Fifth Third Bancorp (FITB) — Q4 2016 Earnings Call Transcript

Thank you, Larry. Good morning and thank you for joining us. Today, we’ll be discussing our financial results for the fourth quarter of 2016. 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 risks and uncertainties that could cause results to differ materially from historical performance. We’ve identified some of these factors in our forward-looking cautionary statement at the end of our earnings release and in other materials, and we encourage you to review them. Fifth Third undertakes no obligation and would not expect to update any such forward-looking statements after the date of this call. Additionally, reconciliations of non-GAAP financial measures we reference in today’s conference call are included in our earnings release along with other information regarding the use of non-GAAP financial measures. A copy of our most recent quarterly earnings release can be accessed by the public in the Investor Relations section of our corporate website www.53.com. This morning, I’m joined on the call by our President and CEO, Greg Carmichael; CFO, Tayfun Tuzun; Chief Operating Officer, Lars Anderson; Chief Risk Officer, Frank Forrest; and Treasurer, Jamie Leonard. Following prepared remarks by Greg and Tayfun, we will open the call up to questions. Let me turn the call over now to Greg for his comments.

Thanks, Sameer, and thank all of you for joining us this morning. As you’ll see in our results, we reported full year 2016 net income of $1.6 billion and EPS of $1.93 per share. We believe that 2016 marks an inflection point for Fifth Third. During the year, we took a number of important steps to help position our bank to deliver superior results through business cycles and better serve our customers. In September, we announced Project North Star with a specific financial goal of generating a return on tangible common equity of 12% to 14% by the end of 2019. For the course of the year, we invested heavily in risk management, compliance, and information technology. We invested in FinTech companies such as GreenSky, ApplePie, AvidXchange, and Transactis. We’re also pleased to receive a partnership with QED Investors, a leading FinTech venture capital firm. In addition, we announced the acquisition of Retirement Corporation of America, a registered investment advisor. We continue to evaluate acquisitions that would help augment fee revenue. Several of these investments, particularly on the digital side, are table stakes. Over time, we believe that these partnerships and investments will help us: 1) expand our delivery channels, 2) enhance our digital capabilities, 3) develop new process services, and 4) drive additional business volume. During the year, we took several actions to help improve the profitability of our bank for enhancing our ability to serve our customers. We announced the agreement with Black Knight to consolidate our existing mortgage platforms. This investment will lower our costs in residential mortgages, increase our mortgage loan origination capacity, and significantly improve our customer experience. We’re continuing to invest in areas of automation to optimize operations. Reflecting the rapid change of technology and customer behavior, we’re on track to implement our omni-channel strategies. We believe this will allow us to better serve the needs of our customers. Over the last 18 months, we have closed or announced plans to close branches representing 12% of our branch network. There’s been good response to both changing customer preferences and our desire to focus on our core markets. We initiated a program to redesign our commercial client experience, which will streamline many of our processes from end to end and reduce our cost to deliver. We renegotiated several key vendor contracts, driving significant run rate savings. We’re focused on relationships that meet our risk-adjusted return hurdles; we were unwilling to sacrifice spreads or credit quality for balance sheet growth. As an outcome of our disciplined approach, we exited $3.5 billion of commercial loans that did not meet our desired risk or return profile. Excluding these deliberate exits, our period-end commercial loans would have been up 7% year-over-year. We launched two credit card products which should help drive higher returns in loan growth over time. Both in credit cards and other consumer loans should also allow us to achieve a better balance between commercial and consumer loan growth. During the year, while we continued to make investments, we kept a close eye on expenses. In 2016, our expenses only increased by 3.4% compared to our initial expectations of 4.5% to 5% at the start of the year. We expect to continue generating positive operating leverage in 2017 and beyond. Lastly, we remain prudent toward capital and returned nearly $1 billion to common shareholders in the form of dividends or share repurchases in 2016 even as our capital levels improved. There’s more work to be done, but we believe that the steps we took in 2016 will help us achieve our performance objectives. Before discussing our fourth quarter results, I want to take a moment to thank our employees for their hard work and dedication over the last year. I believe the foundation we have laid in 2016 will position the bank to deliver higher and more resilient returns in 2017 and beyond. Moving to the fourth quarter results, we reported net income to common shareholders of $372 million and earnings per diluted share of $0.49. Some non-core items highlighted in the earnings release resulted in a positive $0.01 impact through core earnings per share in the quarter. Tayfun will provide full details about these items in his opening comments. Our adjusted net interest margin expanded three basis points sequentially. This improvement reflected our continued focus on higher quality customer relationships and the benefit of higher interest rates during the quarter. Expenses were down 1% this quarter compared to the third quarter of 2016 as we continue to tightly manage expenses in this environment. Credit quality continued to improve with a significant decrease in criticized asset levels for the fourth consecutive quarter. A decrease in criticized assets provides further evidence of our focus on stability and maintaining relationships for a better credit profile. Net charge-offs also continued to improve this quarter. On a full-year basis, our commercial net charge-off ratio was the lowest that has been in the past 15 years. While we continue to expect the benign credit environment to continue for the foreseeable future, charge-offs can exhibit quarterly variability. Fee income was up 2% sequentially, adjusted for notable items in the earnings release. Fee revenue was down 2% year-over-year driven by lower mortgage and retail brokerage banking revenue. We believe that we have an opportunity to accelerate fee growth in 2017 led by our capital mortgage business. We also think evaluating strategic acquisitions that will help drive fee growth. Production metrics remain strong, but the mortgage originations were affected by seasonality and higher rates in Q4. Volume of $2.7 billion was down 5% sequentially but up 54% from last year. Our commercial loan production for relationship managers was up 80% with fees for relationship managers up 30% year-over-year. Our investments in digital channels are paying off. Approximately 61% of all transactions are made through digital channels compared to 30% just a few years ago. Overall, we have seen a 29% increase in mobile usage year-over-year. We have also seen a 170% increase year-over-year in checking and savings accounts opened online. Our capital levels remain strong and improved from last quarter. Our common equity Tier 1 ratio increased to 10.4% from 10.17% last quarter. The strength of our balance sheet and earnings allows us to increase our common dividend by approximately 8% or $0.14 per share in December. At Fifth Third, we still believe in supporting our communities. In the fourth quarter, we publicly announced our five-year $30 billion community commitment with National Community Reinvestment Coalition. We were pleased to work with CEO John Taylor and 145 of their member organizations signing on to a program that will improve lives in communities we serve. It includes a broad-based lending, investment, and services plan. We also announced a new financial alliance with EverFi, a leader in digital and structural technology. We believe this mission will educate more than 150,000 high school students annually throughout our footprint. Overall, I’m pleased that our strong results for the year enabled us to return a significant amount of capital to shareholders, make strategic investments and support the communities we serve. With that, I’ll turn it over to Tayfun to discuss our 4Q results and our current outlook for some additional color in our Project North Star.

Thanks, Greg. Good morning and thank you for joining us. I will start with the financial summary. As Greg mentioned earlier, we are very pleased with our results for the quarter. During the quarter, the expansion of our underlying net interest margin, the sequential decline in our expenses, and excellent credit quality reflect our continued commitment to driving improved financial performance. For the fourth quarter, there was a net positive impact of $0.01 per share resulting from several items; the most significant item was the $16 million pre-tax charge to provide refunds to certain credit card customers, offset by the previously disclosed Vantiv gain, a positive mark from our Visa swap, and a tax benefit from the early adoption of an accounting standard. Our adjusted net interest margin, which excludes the credit card charge, expanded three basis points sequentially. We maintained pricing discipline during the quarter, and our asset-sensitive position allowed us to benefit from the rising interest rate environment. Our reported NIM contracted by two basis points. Expenses remained tightly controlled as we continued to look for efficiencies throughout the organization. Credit quality was excellent as evidenced by our ongoing improvement in criticized assets and a decline in net charge-offs during the quarter. Our focus on improving our returns led us to deliberately exit certain commercial relationships and reduce indirect auto loan originations. This led to a sequential decline in our total loan portfolio. In aggregate, we exited approximately $3.5 billion of commercial loans in 2016, and we expect to exit roughly another $1.5 billion in 2017. So with that, let’s move to the balance sheet discussion. Average commercial loan balances were down 1% sequentially and flat year-over-year. As I mentioned earlier, throughout the year we made deliberate decisions to exit lending relationships that do not meet our desired risk and return profile. This had a negative impact on C&I balances which decreased by 1% both sequentially and year-over-year. During the quarter, we maintained our origination spread levels as LIBOR increased, driving a five basis point increase in our C&I yield. We will continue to optimize the portfolio to achieve better returns while improving the stability of our credit performance. The sequential decline in average C&I balances was partially offset by 1% growth in commercial real estate this quarter. As we have discussed in prior calls, in construction as well as in firm lending, our teams are cognizant of valuation and supply-demand dynamics. Our disciplined client selection and credit underwriting in commercial real estate will continue to rely on stringent standards. Average construction loans grew by 1% sequentially in the fourth quarter. As a sign of a healthy construction portfolio, loan run-off increased this quarter as underlying projects were completed and sold or refinanced. Our pipelines are diversifying away from multi-family, and we are becoming more selective as the sector gets deeper into the later phase of the cycle. Average consumer loans were flat from last quarter and were down 2% year-over-year. Auto loans were down 3% from last quarter and 13% year-over-year in line with our reduced originations. Throughout 2016, we maintained a consistent focus on improving the profitability of this business. We are continuing to work on additional tactical changes to further improve the returns in 2017. Residential mortgage loans grew by 3% sequentially and 10% year-over-year as we kept jumbo mortgages, ARMs, as well as certain 10-year and 15-year fixed rate mortgages on our balance sheet during the quarter. Our home equity loan portfolio decreased 2% sequentially and 7% year-over-year as loan paydowns exceeded origination volumes. Our originations this quarter were seasonally down 14% compared to last quarter and flat year-over-year. Our credit card portfolio grew by 1% sequentially but was down 2% compared to the fourth quarter of 2015 including the impact of the sale of the Agent portfolio in June. Excluding the sale of the Agent Bank portfolio in the second quarter of 2015, our credit card portfolio would have grown by 3% year-over-year in the fourth quarter. The introduction of two new credit card products last October and investments we are making to significantly upgrade our analytical capabilities should lead to faster growth in credit card outstandings. In addition to our new initiatives in credit card lending, our GreenSky partnership should support faster consumer loan growth as well. We started funding loans in October and are confident that our partnership will help us achieve a better balance between commercial and consumer loan growth. Average investment securities increased 3% sequentially in the fourth quarter, partially due to under-investment during the previous quarter. Our investment portfolio yield was stable with only a one basis point decline sequentially. We had three top priorities for 2016 in terms of managing our balance sheet. First, we wanted to make material progress in positioning our loan portfolio for improved and stable returns through the cycle; second, we sought to balance our interest rate risk exposure; third, we wanted to maintain a healthy level of liquidity on our balance sheet. We achieved all three goals by focusing on originating loans that met our targeted return requirements, exiting relationships with sub-par risk return profiles, and optimizing our mix of liabilities. These objectives will also remain our top priorities for 2017. At this time, we have exited approximately two-thirds of the commercial lending relationships that did not meet our desired profile and have roughly another $1.5 billion to go. Excluding these deliberate exits, we expect to grow total commercial loans by 4% to 5% in 2017. Including these exits, we expect our commercial loan portfolio to grow by closer to 2% at year-end. We plan to maintain indirect auto loan originations at $3.4 billion in 2017, which will likely result in a roughly $1.5 billion decline in that portfolio. Including the impact of the auto run-off, we expect our overall consumer loan portfolio to grow modestly in 2017 on a period-end basis. We also expect to maintain our investment portfolio at roughly the same level we are at today. Average core deposits increased 2% sequentially driven by increased commercial interest checking account balances and consumer money market account balances. Excluding the impact of the two market exits, Pittsburgh and St. Louis, average core deposits were up 2% on a year-over-year basis. Inclusive of the impact of the market exits, core deposit growth was approximately 1% year-over-year. Our modified liquidity coverage ratio of 128% at the end of the year was very strong and exceeded the new 100% minimum. Moving to NII on slide six of the presentation. Excluding the impact of the credit card charge, taxable equivalent net interest income increased $12 million or 1% sequentially. Including the charge, NII was down $4 million to $909 million. The impact of the credit card item was partially offset by improved short-term market grades in the fourth quarter and higher investment securities balances. Excluding the credit card charge, the NIM on an FTE basis increased three basis points from the third quarter to 2.91%. The impact of the charge was five basis points resulting in a two basis point contraction in our reported NIM. Fourth quarter margin performance was largely driven by an increase in short-term market rates during the quarter and continued pricing discipline in our loan portfolio. We expect the NIM to widen by approximately 8% to 9% basis points from the fourth quarter reported number to about 2.95% in the first quarter. On a full-year basis, we expect the NIM to range between 2.95% and 3%. The low end of the range is based on the rate scenario with no additional Fed moves, while the upper end of the range assumes two additional Fed moves in June and September. We will continue to execute a balanced interest rate risk management strategy as we have done over the last three years. Our risk management approach aims to limit a downside impact of low-interest rates while maintaining an asset-sensitive position. The cumulative increase in LIBOR over the last two quarters, and our ability to maintain pricing discipline have had a sizeable positive impact on our NIM. If the expectations for higher interest rates actually materialize, NIM expansion will be a function of deposit pricing lags and betas. Our disclosures on this topic are very transparent in terms of the impact of various interest rate and deposit balance scenarios. Including the impact of day count, we expect our first quarter net interest income to be up by 1.5% to 2% from the reported fourth quarter net interest income. With the background of our earning asset growth expectations that I detailed earlier, we are projecting full year net interest income growth of 3.5% to 5% bracketed by the two rate scenarios that I just outlined.

Hey, this is Frank. Good question. We’ve had very consistent asset quality results in this year and back in 2016. And again, our focus has been on deliberately changing the risk part of the balance sheet; we’ve had a significant number of de-risking activities both on the consumer and the commercial side of the portfolio. We don’t have a significant energy book; it’s very small so we’ve not really had any losses of any size there. Our commercial real estate book is performing really well and it’s limited and capped at 15% from a concentration limit of our total book which is lower than our peers. We have a larger mid-cap book into large cap that is primarily investment grade and it’s performed exceptionally well. The other thing to consider relative to NPLs, we reported $660 million NPLs for the year, 72 basis points. 31% of that number are tied to energy, and they’re tied to reserve-based loans which are very well secured. The loss profile on that portfolio is roughly 2% max in our opinion, that’s far lower than what you would typically see in an NPL portfolio with substandard loans that generally have a loss of 10% to 15% to 20%. So again, the profile of that portfolio by the NPLs in the balance sheet management composition of our assets we believe is well diversified and that does very well. We expect in 2017 our credit losses, as Tayfun said, should be range-bound but should be down from what we reported this year which was 39 basis points at an enterprise level.

Thanks, good morning everyone. Just the first question if you could talk about just the overall balance sheet, Tayfun, in reference to still some C&I relationships that you’re still exiting and you’re also exiting auto. So just in the context of your loan growth and keeping securities balances fairly flat, would you expect to see much change in the overall size of the balance sheet?

Ken, I think with the flat investment portfolio and the 2% year-over-year growth, earning assets will grow. It’s probably going to be closer to sort of a 1% type number as the average of the two dollar items.

Good morning. Thank you for taking the question. You helped give us some numbers around expense growth and what that would be without the incremental North Star investments. Can you help us think about the same sort of math on fees and on net interest income? What would that look like without North Star this year?

So on fees Geoffrey, as we indicated before, we were not expecting much of a lift in 2017. These initiatives are underway; some of them will come to their final phases this year. For example, the mortgage system will go online in the fourth quarter of this year, there are others on the capital market side. We are gradually executing that includes potential insurance, etcetera. So our expectations with respect to fee income were focused on growth in 2018 and beyond. We have significant investments in our credit card and personal lending areas that would be encouraging both from a fee side as well as the balance sheet side in 2018 and 2019. So, my overall comment is whether it’s NII or fee income, in 2017, you are seeing the results of what we have done so far through the end of 2016. On the expense side, we clearly have started executing some of the expense initiatives earlier in 2016. Now if you include some of the exit strategies in commercial in 2017, those are more negative than positive for NII as you can imagine from just the pure 2017 calendar year perspective.

Yes, hi. Good morning. I just wanted a little bit of clarification on your loan growth guide for the year, and thank you very much for giving us the details underneath. So, if I’m taking 2% of $92.1 billion, that assumes $1.8 billion of net growth. And I’m wondering, given your guide for C&I of 2%, so that’s about $830 million, and then you have the $1.5 billion of decline in auto. I’m wondering where the rest of the growth is coming from?

So you have the numbers roughly – on the C&I side we will see growth – on the commercial side, we will see continued growth in construction, so that will be one source of growth just on a year-over-year basis. We clearly will see some moderate growth in leasing and we expect to see growth in credit card outstandings on a Q4-over-Q4 level, and relative stability may be a little bit of growth in mortgage as well. And then you also have the positive impact of our GreenSky partnership which we said would produce about $90 million to $100 million growth on a quarterly basis.

Moving on to capital and liquidity. Our capital levels remain strong. Our common equity Tier 1 ratio was 10.4%, an increase of 23 basis points quarter-over-quarter and 58 basis points year-over-year. At the end of the fourth quarter, common shares outstanding were down approximately $5 million or 1% compared to the third quarter of 2016 and down 36 million shares or 4% compared to last year’s fourth quarter. During the quarter, we executed an accelerated share repurchase of $155 million which reduced the share count by $4.8 million shares, primarily reflecting the decline in unrealized securities gains given the rising rate environment. Our book value and tangible book value were down 3% and 4% respectively from last quarter. Book value and tangible book value were up 7% and 8% respectively compared to last year. As I mentioned previously, our common equity Tier 1 ratio increased by 58 basis points from 9.82% at the end of 2015 to 10.4% at the end of 2016. This result, when combined with a $1 billion capital distribution to our shareholders during the year, demonstrates our ability to generate capital at Fifth Third. As we are now going through this year’s CCAR exercise, it is too early to give you meaningful color on our expectations, but suffice it to say that we will remain good stewards of our shareholders’ capital.

Thanks, Tayfun. Before we start Q&A, as a courtesy to others, we ask that you limit yourselves to one question and a follow-up and then return to the queue if you have additional questions. We’ll do our best to answer as many questions as possible in the time we have this morning. During the question-and-answer period, please provide your name and that of your firm to the operator. Larry, please open the call up for questions.

Thanks, good morning everyone. Just the first question if you could talk about just the overall balance sheet, Tayfun, in reference to still some C&I relationships that you’re still exiting and you’re also exiting auto. So just in the context of your loan growth and keeping securities balances fairly flat, would you expect to see much change in the overall size of the balance sheet? How would you just kind of imagine the moving parts across that?

Ken, I think with the flat investment portfolio and the 2% year-over-year growth, earning assets will grow. It’s probably going to be closer to sort of a 1% type number as the average of the two dollar items. Good morning and thank you for joining us. I will start with the financial summary on slide four of the presentation. As Greg mentioned earlier, we are very pleased with our results for the quarter. During the quarter, the expansion of our underlying net interest margin, the sequential decline in our expenses, and excellent credit quality reflect our continued commitment to driving improved financial performance.

Good morning. Thank you for taking the question. You helped give us some numbers around expense growth. What would that look like without North Star this year?

We are continuing to work on additional tactical changes to further improve the returns in 2017.

Yes, hi. Good morning. I just wanted a little bit of clarification on your loan growth guide for the year. Thank you very much for giving us the details underneath.

So you have the numbers roughly – on the C&I side we will see growth – on the commercial side, we will see continued growth in construction.

Hi, I want to make sure I understand what you’re guiding to. So for 2017, you’re guiding for at least 250 basis points of positive operating leverage assuming no rate hikes, is that correct?

Without necessarily giving a precise guidance on total provision dollars, I would point out that this quarter’s provision as lower due to one significantly lower commercial charge off dollar number.

Thanks, Tayfun. Before we start Q&A, as a courtesy to others, we ask that you limit yourselves to one question and a follow-up and then return to the queue if you have additional questions.