Fifth Third Bancorp (FITB) Earnings Call Transcript & Summary

Hi. I'm Jason Goldberg, Barclays U.S. large-cap bank analyst. Very pleased to have Fifth Third with us this morning. Just a couple of housekeeping reminders. On the left side of your screen are audience response polling questions. You can answer each question during the course of the presentation. Please do that kind of early on, and we can go through them towards the end, time permitting. After you ask a question, if you scroll back up toward the top of the screen, you can hit next. Additionally, on the very top of the left-hand side of your screen, you could hit the question button and you could type in a question, and that will be e-mailed to my team. And again, time permitting, we'd be happy to ask Fifth Third the question if you click to -- About, it will take back to the audience response polling question. From Fifth Third, very pleased to have with us today, Greg Carmichael, Chairman, President and CEO; and Tayfun Tuzun, Chief Financial Officer. Fifth Third has a short slide deck they're going to take us through. Some pretty new information in that. So I suggest you pay attention to it. And with that, let me turn it over to Greg.

Thanks, Jason, and good morning, everyone. I will encourage you to please review the cautionary statement on Slide 2. Moving on to Slide 3 of the presentation. We believe we are well positioned to successfully navigate the current environment and emerge as a top-performing regional bank. We have executed several strategic actions over the last 5 years, anticipation of an eventual downturn in the economy. We have also taken proactive measures in response to the pandemic to ensure Fifth Third continues to generate sustainable, long-term value for our shareholders. We have consistently communicated our through-the-cycle principles of disciplined client selection, conservative underwriting and an overall balance sheet management approach focused on long-term performance. From a credit-risk management perspective, we have remained disciplined in our CRE portfolio. Since the last downturn, we have maintained a cautious approach focusing on clients with diversified balance sheets and a strong track record of resilience. We have exited businesses such as commodity trader lending and mezzanine lending. In addition to business exits, we have deliberately run off approximately $7 billion in loans. Over the last few years between our C&I and indirect commercial leasing portfolios, given the risk return profile trading near-term revenue for more stable credit quality. We have reduced our leverage lending exposure by 50% since 2015, with balances now below $4 billion. As a reminder, our portfolio was essentially underwritten and well-diversified by industry and geography. In consumer, we have enhanced our underwriting standards and have also augmented our collections efforts. We are confident that our client selection and proactive approach to credit management will continue to serve us well. We have also strengthened our balance sheet by building long-term protection through strategic positioning of our securities and hedge portfolios with high likelihood of lower rates for the next several years, our proved interest rate risk management should help preserve our core margin. Additionally, our very strong balance sheet equity has enabled us to decisively act and aggressively lower deposit rates. We have a strong balance sheet and have grown our regulatory capital ratios above our internal targets, which should enable us to continue paying our current dividends. In addition to the delivered actions taken over the past several years. We have also strengthened our balance sheet this year by building strong credit reserves in anticipation of a severe and prolonged economic downturn. While we still believe the economic recovery will be uneven, there's some who will continue to face substantial challenges ahead. The recent macroeconomic indicators are moving in a more favorable direction than our initial expectations. We are in the process of finalizing our reserve assessment for the quarter. But based on the recent macro trends, a further reserve build appears to be unlikely. In a stable environment, loan balances tend to dictate the reserve progress. We're also positioning the company to generate sustainable value by taking decisive action to reduce our expense base, both temporarily, reflecting weaker revenue environment and also permanently based on long-term structural saving opportunities. We fully intend to preserve our optimal level of efficiency in this weaker revenue environment while maintain the investments that we believe are vital to preserve the earnings power and the operational resiliency of our business. Although like all banks, we face headwinds that would challenge our near-term return metrics, we believe our focus on maintaining a strong balance sheet, diversifying our revenues and proactive performance in management, combined with our strategic direction, will enable us to achieve top quartile returns along our peer group. Slide 4 provides an update on Fifth Third and customer actions taken since the onset of the pandemic. As you can see, a vast majority of our customers have exited our COVID payment deferral programs. In commercial, clients representing just 1% of bouncers were in a payment deferral by the end of August, less than 2% of clients coming out of their initial relief have requested a second deferral. And our COVID high-impact portfolios, approximately 4% are currently deferring payments, down from 15% at the end of the second quarter. As we mentioned before, in the consumer portfolio, we started transitioning customers off the COVID hardship programs starting July 1, excluding residential mortgage and home equity, which have a 180-day forgiveness period, approximately 80% of our consumer portfolio has exited the relief program and only 13% of those who have exited have reenrolled in our traditional hardship assistance programs. Of those who have come out the low payment deferral program, more than 90% have made one or more payments since exit. This is far better than our regional expectations. A high percentage of customers who have made a payment, a small number of customers requesting additional assistance and the overall strong consumer spending, saving and revolving line utilization metrics, give us confidence and the strength of our consumer portfolio. We continue to encourage customers to utilize our digital tools to [ own ] the pandemic. As a result, we are seeing increased adoption rates with about 75% of all transactions not coming through our digital channels. Turning to Slide 5. We have maintained a very disciplined and a very proactive approach to credit risk management. As I mentioned, we have built robust reserve coverage ratios with one of the highest credit reserves as a percentage of total loans. Our commercial real estate portfolio now represents around 75% of our total capital, which is less than half what it was prior to the last downturn. It is one of the lowest among peers with the lowest concentration of high volatility commercial real estate loans. In addition to our prior actions, we're also taking further proactive measures in the current environment to improve our credit outcomes going forward. We are monitoring our exposures across our total commercial loan portfolio, utilizing early warning systems through a combination of internal portfolio data and third-party data. Relation teams are merely alerted when there's any sign of credit deterioration, which helps us make prompt, prudent and aggregate credit rating determinations without waiting for customer statements. Rather than take a wait and see approach, we believe in times like these, it is better to take proactive measures. As a result of our actions and disciplined client selection, we currently expect our third quarter net charge-offs to be below our previous guidance range of 50 to 55 basis points with a relative stability in the fourth quarter as well. Turning to Slide 6. Our capital and liquidity positions improved during the second quarter. Our CET1 ratio ended the quarter above 9.7%, exceeding the first quarter level even as we build our reserves. Since our second quarter earnings call, we have seen a gradual decline in commercial revolver utilization rates down approximately 3 percentage points since the quarter end to about 35% today. Much of the decline came from our corporate banking clients, particularly from clients in our COVID high-impact portfolios. From a loss absorption perspective, our CET1 ratio, combined with our credit reserves and our unrealized gains stands out as the second highest among our peers. We have been very consistent in stating our view that given our elevated capital ratios, balance sheet strength, earnings power and relatively modest pre-COVID dividend payout ratio, we believe we'll be able to maintain our current dividend. We do not anticipate resuming share repurchases until next year, given the continued macroeconomic uncertainty. From a balance sheet liquidity perspective, we have approximately $105 million in total liquidity sources. So far, in the first 2 months of the third quarter, we have continued to grow deposits despite our aggressive rate actions, combined with [ capital ] loan demand, this has resulted in an increase to our excess cash position. Given our current balance sheet liquidity, we expect our loan to core deposit ratio will remain at a historically low level through at least the remainder of the year. Ultimately, we believe that the strength of our deposit franchise will help us lower and keep deposit costs below previous lows, while continuing to generate strong household growth in consumer and grow client relationships in commercial. As shown on Slide 7, we continue to take proactive steps to mitigate the impact of lower rates, which should provide additional support in the coming quarters. As you can see, we continue to push deposit rates lower with our interest-bearing core deposit rates reaching 13 basis points in August, well below the floor from the previous rate cycle. Given our performance so far this quarter, we now expect to lower our interest-bearing deposit cost another 13 basis points or so in the third quarter compared to the second quarter, which is more than we guided in July. We will continue to assess additional deposit rate opportunities in the third quarter and beyond. As shown on Slide 8, we remain well positioned to mitigate the impact of lower interest rates, our early cycle investment portfolio and hedge actions will provide long-term NIM protection, which will produce meaningful benefits in this rate environment. In addition to generating very strong securities portfolio yields for the past 6 years, our portfolio structure should lead to even stronger relative performance going forward. Our allocation to bullet and walk out structures has led to significantly lower levels of cash flows compared to all peers. This value shield against reinvestment risk will likely continue for the next several years. With market reinvestment rates around 1% or so, we forecast that our securities portfolio yield will widen even more versus peers, which will result in the preservation of approximately $300 million in annual revenue by 2022 compared to a portfolio structured like our peers. In addition to the securities positioning, we continue to have a strong and attractively priced cash flow hedge portfolio of $11 billion, as previously discussed. With LIBOR remaining below 20 basis points, these hedges will generate over $300 million in annual protection for the next few years. This is worth highlighting that although our hedge benefit to NII in the second quarter was just above peer median, we have the second longest hedge protection among those who provide the information in their disclosures. These hedges will provide longer-term support given the low likelihood for higher rates over the next several years. As a result of our strategic securities and hedge decisions, our unrealized gains remained just under $4 billion pretax at the end of August. All that being said, with historically high cash levels and the uncertain timing of PPP forgiveness, we continue to expect near-term NIM volatility. Setting aside the near-term noise, we believe we are well positioned in this rate environment and expect to achieve a 3% core NIM for the next 2 to 3 years, assuming a normalized cash position. Near term, we expect third quarter NIM pressure to exceed the 10 basis point sequential decline that we had anticipated in July to exclusively to the growing excess cash position. That being said, we see the third quarter net interest income tracking slightly better than our original expectations. Moving on to Slide 9. As I mentioned earlier, we have taken the proactive steps to strategically reduce expenses in order to generate sustainable efficiencies and improve our long-term expense trajectory. We remain intently focused on operating leverage in this environment. To that end, we are taking out $200 million in annual run rate expenses effective the first quarter of 2021. In addition to near-term saving targets, we are also implementing a longer-term expense strategy, which will help us achieve an additional $100 million to $150 million in run rate savings within the next 18 months through investments in lean process automation. The recent acceleration in customer digital adoption trends raises the returns on our technology investments made over the past several years. This gives us increased conviction that we can continue to optimize our branch network while also expanding our presence in high-growth markets. Also, our investments and focus on process reengineering in other areas of our operations will allow us to permanently optimize our expenses in our middle office and back-office functions. We continue to invest our shareholders' capital businesses with the best long-term prospects. This approach enables us to continuously review our products and services in all of our businesses to add new capabilities where needed and to reduce capital allocation when returns are not sufficient. These actions will help us achieve expense saves and preserve our returns. Furthermore, we evaluate our organizational structure on a reoccurring basis, including spans of control and gear ratios and make adjustments in our headcount allocation, a long-term experience in rightsizing our workforce will be instrumental in the current environment. We are also reducing our non-branch real estate footprint given structural shifts in a more mobile workforce, we plan to reduce our total corporate office space by approximately 20%. From a longer-term perspective, we are investing in automation throughout the organization with initial focus on 40 or so processes that can be made more efficient and operationally resilient, which also provides scale benefits. As with our previous expense initiatives, including our achieved expense reduction associated with our acquisition of MB Financial, we have a high degree of confidence in our ability to achieve our steady goals and deliver for our shareholders. In summary, we will continue to take proactive and prudent actions to allocate resources and capital appropriately. We have spent several years making our balance sheet more resilient and our revenue streams more diverse. We will put the appropriate level of prioritization and focus on the areas that have the highest probability of driving strong financial returns and generate long-term value for our shareholders in order for us to emerge in the current environment, a top-performing regional bank. With that, Tayfun and I will be more than happy to take your questions. Thank you.

Greg, that was very informative. I think there are several areas we probably want to delve more into, the [ asset ] client and interest income and expenses, in particular, so maybe we'll take them in that order. I guess, first, with asset quality, 2 things jumped out to me. One, you'll be below your net charge-off guidance of 50 to 55 basis points. And then secondly, on the reserve build. So I guess, first, on loan losses, I guess what's driving loan losses coming in better than expected? And then, I guess, how concerned are you as some of these stimulus programs abate? Are we, I guess, reducing the amount of loan losses you expect over the cycle? Or are you just kind of elongating the cycle and maybe delineate between kind of consumer and commercial? And just speak to kind of when do you think these losses begin to emerge?

So, good question. First of on -- our guidance on net charge-offs and our expectation is better than the guidance that we provided earlier is driven by the efforts of the team. We've allocated a lot more resources over to our workout group. The teams we've put in place, the forms we've put in place to assess and quickly address credit-related issues, the early warning program we put in place. I think all those are paying dividends for us right now, with how we manage our potential credit losses in relationships. So I think that's gone extremely well. And I gave Richard Stein and his team tremendous credit for all the work that they've done to continue to position us well for the future. With respect to the Government's stake with us, there's a lot going on, obviously, a lot of questions around are we kicking the can down the road or is it sustainable? I think it's really going to get down to, Jason, the unemployment rate. What's it look like as we go into next year? Who has a job? Who doesn't have a job? Right now, I think the consumer continues to look healthy. We can see that on some of the deferral programs we put in place the forbearance program as they emerge from those programs. So I think overall, the remainder of this year, meaning the consumer is going to hold up fairly well. And then getting into next year, it's what industry, what businesses and what the unemployment looks like with respect to who has a job, and it's going to be very important on how a consumer performs next year. I'm very concerned about a lot of the small mom-and-pop restaurant environments and so forth, that are under a lot of pressure. I think the ones that are going to be able to successfully manage through the survivor are doing that. So I thought, I think a lot of the small urban businesses are challenged when people aren't coming downtown to work. So we're going to kind of watch that as we go through the environment. But overall, our credits held up with respect to our auto business, our commercial business has held extremely well. So net-net, I think we're going to be fine but we've got to watch going into next year, and we continue to make sure we're adding resources and processes, capabilities to things like our collection processes and so forth. And Tayfun, if you have got anything to add?

One thing that's giving us more optimism, Jason, is we're actually monitoring the data on the consumer side of the customers that we also have deposit accounts for and there is a significant amount of deleveraging going on right now. So -- and we're seeing that obviously at the macro level with the savings rate being fairly high. So they're building defenses for what may happen after these programs are done. And we're seeing the same concept on the commercial side as well. So companies are keeping cash on hand, and that's giving us a level of optimism that some of this goodness may be just more than just the timing on better performance.

And the other thing, I guess, on credit quality, that stock out to me was a comment, further reserve builds are unlikely. I guess given charge-offs coming in a bit better than expected, is it the potential for reserve releases? You showed a slide showing your reserves are really strong. Or just how do we think about the level of allowance or allowance versus charge-offs in kind of this new CECL environment?

Yes. I think you know us, and we are very cautious in terms of the decisions we make and how we guide our performance going forward. It's a bit early to predict releases at development. We are still going through our third quarter reserve calculations. We may have a little bit more color in October when we actually talk about our Q3 earnings. But clearly, with stabilizing macro scenarios with better performance, actual charge-off performance, this is a better picture than we predicted even in June, when we set the allowance for the second quarter. So again, the level of optimism that we are feeling with respect to real credit performance potentially could also influence reserves but again, it's a bit early yet to predict releases at the moment.

That's fair. And I guess, on net interest income, you talked to net interest margin down more than 10 basis points versus prior expectations, I think, of down 7 to 10, although not much an impact from that, given the excess liquidity position. But you also said net interest income coming in better than your guidance, which I think was down 3% ex-PPP. So what -- I guess, where is the outperformance on NII coming from?

Yes. I think we are going to be slightly better in NII performance in Q3. Some of that is clearly related to deposit rate cuts. And some of that is a little bit better performance in commercial on the coupon side. So it's a combination of the 2 that are giving us a better picture for Q3. And again, on the margin, we've always said margin is an outcome. And we still, during this quarter, have seen very strong commercial deposit performance. We are going to add higher deposit balances on the commercial side, stable, small uptick maybe on the consumer side. And with the down payments on lines on the commercial side, that liquidity position continues to be strong. But at the moment, we are using it to our advantage, hopefully, to lower deposit rates, which should have a better long-term impact on our NIM once we come out of this environment and once the PPP loans pay off.

Have a suspect with this PPP loan pays off, I guess most people thinking not any this quarter and then more so in kind of Q4, Q1 of next year?

Yes. We're thinking more Q1 and Q2 of next year, Jason. I mean the process is probably going to take longer than any of us have anticipated back in May and June when this program was in full Bloom. I think it's going to be more in 2021 impact on NII at the end.

Okay. And then just like you did with North Star several years ago. We appreciate you unveiling an efficiency program at our conference again this year. I think in aggregate, I think the total number may be a bit touch better than people expected. But I guess one of the bigger questions kind of surrounding, I guess, of the $300 million to $350 million in aggregate expenses just maybe talk to how much of that actually falls to the bottom line or versus kind of how much of that gets -- kind of get reinvested back into the franchise in terms of kind of some of your growth initiatives?

First off, we're very confident in our ability to achieve those extensive objectives. This is an area that I think we've been, over the past, very diligent about, and we understand how we could add it. Tremendous opportunities still. When you think about our facilities, as I mentioned before, 20% reduction in our non-branch infrastructure, further reduction as you would expect in our branch distribution as we move forward. Rightsizing organization based on where the demand is today, we made significant investments, Jason, in technology over the last 5 or 6 years and taking advantage of those technology investments for process reengineering artificial intelligence. I mentioned we have about 40 processes that we're going after aggressively. So we think a lot of that falls to the bottom line. Were there be additional expense dollars that we have to we have to add in there, of course. But I think for the most part, that should -- the majority of that should fall right to the bottom line based on the actions that we're taking. But once again, I have a high degree of confidence in our ability to on those expense actions, especially the $200 million by the first quarter of next year that we have a line of sight. We're executing already on that play. That's going to happen. The $150 million that I mentioned, over the next 18 months, that gets more into process reengineering, it takes a little more time. Probably a little higher risk on delivery, but we expect to get that done, we'll manage accordingly.

Helpful. And I guess you updated us on your net-interest income guidance and your net charge-off guidance from the second quarter earnings call. You kind of also gave some guidance around fee income and expenses. With a couple of weeks ago in the quarter, I mean, just any updates on kind of maybe the near-term trajectory of those 2 outlined items?

Yes. I mean, I think in general, it's in line with our guidance that we provided in July. Clearly, those fee items that are related to consumer spend levels, and in general, economic activity are trending up. And it's -- usually, Q3 is a weaker quarter in capital markets fees, but I think we're -- we've seen decent capital market activity. And good pickup in wealth management fees. And that clearly has been, I think, a strength for us in the last couple of quarters. So in general, our guidance, both on the fees and expenses should be in line with what we indicated back in July.

Got it. And just for those maybe joined a little bit late on the left hand of your screen is the audience response questions. [Operator Instructions] We do have a question from the audience. Management talked to kind of a sub-50, 55 basis point net charge-off guidance for this year. What are they thinking about net charge-off cadence for next year? And do they want to put a figure around that?

I'll start. Move south of 100 basis points would be our expectation. Obviously, a lot of discussion on that right now, what we determine some of the uncertainties. And potential opportunity for more clarity going forward on the -- economies unfolding here, we believe we're pretty comfortable below 100 basis points.

There's another audience question. Tayfun mentioned loan growth coming in a bit better than expected on the commercial side, does the company expect to do better than its guidance of down 3.5% to 4.5%? And maybe just more color in terms of where that upside is coming from what segments?