Fifth Third Q4 Earnings: Buybacks Coming Sooner Than Expected (NASDAQ:FITB)

Shares of Fifth Third Bancorp (NASDAQ:FITB) have underperformed the market meaningfully over the past year, but they have recovered nearly all of their losses in the wake of last winter’s regional banking crisis, which significantly increased funding costs. In September, I argued that shares were a hold at $28 and would be a buy at $23, where they traded to in November.

Since then, shares have exploded higher, as you can see in the chart below. While FITB was trading in line with regional banks (KRE) from August through November, they have significantly outperformed over the past two months. Fifth Third’s most recent quarterly earnings validate this outperformance with buybacks set to resume sooner than I expected, though at 10.5x-11x earnings, much of the good news is now reflected in the price. As such, I would be a “hold” here rather than recommend putting new money to work in the stock.

In the company’s fourth quarter, Fifth Third earned $0.99, besting estimates by $0.09, even as revenue fell by 6.5% to $2.2 billion. The bank’s credit quality showed some deterioration, but it remains solid. While funding pressures still exist, FITB has done a strong job in retaining deposits. Moreover, actions to reduce risk in its balance sheet have put capital in a solid position, opening the door to buybacks later this year.

Fifth Third’s net interest margin in Q4 came in at 2.85%. This compressed by 13bp from last quarter and 50bp from last year, driving a 1.5% sequential decline in net interest income. A combination of higher funding costs and a lower-risk balance sheet are driving this narrowing, and while management is guiding to a modest further decline in net interest income in 2024, the vast majority of this pressure is behind the company.

I have viewed a stable deposit base as a prerequisite to investing in regional banks, and on this measure, FITB is solid. As you can see below, period-end deposits rose by $1.2 billion. Deposits are actually up about 3% from last year, a strong performance in a year the industry saw deposits decline. This deposit base is costing the company more with Interest-bearing deposit yields rising by 24bp to 3%, up from 1.12% last year. With deposits rising, it does appear that FITB has increased rates enough to protect its franchise.

Assuming markets are correct that the Federal Reserve has completed its rate hiking cycle, we should see limited further deposit rate increases, and we may even see funding costs fall a bit by mid-year. Additionally given the strength in deposits, period-end wholesale funding declined by nearly $3 billion to $24.6 billion. This funding costs over 5.3%, so moving from wholesale funding to deposit funding is a favorable mix shift.

With the liability side of the balance sheet looking solid, let’s turn to the asset side. Fifth Third has been reducing the risk on the asset side and boosting liquidity, which has contributed to lower net interest margins. Average loans declined by $2.7 billion sequentially to $118.9 billion, primarily due to lower commercial loan balances. The average rate on loans rose by 12bp to 6.3%, reflecting a full quarter of fed funds at 5.33%. At the end of the quarter, FITB’s loan to core deposit ratio was 72%. While management does not expect a return to the 80+% pre-COVID, given increased regulatory liquidity needs, there is scope for this to go into the “mid-70’s” over-time, though loan growth is unlikely to begin before H2 2024. As loans do grow, that should help to alleviate some margin pressure.

With deposits rising but loans falling, Fifth Third’s securities portfolio grew by $400 million to $57.4 billion while its short-term holdings rose by $8.5 billion to $21.5 billion. This constrained securities portfolio growth is consistent with the strategy of letting low-yielding maturities roll off. With over $21 billion in short-term investment, FITB’s asset base is highly liquid, and assuming deposits remain stable, there may be scope to deploy this into loans over the next year to increase yields. Aided by maturities, its taxable securities yield rose by 3bp to 3.13%.

This is clearly well below prevailing interest rates with FITB, like essentially all banks, having bought fixed income at yield levels much below current levels. Because of this, Fifth Third has a significant unrealized loss, which sits in accumulated other comprehensive income (AOCI). We will discuss this account further below as it is most relevant to FITB’s capital position.

The credit quality of Fifth Third’s asset portfolio also remains solid, though nonperforming loans did tick back up to $649 million. The net-charge off rate of 0.32% was down from 41bp in Q3 and is expected to be 35-40bp in Q1 2024. Its allowance for credit losses declined by $41million from Q3 due to lower loan balances. At $2.5 billion, they are nearly 4x nonperforming loans, a healthy coverage level (I view 250% as healthy for most banks). As such, I would expect allowance builds to be minimal from here, consistent with guidance, barring a more severe economic downturn.

Thanks to retained earnings and lower loan balances, Fifth Third’s common equity Tier 1 ratio was 10.3% from 9.8% in Q3. The reduction in risk-weighted assets is now complete, and management expects CET1 to be 10.5% by mid-year. Now, by the end of 2025, FITB will have to begin phasing AOCI losses into its capital calculation. Right now, it has a $4.1 billion loss. Including this, its capital position is 7.7%.

That is low but above the regulatory minimum of 7.0%. Importantly, as bonds mature and pull to par, this loss will naturally shrink. It should decline to $2.8 billion by the end of 2025 if the forward curve plays out. That alone will bring pro forma capital up to 8.5%. With incremental retained earnings, FITB is well positioned for a pro forma capital position of nearly 9%.

As a consequence, management is guiding to $300-$400 million in repurchases during the second half of the year, making FITB likely one of the first regional banks to resume meaningful share repurchases. Now if we see a surprising interest rate spike, this could be delayed by a quarter or two, but FITB, by reducing risky assets, has solidified its capital position, at the cost of slightly lowered net interest income.

This buyback guidance follows overall solid financial guidance released with quarterly results. While net interest will decline, it should be relatively modest. This guidance implies net income falling by $250-325 million in 2024 vs 2023, or about $3.20 in EPS, barring any one-time items. This is a bit above the $3.10-$3.20 I was looking for in my write-up in September. While FITB’s earnings guidance is similar to my expectations, its capital performance has exceeded my hopes, aided by lower bond yields, pulling buyback timing forward by 6-12 months.

At over $34, shares are trading about 10.5x 2024 earnings. FITB has a dividend yield of 4.1%, and it should repurchase up to 1.5% of shares, for about a 6.5% capital return yield. This is a bit of a premium to peers like Citizens (CFG) and Capital One (COF) and in-line with U.S. Bancorp (USB), which may have even more balance sheet flexibility. Its buyback announcement justifies its outperformance since the November lows, but with the good news already in the price, I would view shares as a hold. If we see a pullback below $31, or safely below 10x earnings, I would consider adding shares, but for now, FITB is a hold.