Fifth Third Bancorp (FITB) — Q1 2018 Earnings Call Transcript

Thank you, Tamiya, good morning and thank you all for joining us. Today, we'll be discussing our financial results for the first quarter of 2017. 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 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, and we encourage you to review them. Fifth Third undertakes no obligation to 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 during 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 Chairman 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 for 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. Earlier today, we reported first quarter 2018 net income available to common shareholders of $689 million and EPS of $0.97. Our reported EPS included a positive impact of $0.40 from a few significant items including a step-up gain of $414 million recognized from a Worldpay stake. Our first quarter results were strong and reflect our efforts to enhance the resilience of our balance sheet, capitalize on rate hikes, and maintain tight control over expenses. Recall that last quarter, we revised our ROA and ROTCE targets higher after tax legislation resulted in lower corporate tax rates. Now on year two of Project North Star, our first quarter results showed that we remain on track to achieve the upper end of our leasing device ROTCE target in the 15.5% to 16% range, an ROA of 1.35% to 1.45% by the fourth quarter of 2019. Excluding the Worldpay gain, another non-core item, our underlying ROTCE for the first quarter was over 30% further adjusting for additional capital generated from the step-up gain, our ROTCE for the quarter was 13.7% compared to 9.7% in the first quarter of 2017. We remain focused on driving improved shareholder returns as we continue to execute on our strategic initiatives under Project North Star. Discussing some of the highlights for the quarter, I'd like to make a few observations about the broader economic environment. We are closely watching our commercial client activity and remain cautiously optimistic about the outlook for employment and capital investment. For the low level of employment is supportive of a healthy consumer sector; we’re also cognizant of elevated consumer debt levels. Moving on to our first quarter results, our asset-sensitive balance sheet allows us to benefit from increased short-term interest rates. Our adjusted net interest margin expanded eight basis points sequentially and exceeded our previous guidance, primarily reflecting higher interest rates. We also benefited from our focus on maintaining commercial loan pricing discipline. End of period commercial loans and leases increased 1% sequentially, while the industry balances reflected. A sequential increase in our commercial portfolio was primarily driven by growth in C&I loans which grew by 1% on both a period-end and average basis. As some of you may recall, we discussed our commercial client experience initiative or TCEI at our Investor Day last December. TCEI is enabling us to significantly improve customer service in our middle market lending business by streamlining the origination underwriting process; our relationship managers are able to spend more time on cultivating new relationships and better servicing our existing customers. With all these initiatives already paying off, we’re extremely pleased with the implementation. In the consumer portfolio excluding our loans, average consumer balances grew 2% year-over-year, largely driven by continued growth in our unsecured lending portfolio. As we have discussed previously, we would like to achieve a better balance between consumer and commercial loans. Growth in our unsecured lending portfolio is consistent with this objective and in the mortgage space, I'm pleased to announce that all distribution channels will rely on a new mortgage loan origination system this week. This system will help improve the customer experience, increase employee engagement, and support market share growth. In terms of fee income, we experienced another record quarter in our wealth and asset management business reflecting seasonally high tax credit fees, growth in new relationships, and strong equity market performance over the past year. Our corporate banking revenue was negatively impacted by newly market activity. We sold sequential growth in our M&A advisory business and corporate bond fees, which was stronger than the overall industry average. Although consistent with general market trends for the quarter, we generated lower loans syndication fees. Non-interest income was also impacted by lower equity method income resulting from the Vantiv Worldpay merger. For the first quarter, we managed our underlying expenses well below previous guidance despite ongoing strategic investments in Project North Star. At Fifth Third, we appreciate the importance of ensuring that our core expense base is optimized for the realities of our operating environment. We believe we saw room for improvement and are working with a third-party consulting firm to help identify and execute on additional expense savings throughout 2018 and into 2019. The initiatives we are currently reviewing are in addition to what we had planned under Project North Star and could increase our return targets closer to 17%. These are pure expense initiatives and include spend control design, back to middle office efficiencies, and enhanced focus on vendor spend. In light of evolving customer preferences, we continue to assess the optimal size of our branch network and decided to close nine branches during the quarter. We are also considering opening new branches in our high growth markets where we have opportunities to expand our franchise. This process is an ongoing exercise and we continue to leverage our newly developed analytical capability to optimize the size of our retail branch network. During the quarter, credit quality remained strong. Credit size loans declined again reflecting the attribute of taken over the past two years to strengthen our balance sheet; net charge-offs and nonperforming loans also remained at or near pre-crisis levels. Our capital and liquidity levels remain very strong with our common equity Tier 1 ratio at 10.8%, while our modified LCR continues to be well above regulatory requirements at 113%. With our strengthened balance sheet and focus on through-the-cycle credit performance, we continue to believe our optimal CET1 ratio should be significantly below current levels in the 9.5% to 9.7% target range. As a result, we anticipate a total payout ratio over 100% over the next year or so, with a continued balance between higher dividends and share buybacks. We also recently announced additional strategic partnerships, acquisitions, and equity investments. Our recent acquisition of Coker Capital Advisors built upon the strength of our healthcare vertical and enhanced our M&A advisory capabilities. Turning to our Epic Insurance and Integrity HR acquisitions from last year, we expect this transaction to help support fee income growth. Our strategic approach to fee-related acquisitions revolves around acquiring and growing within our markets, fully integrating these businesses into the bank, and leveraging our unique one bank every mile to grow in an efficient demand. As many of you know, student debt is a challenge facing our millennial customers. We launched our momentum app last year to help with this problem, and we’re pleased to recently announce an equity investment in CommonBond, one of the largest digital student loan originators, and look forward to working with them to bring proper solutions to the market. We’ve also made significant progress on our commitment to improving the communities we serve. In particular, we recently became the first Fortune 500 company to sign a power purchase agreement to achieve 100% renewable power. This achievement will help promote a healthy and sustainable environment and help protect our planet for future generations. I’d once again like to thank all of our employees for their hard work and dedication, which is evident in our financial results. I was pleased that we were able to deliver strong results and remain on track to achieve our North Star targets. With that, I’ll turn over to Tayfun to discuss our first quarter results and our current outlook.

Thanks Greg. Good morning and thank you for joining us. Let's move to the financial summary on Slide 4 of the presentation. As Greg mentioned, during the quarter, NII growth and expansion, expense control, and ongoing strength in credit quality metrics reflected our commitment to driving improved financial performance and shareholder return. Reported results were positively impacted by the items noted on Page 1 of our release. The most significant item was the $414 million positive pretax impact of the Worldpay step-up gain which we had previously discussed. This was partially offset by a $39 million pretax charge related to the Visa total return swap and $8 million impairment related to our plan to reduce our branch network by nine branches, as well as an $8 million charge associated with an increase in litigation reserves. As we had discussed on last quarter's earnings call, our first quarter results were affected by seasonally higher expenses resulting from compensation-related items. Despite this headwind, our underlying ROA and ROTCE metrics improved substantially from the fourth quarter. Core ROA of 1.23% improved 11 basis points sequentially, with core ROTCE of 13.4% up 1.7% from adjusted fourth quarter results. Recall that last quarter we revised our ROA and ROTCE targets to reflect our confidence in retaining the majority of the benefits from recently enacted tax legislation. As Greg mentioned earlier, we are taking a closer look at our expense base in light of the ongoing lack of strength in loan growth and the muted fee environment, more on that a little bit later. Moving to Slide 5, loan growth continues to be challenging in commercial lending. The all-end impact of tax reform has been modestly positive for the quarter. Clients have largely maintained their wait-and-see approach, and as a result, both loan production and payoff activity was relatively tepid. But based on a very healthy pipeline in commercial lending, especially in the middle market, we anticipate that we will achieve our targets during the rest of the year. Average total loans were flat sequentially. Growth in C&I and other consumer loans was mostly offset by a continued reduction in our home equity, commercial real estate balances, and the planned decline in our indirect auto loan portfolio. Average C&I loan balances were up 1% or approximately $340 million compared to the fourth quarter of 2017 and were flat year-over-year. While production was relatively tepid during the quarter, we had tailwinds from line utilization and lower paydowns which led to a modest increase in balances. The sequential increase in average C&I balances was partially offset by a 1% decline in both CRE and commercial leases. We expect commercial leases to continue to decline another $400 million by the end of 2018, mainly in our indirect large-ticket leasing portfolio given our focus on driving relationship-oriented profitable growth. Similar to prior quarters, price competition in commercial lending is aggressive, but we continue to remain competitive, striking an appropriate balance between growth and prudent risk. Average commercial real estate loan balances declined 1% sequentially in the first quarter with mortgage down 3% and construction flat. We will continue to maintain a cautious approach in commercial real estate given where we are in the cycle. We currently expect our end-of-period total commercial portfolio to grow about 1% to 1.5% sequentially in the second quarter and about 4% in 2018 compared to end of year 2017, including the impact of the runoff of our national leasing business. Growth should predominantly come from C&I. Stated differently, excluding the runoff in our leasing business, our growth rate is expected to exceed 5%. In consumer, including the planned decline in the indirect auto loan portfolio, average loans were flat sequentially and year-over-year. Excluding auto, average consumer loans were up 2% year-over-year. Auto loans were down 7% year-over-year, reflecting the ongoing impact of our decision to curtail indirect originations and redeploy capital. The rate of decline in the auto portfolio should slow as we currently expect the pace of originations to increase in 2018 from 2017, given current returns. We currently expect our total production to be closer to $4 billion in 2018. Average residential mortgage loans were flat sequentially and up 2% year-over-year as we continue to retain jumbo mortgages and arms on our balance sheet. We acquired a $2 billion servicing portfolio during the quarter which will be onboarded in the second quarter. Since the beginning of last year, we have acquired approximately $12 million in servicing assets. We continue to assess MSR purchase opportunities to take advantage of our scale and enhance our return on capital. Our average credit card portfolio increased 1% from the fourth quarter, supported by our enhanced analytical capabilities. We continue to expect card balance growth in the mid to high single digits for 2018. Our home equity loan originations were down 3% sequentially and 9% year-over-year as demand for home equity loans remained weak. Across the industry, applications are down over 10% year-over-year. We believe this highlights evolving borrower preferences for speed and simplicity in consumer lending. This is the underlying premise behind our efforts to grow our unsecured consumer loan business. Other consumer loans, which primarily consist of our personal lending portfolio, including loans generated through GreenSky, increased 17% sequentially to $1.6 billion. We continue to expect personal lending balances to grow to $2 billion by the fourth quarter of 2019 from approximately $1 billion at the end of the first quarter. Loan originations will remain focused on high-quality prime customers with GreenSky providing first loss coverage as we have discussed before. In the second quarter, we expect total end-of-period consumer loan balances to increase approximately 1% relative to the first quarter. For 2018, we expect end-of-period loan growth of 1% to 1.5%, down from our previous guidance of 2% to 3% impacted by the continued headwinds in home equity. Excluding indirect auto loan balances, we expect consumer growth of about 3%. Our average investment portfolio increased 3% in the first quarter as market dynamics led to opportunistic purchases. We expect to maintain our portfolio balance at roughly the same level in the second quarter. We had solid deposit performance and household growth in the first quarter. Average core deposits were up 1% sequentially. The sequential increase in commercial interest checking deposits and commercial money market account balances was partially offset by lower commercial demand account balances. Typical of a rise in rate environments, deposit markets remain competitive. We continue to make rational decisions between pricing appropriately for profitability and maintaining and growing relationship-based LCR friendly deposits. Despite the environmental pressures, we believe we have an opportunity to steadily grow the consumer book leveraging our recent success in analytical-driven direct marketing efforts. Our modified liquidity coverage ratio continued to be strong at 113% at the end of the quarter. Taxable equivalent net interest income of $999 million was up $36 million or 4% from the fourth quarter. The prior quarter was impacted by a $27 million leveraged lease remeasurement due to the change in corporate tax rates. Excluding the impact of the remeasurement, NII was up $9 million or 1% sequentially reflecting higher short-term market rates, partially offset by a lower day count. Excluding a non-core card remediation benefit from the first quarter of 2017, NII in the current quarter increased $72 million or 8% on a year-over-year basis. This was primarily driven by the impact of higher short-term market rates and an increase in investment portfolio balances. The NIM adjusted for the same items increased eight basis points from the fourth quarter to 3.18%, exceeding the midpoint of our previous guidance by four basis points. The sequential improvement was driven by a six basis point benefit from higher short-term market rates, one basis point from growth in higher yielding consumer loans, and a three basis point benefit from day count. This was offset by a one basis point drag from the FTE adjustment given the tax law change, as well as one basis point from higher securities balances. The NIM in the second quarter of 2018 should be approximately three to five basis points higher compared to the first quarter. We expect full year 2018 NIM in the 3.22% to 3.24% range, exceeding our January guidance, including the impact of two more rate hikes this year, one in June and another one in December. The improvement in our outlook reflects the impact of the elevated LIBOR levels and strong pricing discipline in our lending business. Supporting this outlook, overall deposit pricing thus far has remained relatively muted. Our cumulative beta leading up to the March 2018 Fed hike was 25%, with consumer in the mid-20s and commercial in the mid-40s. The December hike resulted in a blended beta of approximately 40%, and we expect the March rate increase to also result in a beta of around 40%. We are currently forecasting a low to mid-50% beta resulting from the June rate increase. As we have said before, if we see betas at lower levels, our margin could exceed our guidance. We expect our second quarter net interest income to be up approximately 3% from the first quarter's net interest income to $1.025 billion to $1.03 billion, which is largely a function of higher market rates and day counts, as well as expected loan growth in the commercial portfolio. For the full year 2018, exceeding our previous guidance, we expect NII to grow by approximately 8% from the adjusted 2017 NII and range between $4.14 billion and $4.16 billion. The strategic actions we have taken during the last two years, including the reduction in auto loan originations, exits from some low-return commercial relationships, and the reduction in indirect large-ticket lease originations, have led to a redeployment of capital away from loans with lower returns, and helped us achieve a very good NII and NIM profile. In addition, over the past few years, we have created an interest rate risk profile that allows us to grow deposits at competitive rates while driving greater NIM expansion compared to our peers. Excluding the impact of the non-core items, noninterest income in the first quarter was $553 million compared to $587 million in the fourth quarter. The sequential change was impacted by $44 million in Worldpay TRA revenue and a $25 million lease remarketing impairment recognized in the fourth quarter of 2017. Underlying fee revenue decreased 3% sequentially due to lower equity method income during the quarter resulting from the closing of the Worldpay acquisition and their merger integration costs, partially offset by an increase in wealth and asset management revenue. Mortgage banking net revenue of $56 million was up $2 million sequentially. Origination fees were down $8 million sequentially reflecting lower rate lock volumes and tighter spreads. Originations of $1.6 billion were 18% lower than the fourth quarter, with a first quarter gain on sale margin of 189 basis points compared to 206 basis points in the fourth quarter. Gain on sale margins are tighter than we had expected and are likely to remain weak during the remainder of the year. During the quarter, 57% of our origination mix consisted of purchase volume. Just under two-thirds of our originations were sourced from the retail and direct channels and the remainder through the correspondent channel. Challenging market conditions weighed on overall corporate banking fees during the quarter. Fees of $88 million were down $14 million sequentially excluding the prior quarter impairment, primarily driven by lower loan syndication and business lending fees. This was partially offset by increased corporate bond and M&A advisory fees. We currently expect corporate banking fees to rebound from the softer first quarter, driven by a solid pipeline of deals that were pushed out given market factors, as well as the impact of the strategic investments and acquisitions. We expect corporate banking fees to increase between 20% and 25% sequentially, subject to market conditions. Deposit service charges remain relatively unchanged from the fourth quarter. Card and processing revenue was down 1% sequentially, reflecting seasonally lower credit card spend volume compared with the fourth quarter. Full wealth and asset management revenue of $113 million was up 7% sequentially, primarily driven by seasonally strong tax-related private client service revenue. Recurring revenues in this business have increased to approximately 85% of fees from the 79% last year. For the second quarter of 2018, we expect fees to be between $575 million and $585 million or up approximately 5% from our first quarter adjusted noninterest income. For the full year of 2018, we expect fees to be approximately $2.35 billion. Although this guidance is slightly below our January guidance, excluding the ongoing weakness in the mortgage business, it still equates to higher than 4% growth in other fees. We remain focused on disciplined expense management while continuing to invest for revenue growth. Reported noninterest expenses decreased 2% sequentially. Excluding the one-time items recognized both this quarter and in the fourth quarter of 2017, expenses were up 6% sequentially, reflecting seasonally higher FICA payments and unemployment insurance, as well as increased amortization of affordable housing investments resulting from the Tax Cuts and Jobs Act. Our adjusted efficiency ratio for the first quarter was 67%. Recall that the amortization of our low-income housing investments is recognized in expenses, which most of our peers reflect in their tax line. This difference in accounting added over 3% to our efficiency ratio this quarter relative to other competitors. We expect our efficiency ratio to decline every quarter during the remainder of this year and for the year on an adjusted basis based on our outlook we should get to below 60%. Based on our current forecast, we still expect to achieve the upper end of our ROTCE target range of 15% to 16% at the end of 2019. Regardless, our intent is not to limit our progress to a given range and challenge ourselves to execute a continuous improvement program. As part of that progression, especially in light of ongoing environmental challenges, the low growth in revenue growth, we are taking a closer look at our expense base with a specific focus on non-revenue producing parts of our organization. This review includes a span of control study, as well as an evaluation of absolute staffing levels. We will also be undertaking another review of potential opportunities in the procurement area with a renewed focus on demand management. We intend to share our expectations on the scale and timing of these efficiencies with you next quarter, but we believe that these potential actions may get us closer to a 17% ROTCE level. In addition as Greg discussed, we continue to evaluate our strategies related to our retail branch network, which also has implications for further expense efficiencies. At this time, we expect total expenses to be at the lower end of our January guidance of $4 billion to $4.1 billion in 2018. Some of the new expense initiatives may impact the results and we intend to update you as we make more progress in those announcements. Second quarter expenses are expected to be down about 2% from the first quarter as we come off of seasonally higher first quarter levels. We expect expenses to continue to fall throughout the remainder of the year. First quarter credit results continue to follow positive trends reflecting low unemployment and the benign economic backdrop, as well as the positive impact of deliberate actions that we took to reduce high-risk exposures during the past two years. One of the leading indicators with strong correlation to these decisions to resize the asset ratio continued to improve and at the end of the first quarter was down 100 basis points from the beginning of 2017. Net charge-offs were $81 million or 36 basis points, up three basis points from the fourth quarter of 2017 and down four basis points from last year. Commercial charge-offs were 21 basis points, down one basis point from the fourth quarter and down eight basis points year-over-year. Consumer net charge-offs of 60 basis points were seasonally up nine basis points sequentially and were up four basis points year-over-year. Total portfolio nonperforming loans and leases were $452 million, down 34% from last year and up 3% from the previous quarter. The sequential increase was primarily due to higher C&I NPLs from our most recent SNC review which includes $28 million in RBL loans, current on interest and well collateralized. Our loss provision was $23 million in the quarter, down $44 million sequentially reflecting continued low levels of net charge-offs and the improving credit profile of our loan. The reserve ratio declined six basis points to 1.24%. Our reserve coverage of overall NPLs remains at 250%. As we remind you every quarter, we remain in a relatively stable credit environment and the economic backdrop continues to support a benign credit outlook. We nevertheless caution you that we could potentially experience some upward pressure in the future. Capital levels remain very strong during the fourth quarter. Our common equity Tier 1 ratio was 10.8%, about 21 basis points sequentially. We initiated and settled a $318 million share repurchase which included a $35 million request above our original CCAR period. We currently have approximately $235 million in buyback capacity remaining for the second quarter to complete our CCAR 2017 repurchase. Recall that we also have another potential $0.02 dividend raise scheduled for June, pending approval from our Board. Our tangible common equity ratio excluding unrealized gains and losses increased 20 basis points sequentially. At the end of the first quarter, common shares outstanding were down 9 million shares or 1% compared to the fourth quarter of 2017 and down 65 million shares or 9% compared to last year's first quarter. Book value and tangible book value were up 8% and 7% from last year respectively. Our capital levels are currently higher than what we prudently need given the risk profile and business composition of our company. In addition, we also have a 4.9% ownership in Worldpay and it’s not fully recognized on our balance sheet. When combined with our ability to generate a significant amount of capital organically, our current position bodes well for strong levels of capital returns to our shareholders. As Greg mentioned, our CCAR submission reflected these levels and we will receive the Fed’s response later this quarter. Barring any environmental changes, our capital actions should continue to benefit from the combination of our balance sheet strength and strong earnings beyond 2018. Recent legislation being debated in Washington and proposals for new regulatory rulemaking should further increase our flexibility in capital management. We will share with you any changes to our capital management approach as we get more clarity on these potential actions that are in front of Congress and the regulatory body. With respect to taxes, our first quarter rate of 15.8% was impacted by the Worldpay step-up gain and other items disclosed in our release. Excluding these items, our tax rate was approximately 14.1%. We expect our tax rate for the full year to be in the 16.25% to 16.75% range, which is a little higher than our January expectations, excluding the items that are specific to 2018. We would expect our long-term tax rate to be in the 15.5% range. Our revenue growth outlook, the ability to achieve positive operating leverage while maintaining underwriting standards, our strong balance sheet, and our strategic positioning give us confidence in our ability to create additional shareholder value. With that, let me turn it over to Sameer to open the call up for Q&A.

Thanks Tayfun. Before we start Q&A, as a courtesy to others, we ask that you limit yourself to one question and a follow-up, and then return to the queue if you have additional questions. We will 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. Tamiya, please open the call up for questions.

This is Anthony Elia for Peter. My first question is, with all the uncertainty regarding tariffs, are you guys seeing that this is keeping some borrowers on the sidelines until there is some more clarity or legislation out of Washington?

We are hearing some feedback on that, but I would say that the number one thing that we're hearing from our clients is really digesting still the tax law changes along with our rising labor cost. I wouldn't say that tariffs are really the number one priority, but it's clearly an issue on their mind and certainly is causing them to, I think, take a pause, which is what we saw in the first quarter.

And then Tayfun, maybe one for you. If fee income for the year comes in a little bit stronger than expected, would you expect expenses to come at the low end of the $4 billion to $4.1 billion range?

Yes, I think so. I mean there may be slight increases in incentive comp-related line items, but in general, I would expect to be able to hold on to that guidance.

When you look at the fintech investments that have occurred outside of Worldpay, would any of these be harvested in Q3 that would make our CCAR impact or have a meaningful change to that plan?

Not really. Once again, our focus on the fintech space is really going to be additive to all our businesses: businesses like GreenSky or recent investment in CommonBond, the acquisitions we made sort of fintech will be additive to our fee lines and really shouldn’t have an impact on our CCAR and capital distributions.

This is Rob in for Mike. If I could follow-up on that last one, you had a pretty decent jump in the growth rate and technology spend year over year. I sort of wondering if this is a permanent step-up and where the spending is occurring and how you guys think about your tech budget overall?

First of all, we think our tech spend is consistent with what we are seeing in other businesses. As we go through this digital transformation, it’s important that we make our investments in smart places to help us be successful in our businesses. So we’re not trying to be digital everywhere; we’re not trying to grow everywhere. We’re really focused on our core businesses and being additive to our core businesses. We have a great technology organization, and we continue to enhance our current capabilities, adding new products and solutions for our customers. So we feel comfortable with our tech spend, we think it’s appropriate. We also are always considering opportunities to enhance our position. Our strategy around tech spend is basically to buy first, then partner, and then build. I think the evidence is demonstrated here with our investments in fintech companies and some of the new things we rolled out like our momentum app, which reflects that strategy.

And if I could just follow-up with a bigger picture question on efficiency. I think a few years ago you talked about an efficiency ratio in the mid-50s with a normalized rate environment. Is the thought still that you could get there, or is it more a focus on fees and fee growth that might be lower efficiency but higher return on equity?

As Tayfun mentioned in his prepared remarks, we expect by the year-end to be below 60% on efficiency ratio, but we also believe there is more opportunity there both on the revenue side and on the expense side, which is why we've engaged a third party to look at additional items that we could focus on as we move into the rest of 2018 and into 2019.

On your capital guidance, at your Investor Day you talked about payouts of 120% to 140%, and then your guidance this morning you talked about over 100%. So the wording, I think it’s a little bit more general than what you had guided to at Investor Day. And so I’m curious, is there any change in thinking in terms of your capital planning and in your capital strategy in light of tougher CCAR examinations and the new guidelines of stress capital buffers? Is this just - if you want to be a little bit more generalizing in your commentary ahead of this year’s CCAR?

There really isn't, Saul. I think in general our targets remain intact. Clearly the stress scenarios in the current CCAR exercise were a little bit more stressed than we anticipated, which may just slow down our march towards that mid-9s type of capital number. But we anticipate that we will get there and also there are some changes that the regulators are considering making, which may also have a positive impact. In general, our approach to where we think we can manage this balance sheet has not changed. I don’t know, Jamie, if you want to add anything.

It sums it up, I guess. The topic I think to touch on is the stress capital buffer in terms of all the work we've done to derisk our balance sheet. If you look at the proposed rule and you go back over the last three years of CCAR submissions, Fifth Third's capital destruction is well below the 2.5% SCB buffer that's being proposed. So from a derisking standpoint, we would certainly be managing our portfolio well below 7% and therefore will be subject to the 7% limit. And then from there, obviously the benefit of the proposed rules will just allow us more flexibility for our management team and our board to manage capital going forward. But for now, for 2018, the CCAR scenario was pretty stressful in terms of the scenario. Therefore, we want to wait and see what the results look like at the end of June, but like Tayfun said, we’re targeting over 100% there.

And can you just give us an update on how you're thinking about your M&A strategy, the use of capital, both from the standpoint of the fee-based businesses and depositories?

From an M&A perspective, our position hasn't changed. Our number one focus is on building out our core businesses, making those core businesses better at serving our customers in the markets that we operate in today, so that's job one. A lot of investments you've seen us make on non-bank M&A are geared towards supporting those businesses from a fee perspective. We are going to continue to look at those opportunities and to be additive to our fee and service products that we offer our customers, and that's job one for us. Other M&A opportunities that may emerge, we will assess those, but once again, it's a difficult challenge right now to figure out where those opportunities lie and our ability to capitalize on it. But job one is focusing on building out our core and non-core businesses and non-bank M&A opportunities to be additive to our business lines. If bank M&A materializes, it will be because of the best interest of our shareholders.

I just want to follow up on the expenses. If I am doing the math correctly, it seems like you're taking in a pretty nice decline and causing the back half of the year versus the first half – that's a 7% drop on average. So we haven't seen that kind of quarterly progression in the past. I know there is some seasonality in 1Q and I guess I am just trying to get a better sense of how confident you are in getting that and how much you are kind of baking in some of these initiatives that you highlighted in your prepared remarks versus just normal seasonality and some upfront investment spend maybe you had this quarter?

There's some seasonality associated with it, Matt. There’s also the additional benefit from the FDIC surcharge going away towards the end of the year. So we are picking that up as well. We feel fairly comfortable with the guidance, and there were also some severance expenses in our numbers this quarter. We're not forecasting those; we don't include those in our outlook for the remainder of the year. So I think, all in all, we should see a fairly decent decline on a quarterly basis overall.

And then I guess more broadly speaking, I heard like you've been working on expenses for a few years here. You got the Project North Star. And I guess, I'm just wondering kind of what made you think that there is more opportunity to increase the urgency to take another look, hire an outsider, and take a stab at this?

First off, the Project North Star has a lot of expense initiatives baked into it which I chose to embrace, and we've executed well against those initiatives as evidenced by the fact we were roughly flat year-over-year last year under our guidance for the first quarter of this year, and we just discussed the outlook moving forward. So we're very pleased with the initiatives that we put into the initial pipeline. But we're also mindful of everything happening in our business and our industry that creates opportunities for further improvement that we're assessing. We're also watching what other businesses and banks are doing, and we continue to believe there may be opportunities for us to do a better job of managing our expenses going forward. So we're going to take a look at the next level of what opportunities. Our “low-hanging fruit” was harvested in the first phase of Project North Star, but as we move forward, we do believe there are opportunities for further improvement. We don't have anything on the table. So bringing in a third party who has done a lot of work in other areas could be beneficial to how we’re thinking about our business and we want to take that opportunity to assess our position today and what it may look like in the future.

And Matt, one clarification that I want to provide is these types of studies take a little time. So we are at the end of the first quarter here in 2018, and it will be some time before we can actually finalize our perspective. So, I don't want to—we gave you guidance for 2018 total expenses, and the results of this study may have some impact at the very back end of 2018, but any changes will most likely come more in 2019. So our guidance for total expenses remains intact as stated in our slides as well as in our script.

Just going back to the NIM guidance. Obviously, it has increased, which is positive. How much of that relates specifically to the higher LIBOR spreads? And I guess the question is if LIBOR or spreads do decline or go back to where they were a couple of months ago, does that pose a risk for your NIM guidance? Thanks.

On the LIBOR OAS spread, what we've assumed in our outlook is that spread. For us, it's really sensitive to one-month LIBOR. So, one-month LIBOR to Fed funds, we assume a 13 basis point spread level. So, that's obviously up from the 5 bps in the fourth quarter and the 12 bps in the first quarter, but a little bit below where we sit today. We have that at 13 basis points the rest of the year, but then we have it normalizing in December where we revert back to 5 basis points. So, is there some risk in the number to the downside? Yes, a little bit, but the historical spread on one month to Fed funds, I think it's about 10 basis points. I think we're into a new normal, but we don't have that number expanding and there could be some upside if one month LIBOR were to expand. In terms of our balance sheet on a one month LIBOR basis, about 30% of our interest-earning assets are tied to one month and only about 1% of our liabilities are. So that certainly carries some benefit to a balance sheet, likewise.

I think we also have been able to avoid the basis risk some of our peers have seen negatively impacting their NIM, so that was a benefit.

And then just a follow-up question, in terms of loan growth guidance, obviously seems like a starting off a little weaker this year. Can you just talk about the pull-through rates because I know you mentioned good pipelines in commercial. Do you think that’s going to drive higher loan balances to hit your targets later in the year? But how much of those pipelines actually end up resulting historically in actual loan growth?

There is variation obviously throughout the cycle. Part of it has to do with your competition out there, how much they're structuring in terms of pricing, structure, and your pipeline pull-through. I would say that today, though, largely while it's very, very aggressive, we've seen structure and pricing somewhat stabilized. So if I look at our pipeline today versus 90 days ago, for example, I think we get pretty fairly comparable apples-to-apples. And we see very robust growth both in our core middle market across almost all of our regions and across almost all of our corporate banking operations. What the ultimate pull-through will be in timing will be largely affected by the economic conditions, the confidence level of our clients. We're going to stay very close to them, but I can't give you an exact pull-through number. But I would tell you just throughout my 30-plus years of banking, the pull-through, the pipeline tends to be somewhere in the 25% range, but I'm not sure that’s meaningful. I think what’s more meaningful is the fact that our pipeline is becoming much more robust and frankly, it’s growing in the businesses in the geographies where we would want it to be.

Number one, do C&I yields if you could just talk about any recoveries in that number?

No.

Secondly, I'm trying to understand a little bit about your efficiency ratio on a core basis, trying to strip out all the non-core items, and there's a bunch of them. If I look at just total revenue growth and look at total expense growth and the efficiency ratio, the efficiency ratio was essentially flat year-on-year, despite all the stuff you've been doing on the North Star. And if I look at whole growth that also seems to be slightly above where - on a year on year basis. So any color on sort of what happened this quarter, why it stayed flat and we saw no improvement?

So a couple of comments to that. There are some—if you peel all the one-timers, there are a couple of items that have impacted the year-over-year change. One of them is the impact of the change in corporate tax regime on LIH amortization. There is a little bit of severance expense this quarter in our numbers. And also, there is a reduction in fee income related to the closing of both the reduction in percentage ownership in Worldpay, as well as some of their quarterly noise. So if you sort of peel those numbers out, I think there is a decent directional improvement in our efficiency ratio. For the year, our guidance on NII clearly is now getting to a pure 2017 to 2018 comparison perspective to over 8%. Overall total revenues are getting near 6%. The combination of those very powerful impacts has a powerful impact on our core efficiency ratio. If you peel down the low-income amortization line item, that momentum takes us to below 60%, and that is a decent year-over-year improvement. We would expect that momentum to continue into next year as well.

Any color on sort of numbers around that LIH amortization expense, what are we talking about in terms of how much this year versus a year ago first quarter…

I think – we don't necessarily give out – we give obviously annual guidance. This quarter the number was about $9 million or $10 million above the last…

And you think that's likely to continue at this sort of rate through the rest of the year…

There is a temporary uptick in that line item because of the change in corporate tax rates, but towards the end of I think next year, that incremental impact that is borne by the change in the tax rate should start to disappear.

This is actually Brendon from Scott's team. Just want to ask the question on the provision here, came in a good deal lower than we were looking for despite charges being pretty consistent with what they've been running at. Do you view this quarter step down and reserve ratio as kind of a one-time step down or do you think, given the current credit environment, there is the potential for another step-down in the reserve ratio?

So a question with potential two answers. I'm going to answer the quarterly change in the provision and then I'm going to turn it over to Frank to comment on credit. Clearly, it was a sizable step down from 1.3% to 1.24%. But there were some significant declines on the parts of the portfolio that sort of supported a higher reserve coverage. So that was actually a very good development. There were some specific reserves that tend to impact coverage levels and changes in coverage levels quarter-over-quarter. Overall, really that change was significantly due to an overall improvement in the risk profile of the loan portfolio. Having said all of this, we still remain in the top quartile of coverage levels when you look at our peers. So, Frank, any comments on the credit?

Not really, we were up guidance for the year still range down to what we've given guidance on – we made various low lumpiness quarter-to-quarter. But our overall portfolio, both in the commercial and the consumer side, is managed very well. Our criticized assets are 4.8%, continuing to come down quarter after quarter. There's not a whole lot of room probably left for that, just given where we are in the cycle. Our non-performing assets have been stable and are in the upper quartiles relative to our peers; we feel very good about that. Our charge-offs again you'll see for the most part a range in the 25 to 35 basis points over the course of the year. The work that we got over the last few years is paying off for us; we've taken out $5 billion of risk in our balance sheet, $1.7 billion of that is leverage lending which had contributed in prior years to some more significant write-downs. So we've positioned the company, as we said consistently to perform exceptionally well through cycles. We're seeing that. We're seeing that in the reserve. You're going to see that, I believe, in our results going forward.

And then one final question just on the tax rate guidance beyond 2018. Just curious as to the change from the prior guidance of 14% to 14.5% up to 15.5%. Is this just the result of kind of digging deeper into the specifics of the tax law change or is there something more specific you want to call out?

It's really more due to the increase in expected income levels because those marginal increases come at all tax rate versus the credit impacted tax rate.

This is actually Steven Duong in for Gerard. Thanks for taking my question. Just a question on GreenSky, can you guys remind us what your first loss protection is on that portfolio? And does it change with the different loss levels?

The protection you get in the GreenSky arrangement is a 1% escrow balance for first loss, and then after that there's a loss coverage that's generated from what we call the waterfall of the cash flows off the portfolio. In total, that number we ballpark in the 5% range. So we feel quite good that given the FICO in the 760 range and a little bit over a 5% gross yield along with a little bit over 5% loss coverage. So these will be good assets for our return.

Just curious on that, have you guys modeled out what your losses would be if we had another big recession say on employment at 8% to 10%?

So we actually do that in our CCAR submission and it really shakes out how we look at the portfolio: fairly close to what some home equity products would have been pre-crisis and in the crisis to that in a base environment, we model a loss range could be around 3%. And then in a stress environment, you could get two to three times that in losses. Obviously comfortable with how that plays out last year.

And just a final question, your construction loan portfolio you had some good year-over-year growth. Can you give us some color on that? What's driving the growth you're underwriting, the property types, where you're seeing the strongest growth, etcetera?

So a couple of things. First of all, the growth that you did see was really primarily driven by fundings under legacy construction facilities. Frankly, we are beginning this season while coming towards the end of a cycle. In our opinion, we're being much more prudent about our assets selection and our client selection. As you may recall, we previously after the great recession really pulled together an expert underwriting group with some talent versus having underwriting done out in the regions. That's producing some excellent results; the asset quality and portfolio continues to be very, very strong. But as you look out this year, I wouldn't expect to see significant growth out of that portfolio, as we've previously shared. But to the last part of your question, we have really pivoted to some other asset classes away from multi-family a year ago, probably half of our production would have been in multi-family. Today, it's less than a quarter, as we really focus on those assets that we believe will have more economic scale to them and make sure that we are appropriately exposed to the commercial real estate market in the event of a cycle turn.

Great, thank you Tamiya. And thank you all for your interest in Fifth Third Bancorp. If you have any follow-up questions, please contact the Investor Relations department and we will be happy to assist you. Thank you.