment while continuing to invest in our company for the long term. Continuous fundamental improvement is the key here. Our expense management philosophy supports our goal of continuing to invest in the growth of our business. Credit results reflect the impact of a legacy commercial credit that Tayfun will discuss in further detail. But it is important to note that this is not the type of credit we would underwrite today, nor is it reflective of our credit risk appetite going forward. Student loan portfolios are being assessed more conservatively in the market, and we reflected the valuation of the underlying loans in this commercial credit exposure. Excluding this legacy credit our net-charge-off ratio would have been 37 basis points, consistent with the previous quarter. Non-performing assets were down 24% from a year ago. And our NPA ratio continues to decline, ending the quarter at 65 basis points. As we discussed all year we are at a threshold in our provisioning, as we are starting to cover our quarterly charge-offs. In addition, our provision this quarter reflects the acknowledgment of the stresses that are building in the domestic and global economic environment. The third quarter set us up well for a strong finish in 2015. I mentioned before that driving better efficiencies through technology and improving our ability to serve has been a priority. Both customer and regulatory expectations continue to change. And I am focused on technology investments as a core part of our strategic agenda to drive revenue growth, improve how we operate, enhance the customer experience, and achieve regulatory excellence. We are very focused on taking this company forward with an increased pace of play and establishing ourselves as a top through-the-cycle performer in our sector. With that I'll turn it over to Tayfun to discuss our third quarter operating results and our outlook for the remainder of the year.

Thanks, Greg. Good morning and thank you for joining us. As Greg said this quarter was an active quarter for us. In addition to the legal settlement and other business activities, with Greg's transition and the approaching year end, our teams are heavily engaged in our strategic and financial plan reviews. And we look forward to sharing our perspectives with you in January. All business leaders and support functions are working with a clear direction to focus on growth, supported with efficient operations and client service excellence. Our established risk appetite and risk return targets are positioned for long-term shareholder value creation. Speaking of shareholder value, the $130 million improvement in our Vantiv warrant position this quarter is a great example of shareholder value creation as a result of focused strategic decisioning. We will continue to execute our frequently stated objective to manage our financial stakes in Vantiv in the optimal way for our shareholders, as we have demonstrated since the IPO. Our direct ownership, the warrant, and tax receivable agreement in aggregate are of significant strategic value. Let's start with the financial summary on page 3 of the presentation. We reported net income to common shareholders of $366 million or $0.45 per diluted share. There were several items that affected earnings in the quarter as Greg mentioned. The improvement in the value of our warrant position more than made up for the negative impact of a few one-time items this quarter. As I mentioned the positive warrant valuation was $130 million. We also had a $9 million charge associated with executive retirement and severance, and an $8 million charge related to the valuation of the Visa total return swap. There were also charges to provision expense of $35 million related to the restructuring of a 2007 student loan backed commercial credit in the quarter. The net impact was a benefit of $0.06 per share. The third quarter charge-offs were higher due to the restructuring of a large 2007 vintage student loan backed commercial credit. In connection with the restructuring we recognized net charge-offs of $102 million, $80 million of which had been specifically provided for in prior quarters. This is a legacy credit dating back to the financial crisis. In late 2013 we had restructured a note and determined that we had appropriate cash flow and collateral coverage. And the note had performed well since then on a cash flow basis. And as evidenced by the existing reserves of $80 million, we've been diligently focused on maintaining appropriate coverage. However this credit is backed by private student loans. And as you know during the quarter volatility in the student loan markets caused significant stress on the valuation of underlying student loans. The reserve on this loan is based on the value of the underlying collateral. Based on updated valuations and cash flow projections associated with the collateral, we determined that another restructuring was needed, which triggered the $102 million charge-off under TDR accounting guidance. The remaining note balance after charge-offs is $205 million. The collateral coverage is 107% of remaining performing underlying student loans, which have an outstanding principle balance of $225 million and an average attached FICO score of 756 with 75 months' seasoning. In addition to the collateral coverage we added $13 million to our specific reserves for this note, which resulted in a net release of $67 million in specific reserves. We have no student loan exposure in our loan portfolio other than this indirect commercial exposure. I'll cover the remaining asset quality details later in the presentation, so let's move to the average balance sheet and page 4 of the presentation. The strong loan production activity in the first half of the year carried throughout the third quarter and generated average portfolio loan balances that were $1.2 billion higher than the second quarter. Loan growth metrics continue to reflect the results of our consistent efforts to select new clients that meet our return targets within our risk appetite. Our C&I balances were up 1% on an average basis with particular strength in middle market, mid-corp, and healthcare. Average commercial mortgage balances were down 2%. Commercial construction lending remains strong with balances up 16% sequentially, mainly in multifamily and industrial commercial construction. Commercial production was seasonally lower compared to the second quarter, but was 14% higher year-over-year. The largest contribution came from the middle market portfolio. Payoffs and pay downs were flat sequentially and down 5% from last year. Year-to-date most of the payoffs in our commercial portfolio resulted from clients' M&A activity and the permanent financing of commercial construction lines. Utilization rates were flat compared to the second quarter. We have seen some stabilization in new production coupons, but it's too early to call an end to the credit spread contraction. In the third quarter average investment securities increased by $900 million or 3% sequentially, partially reflecting the impact of securities purchased during the second quarter. Average core deposits decreased $1.8 billion from the second quarter, driven by lower interest rate checking account balances. The decrease was largely due to targeted pricing changes in LCR punitive commercial accounts. The early compliance that we have achieved with the final LCR targets is enabling us now to position our deposit composition in a more efficient manner to establish a very comfortable operating liquidity position. Our LCR ratio was at 107% at the end of the quarter. Moving to NII on page five of the presentation. Taxable equivalent net interest income increased $14 million sequentially to $906 million, primarily driven by loan growth, partially offset by higher interest expense associated with the $1.1 billion of holding company and $1.3 billion of bank level debt we issued this quarter. These issuances are partially replacing upcoming maturities in 2016. Our funding actions ahead of the maturities once again display our focus on long-term shareholder value creation instead of current quarter earnings focus. The net interest margin was 289 basis points, down one basis point from the second quarter, driven by the impact of those debt issuances, day count, and loan yield compression, partially offset by the benefit of the slightly lower short-term cash position during the quarter. Shifting to fees on page six of the presentation. Third quarter non-interest income was $713 million, compared with $556 million in the second quarter. Results included the $130 million positive mark on the Vantiv warrant that I mentioned earlier. As a reminder, second quarter results included a $97 million impairment charge related to the changes in the branch network and a $14 million positive mark on the Vantiv warrant. Quarterly results also included charges on the Visa total return swap of $8 million in the current quarter and $2 million last quarter. Excluding these items in both quarters fee income of $591 million decreased $50 million or 8% sequentially, led by mainly MSR related decreases in mortgage banking and seasonal decreases in corporate banking revenue. Corporate banking fees decreased $9 million sequentially as expected due to seasonally lower institutional sales and business lending fees. These seasonal declines were partially offset by higher interest rate derivative fees that benefited from higher rate and currency volatility, lease remarketing fees, and syndications revenue. Mortgage banking net revenue of $71 million was down $46 million sequentially, primarily due to lower net hedging gains this quarter. Originations were $2.3 billion in the third quarter with 58% purchase volume. 80% of the originations came from the retail and direct channels, and 20% from the correspondent channel. Gain on sale margins were up 10 basis points sequentially. Net servicing asset valuation adjustments, which include amortization and valuation adjustments, were negative $29 million this quarter, versus positive $18 million last quarter. Deposit service charges increased 4% from the second quarter and were flat relative to the third quarter of 2014. Total investment advisory revenue of $103 million decreased 2% sequentially, primarily due to the market decline during the quarter. We show non-interest expense on page seven of the presentation. Expenses were $943 million, compared with $947 million in the second quarter. The sequential comparison reflected $9 million in higher compensation expense primarily associated with executive retirements and severance, partially offset by reversal of litigation reserves. Turning to credit results on page eight. Excluding the student loan backed commercial credit, net charge-offs were $86 million or 37 basis points in the third quarter, flat with net charge-offs in the prior quarter. Total net charge-offs were $188 million or 80 basis points as a percentage of average loans, including the restructured commercial credit charge-off of $102 million, $80 million of which had been specifically reserved for in prior quarters. Non-performing assets excluding loans held for sale declined $20 million from the previous quarter to $606 million, bringing the NPL ratio to 49 basis points and the NPA ratio to 65 basis points. A year ago commercial NPAs were at 90 basis points. The sequential decline of $6 million was primarily due to a $10 million decline in C&I. NPAs in the C&I bucket was 43 basis points, down from 45 basis points last quarter and 68 basis points in the third quarter of 2014. Consumer NPAs decreased $14 million from the second quarter, driven by a $10 million decline in residential mortgage and a $3 million decline in home equity NPAs. Our criticized asset levels this quarter remained flat with last quarter's levels. Our energy portfolio declined by $45 million to $1.6 billion from the second quarter. And the composition remained stable with approximately 50% related to reserve-based lending, where we are senior secured lender within many cases significant levels of subordinated risk ahead of the bank's position. As expected, we have seen negative ratings migration in the portfolio, but especially in the reserve-based portfolio strong collateral coverage levels should limit the future migrations. Our team will have continued updates to the analysis this quarter. But overall expectations have not changed. And we don't anticipate any material impact from a loss given default perspective. We have no NPLs in this portfolio. Wrapping up on credit, due to the net $67 million specific reserve release related to the student loan backed commercial credit, the allowance for loan and lease losses declined $33 million, compared with a $7 million decline last quarter. The change in the allowance includes a $35 million addition to our overall reserves. We have been publicly discussing our expectations that there would likely be a quarter in which the provision would equal if not exceed charge-offs on a quarterly basis. This credit cycle is diverting from the average length of expansion cycles with every passing quarter. In light of further slowdown in global manufacturing activity, volatility in capital markets, and the projected prolonged downturn in the energy sector, addition to the ALLL was warranted. The resulting reserve coverage remains at 1.35% of loans and leases and 275% of NPLs. Looking at capital on slide nine. Capital levels continue to be strong and well above regulatory requirements. The common equity Tier 1 ratio was 9.4%. At the end of the third quarter, end of period common shares outstanding were down approximately $15 million. During the quarter, we announced two common stock repurchases of $150 million each. The first started on July 29 and settled on August 31 and reduced the third quarter share count by 7.4 million shares. The second ASR is expected to settle on or before December 4 and reduce the third quarter share count by 6.5 million shares. Turning to the outlook for the remainder of the year. In terms of core business activity our expectations remain the same as the last few quarters. We see good loan activity in our commercial business. We should see that trend continue into the fourth quarter supported by diverse origination activity. Our annual guidance in January called for growth in commercial lending to exceed 3%, supported by our strategic investments. Based on where we are today and our expectation for the fourth quarter, full year commercial loan growth should be approximately 4% for the full year. On the consumer side, we expect to see similar trends in the fourth quarter compared to previous periods. We are currently selling all of our conforming mortgage production other than the ARMs. We are not seeing meaningful changes in market conditions and loan demand across the categories that will have an impact on recent growth trends. Our NII outlook remains roughly the same as our last guidance. Excluding the impact of the deposit advance product, we actually have grown NII this year so far compared to last year's first three quarters. We are maintaining the guidance that we gave at the beginning of the year for full year 2015 NII growth compared to last year, excluding the roughly $100 million negative impact of the deposit advance product. We do expect a slight downtick in our fourth quarter NIM and NII resulting from the removal of the December Fed move assumption, as well as the full quarter impact of our two debt issuances from the third quarter. In July our NIM guidance was 2.88% for the second half of the year. And we will be within a basis point or two of that guidance, despite the removal of the rate increase assumption and the carrying costs associated with prefunding a portion of our 2016 debt maturities. Fourth quarter corporate banking fees tend to be seasonally stronger with higher business lending and syndication fees relative to the third quarter. As expected mortgage banking production net revenue should be seasonally below third quarter levels but in line with fourth quarter of last year. The ongoing annual income from the tax receivable agreement payment we expect to receive from Vantiv is approximately $30 million. Our core non-interest expense guidance in July was a 2.5% increase in total core expenses during the second half of the year over the first half totals. Good news is that we expect to come slightly inside that guidance. The seasonal uptick in expenses during the fourth quarter will include higher EMV-related expenditures, which we discussed earlier in the year, as well as higher performance-related compensation and the continuing uptick in base comp related to the buildup in compliance and risk infrastructure. As we also discussed before, we expect our technology expenses during the fourth quarter to be about 10% higher than the third quarter. These costs are designed to support our long-term strategic actions and investments in our franchise, including IT projects that are targeted for risk and compliance infrastructure and those that are targeted for direct business-related purposes, such as digital technology. We are spending a significant amount of time on expense management in all of our core businesses and staff functions. As the Fed's anticipated rate actions continue to be pushed back, we are ratcheting up our focus on improving operating leverage in our businesses. Greg's direction to the entire organization is to operate under the assumption that we will extract efficiencies from our processes year in and year out. We expect to continue to invest in our businesses to build shareholder value. And the savings from our existing processes will provide part of the funding for the new investments. The upward slope in our risk and compliance infrastructure-related expenses is not permanent. The combination of the renewed commitment to tighter expense management in our existing platforms in this environment, and the end to the upward slope in risk and compliance expenses in 2016 will be important to achieve our goal to outperform through the cycle. Turning to credit. As expected we have probably seen the end of reserve releases. And going forward provision will be impacted by loan growth and the impact of broader economic trends on the portfolio. Net charge-offs are expected to be more in line with our core losses last quarter and the levels we have seen in the first two quarters of this year. We also would like to remind you that the revenue expectations that we shared with you today do not include potential, but currently unforecasted items, such as Vantiv warrant marks and gains on share sales. In summary we continue to be focused on making the right decisions for the long term, strategically positioning us to be a trusted partner to our clients, and building a strong balance sheet with prudent liquidity, interest rate, and credit risk exposures for through-the-cycle performance. With that let's open the line for questions.

Good morning, Erika.

Hi. Good morning.

Good morning.

Yes. My first question is for you, Greg. On an adjusted basis over the past two quarters the core efficiency ratio of this company has been around 62%. Given that the revenue backdrop may be challenging for longer, and Tayfun's remarks about a renewed focus on expense management, can you improve that 62% over the next 12 months without really any help from the revenue environment? In other words, is there savings that you can extract from today's cost base that could be above and beyond what's required to invest back into the company?

Erika, we've been focused, as we announced earlier in my comments on expense management, as we announced the reduction of 105 branches and some of the talent re-engineering that we've accomplished. We'll continue to stay focused on our core efficiencies, making sure every investment dollar we put forth, we get return on that investment. But it's a very difficult environment right now with low interest rates, high regulatory costs. We'll give more guidance in January for 2016 on efficiencies. But right now, I would tell you job one is to make sure we're taking care of our customers. And wherever possible we're extracting efficiencies on our current core operating environment.

And my second follow-up – sorry. My follow-up to Tayfun is on the LCR, given that you're at 107%. Are the wholesale changes on the balance sheet behind you with regards to either the repricing of non-operational deposits on the liability side? And should we think about the size of the securities portfolio relative to loan and deposit growth from here?

Yeah. Yes, Erika. I think the broader increase in the size of the investment portfolio is behind us. From now on we probably will see investment portfolio growth more in line with the rest of the balance sheet growth. In terms of larger moves on the deposit side I think we've taken care of most of the large deposits that tend to be LCR punitive. But we will always be focused to manage the deposit side efficiently in light of this continued low rate environment. And as I mentioned in my script, our early move on the LCR last year is giving us room to be able to do those efficiency moves on the rest of the deposit base.

Got it. Thanks.

Good morning. Thanks for taking my questions. First of all in terms of the rate sensitivity, Tayfun, it looks like that has not materially changed quarter over quarter. And how would you think about that going forward, assuming we get a very minimal level of rate increase in the first half of 2016?

Yeah. Matt, as I mentioned, we removed our rate increase assumption from our outlook for this year. And it looks like next year right now, there are a couple of moves in the forward curve. In terms of our rate sensitivity we've always said that we are not taking the extreme rate sensitivity position and expectation for aggressive rate moves. And we want to be balanced because we see the risks balanced going forward. Even if the Fed starts moving rates, I think it's going to be less steep and [indiscernible] than people thought a year ago or so. So therefore we're not anticipating significant changes to our asset sensitivity from here. We will be mindful obviously if and when rates start to rise to extract most of that benefit and let it fall to our balance sheet. But we've been very transparent in terms of the assumptions that we are using in our outlook. Jamie, any comment?

No. I think that – good summary.

Okay. Thank you for that. And then in terms of my follow-up, based on what appears to be a less bullish outlook for rates, certainly this year and it seems into 2016, how are you thinking about deposit pricing? Several other banks this earnings reporting season have discussed their view that there could be relatively high degrees of competition for core deposits as rates rise. But that seems to imply a relatively stair-step increase in rates, which my sense is the market is not in line with. So how are you thinking about potential deposit pricing competition in a lower for longer rate environment?

Yeah. This is Jamie. One thing you can see from our activities this year and even from the deposit changes this quarter is we've been very focused on trimming deposit costs for what would appear to be a lower for a longer environment. You've seen that in our core deposit levels down – rate costs down a bp or so each quarter this year. And frankly with our LCR at a pretty strong position at 107%, it gives us a little bit of flexibility to wait and see how competition responds. But the reason why we have pretty high betas in our interest-rate risk modeling is we believe your comments are on point, which is there could very well be higher price competition on retail deposits should the Fed decide to raise rates for those banks that are below or barely compliant with the LCR. So we model a 70% beta for every rate move linearly. However, as Tayfun said, we would hope that given our strong balance sheet position, we'd be able to take advantage of maybe the first couple moves and operate at a beta lower than that. But again we'll have to wait and see how the competition plays out for those retail deposits.

Okay. Thanks very much.

Welcome.

Morning, guys. Hey, just want to get my arms around the credit outlook. So the net charge-off outlook, that seems very stable. All the NPA indicators basically seem fine. But sort of the written commentary and then, Tayfun, your comments, maybe a little more cautious. And then the ongoing reserve build this quarter, when you net away all the noise from the student loan backed issue was perhaps more than I would've thought. So, Tayfun, maybe if you could just sort of expand on your comments on credit broadly? And then I think the crux is if you could maybe discuss the need to add to reserves at a level consistent with this quarter's level going forward?

Yeah. So I look at – we actually in the analysis that leads to the ultimate reserve levels, we look at the broad macro indicators. This expansion now is approaching, I think, the 76th month of the start date, and it's now the fourth longest expansion since the Second World War. And the next one up is the 1980-1981 expansion. And we have to respect where we are. I look – we look at all the credit spreads indicators. And you just have to respect what the market is telling us. It doesn't – the spread expansion doesn't necessarily mean that a recession is right around the corner. But sometimes it can potentially feed the sort of next moves in the credit cycle. We're just basically cognizant of where we are in this expansion cycle and want to make sure that our reserve levels appropriately reflect that positioning. Beyond that, you've seen all of our credit metrics. Our guidance is for core charge-off performance to resemble more the first half rather than the actual levels this quarter. I think we're just basically reflecting what we see in the broader macro sense. In terms of provision levels going forward, we're not necessarily forecasting provision into the next quarter. We had a $35 million add this quarter. But all we're saying is it should – obviously this is all based on the analytics that supports our reserve levels. But it should more resemble the actual credit performance. And we're obviously going to look at how the balance sheet is moving forward as well. Frank, I don't know if you have any other comments on that?

No, I think you covered it well, Tayfun. Again the thing – one thing to keep in mind is when you look at the size of our energy book and you look at the size of our commercial real estate book, they're relatively small compared to our peers. They're stable. They're performing very well. And we feel very good about the outlook. So I have nothing else to add.