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Regional bank stocks in the ETF (KRE) have risen by nearly 30% on average since their May lows but are still down around 17% YTD. Accordingly, there is a significant divide amongst investors regarding the discount value potential of regional banks. One notable example is Fifth Third Bancorp (NASDAQ:FITB), which is currently down ~15% YTD, outperforming its peers by a small degree. Like most of its peers, Fifth Third trades at a considerably lower valuation than usual but is much more expensive than in May. The bank is also down around 6% over the past two weeks as many stocks show signs of weakness, opening the door to a potential bullish discount or bearish reversal.
Many investors today are very interested in the discount potential of regional banks; however, gains to be made from discounts are much lower today than before. Further, while most believe the “banking crisis” is over, the future remains indeterminate, and various factors could cause it to return with force. Regarding Fifth Third specifically, the bank has a considerably lower risk of critical issues in the commercial property market. Still, it is also likely to face strains to its Net Interest Margins and could see a problematic increase in loan losses. The bank also has a considerably lower CET1 ratio of ~9.5%, toward the low end of the spectrum among large banks. However, its risk exposure is generally believed to be lower than that of most regional banks today, making it a popular discount value stock.
In my view, there are three key questions investors in FITB must ask, which are similar for nearly all regional banks. First, is it likely that the banking crisis is over? Second, based on FITB’s exposure, what is its downside potential if the crisis returns? Lastly, if the problem is over, what is FITB’s upside potential from its current position? For FITB to be a bullish opportunity today, it must have significant upside potential if the crisis is over, and it must be likely that systemic banking strains are over. The opposite must be true for the bank to have a strong negative outlook.
Fifth Third’s Best-Case Bullish Potential
In my experience, most readers are primarily focused on reward potential and can overlook risk, so I will begin with the bullish potential, which many readers may be primarily interested in. FITB’s bullish potential ultimately stems from a potential discount on its tangible equity value. Additionally, we must assess the possibility of an increase in its dividend based on an improvement in income.
FITB trades at a lower forward “P/E” of 8.3X, roughly 14% below the sector average and 23% below its historical average. That gives us an initial indication that the bank could be discounted based on the current market situation. Although its valuation is low compared to banks in general, it is roughly the standard of regional banks today, being toward the higher end of its immediate peer group. Its dividend yield of 4.8% is also slightly lower than its peers, while its price-to-book of 1.1X is somewhat higher. Preferably, a discounted bank would trade below its book value. However, banks’ book values do not necessarily indicate their actual “liquidation value,” primarily due to intangible assets and off-balance sheet losses or gains.
Fifth Third has a very high portion of its assets in intangible assets and goodwill due to recent acquisitions. These assets may have a real value equal to, above, or less than the price paid by Fifth Third, depending on the bank’s success in growing the acquired companies. However, from a risk and value standpoint, I believe it is often wiser to discount goodwill and intangible assets as it may be many years before significant returns are found on those acquisitions. See below
Including intangibles, Fifth Third’s book value is ~$15.7B or about $23 per share. Fifth Third’s book value is just $13 per share, excluding intangibles, making FITB significantly overvalued if its intangible assets are excluded. Notably, the bank’s tangible common equity is only ~4.2% of its total assets, so it would only take a slight decline in its asset portfolio to wipe out its common equity.
One important consideration is the bank’s significant unrealized pre-tax losses of $6.1B, which are accounted for in its book value calculation because virtually all of its securities positions were converted to available-for-sale. Like many regional banks, Fifth Third suffered significant losses on its debt securities position due to the rise in long-term interest rates last year. However, unlike most banks, those losses are not hidden off-balance sheet through held-to-maturities positions. For some banks, such as Truist (TFC) and Bank of America (BAC), their common tangible equity would be essentially zero if all securities were converted to AFS. Thus, while FITB is trading at a ~10% premium to its book value, its book value is likely closer to its liquidation value than it is for many banks.
Fifth Third’s management also stated that around 50% of those losses would be accreted back into equity by the end of 2025, assuming the yield curve remains stable. That represents a ~$3B potential improvement to its equity to $18.7B or $27.5 per share – roughly the bank’s current price. Of course, the yield curve is exceptionally inverted today and usually steepens cyclically, implying a 1-2% potential upward move in interest rates over 2-3 years to maturity. Should the curve steepen without the Federal Reserve making interest rate cuts, FITB would not recoup as much as it currently expects.
Overall, I believe FITB is priced as if the banking crisis is over. It is trading near its potential value, given its intangibles are accurately valued, and interest rates are eventually reduced as the yield curve expects. The latter would require a continued reduction in inflation, which may not occur given the recent slight increase in the inflation rate. FITB does have a strong track record for increasing its dividend per share, rising by ~90% over the past five years and 7% over the past year. Its dividend is also well covered at ~$1.3 per share compared to $3.5 EPS. FITB’s dividend may continue to rise; however, it is not necessarily likely, given factors weighing its profitability. Overall, I believe FITB has some potential upside given no recessionary (or similar) influences; however, that bullish possibility appears to be very small since the bank is trading far above its tangible book value.
Fifth Third’s Risk Exposure Differs From Peers
Fifth Third’s key risks include a sharp rise in medium-to-long-term interest rates, a risk factor many of its peers share. Should the yield curve steepen, as expected, without the Federal Reserve cutting interest rates, the bank’s losses on its AFS portfolio could be similar to the ~$6B level seen today. That said, it is generally unlikely that such significant long-term interest rates rise would occur, as seen last year, without inflation rebound with immense force. Thus, I believe it’s a more accurate downside risk given further losses on its AFS portfolio are likely closer to $2B, still requiring a rebound in inflation and a yield curve steepening.
Fifth Third’s exposure to commercial property loans is generally tiny, 7.2% of its total loans. Office loans, the riskiest segment in regional banks today, are just 1.3% of the bank’s total loans. Given that, the bank’s exposure to the ongoing crisis in the office loan market is minimal. However, its commercial and industrial loan exposure is at ~$57B, or 27.5% of its total assets. That compares to most US banks having commercial and industrial loan portfolios at ~12% of assets. Fifth Third’s consumer loan portfolio is also larger at $45.5B, with its most significant risks likely in its $16.1B indirect secured loan book.
Recently, Fifth Third halted indirect auto loans in western states, indicating issues lending against vehicles in California and nearby states. The 30-89 day delinquency rate on its total indirect secured consumer segment has risen from 59 bps in Q2 2022 to 75 bps in Q2 2023, indicating a problematic risk trend. LTVs in that segment are also higher at 88%, a particularly significant issue given the recent sharp rise and fall in new and used car prices. Consumer and auto loan defaults remain generally low, boosted by the savings boom in 2020-2021, but are rising quickly as savings fall below the normal range. See below:
Fifth Third’s immediate risk exposure to consumer credit is not high. Still, low personal savings, and the recent decline in personal savings, indicate that it could rise higher over the coming year. This data suggest that, although many are meeting obligations, they are increasingly struggling to do so as people’s capacity to save is eroded by inflation. The upcoming restart of student loan repayments will likely worsen this issue, removing the last major consumer stimulus from 2020. The fact that the bank is halting some of its consumer lending operations indicates that it is aware of these issues and is trying to mitigate total exposure. Without a recessionary rise in unemployment, Fifth Third’s total risk exposure to consumer credit is material but not huge compared to its equity.
Fifth Third’s significant commercial and industrial lending portfolio could be another critical issue. Its NPL ratio in this segment has risen from 48 bps in Q2 2022 to 57 bps in Q2 2023. Its total nonperforming loans are not huge, nor is the increase too dramatic, but it is still a risk factor given the overall size of its commercial lending segment. This segment carries similar risks to the BDC PennantPark (PNNT), which I covered recently because it is focused on the Middle Market niche. I believe these loans typically offer decent returns for risk compared to bonds. However, they could still be overvalued due to the substantial mismatch between credit spreads (very low today) and the economic trend (seemingly negative). Should more companies face headwinds, Fifth Third could suffer significant equity deterioration due to associated losses.
Fifth Third’s risk exposure differs from most of its peer group. The bank’s greatest immediate risk is curve steepening which could promote further AFS securities losses. Its greatest overall risk is a classical economic recession that results in a spike in loan losses. I believe investors are underappreciating this risk due to the meager corporate and consumer default rates seen since 2020. However, I think default rates have been artificially low due to the immense savings many companies and people saw in 2020, which have been rapidly eroded due to rising costs. With most smaller companies and households seeing savings decline, a slight rise in unemployment could create a massive increase in nonperforming loans – a critical significant risk factor that FITB is not discounted for.
The Bottom Line
Fifth Third’s performance over the coming year depends significantly on what occurs in the economy and the banking system. Compared to most regional banks, Fifth Third likely has much lower upside potential given an end to bank-related risks since it trades at a book value premium and is valued slightly higher than its peers. Conversely, Fifth Third has lower exposure to the banking crisis due to its lower commercial property holdings and slightly lower securities exposure. That said, the bank still carries some risk should total deposits dwindle, or long-term Treasury rates rise further. Fifth Third’s most significant overall risk is a recession, with arguably greater loan loss risk exposure than banks in general.
Is the “banking crisis” over? Potentially, but not necessarily. Indeed, the upward trend in long-term interest rates is not as significant a risk factor as in 2022. However, the risk of deposit outflows is notable, given the ongoing decrease in the Federal Reserve’s balance sheet. As the Fed’s assets decline, the M2 money supply will usually trend lower, meaning less total money in the economy can be deposited in banks. See below:
In my view, the fact that total Fed assets continue to fall at a solid pace makes it likely that bank deposit outflows will continue. As a result, Fifth Third will likely need to increase deposit rates faster to maintain depositors, probably creating strains on its 3.1% NIM (down from 3.3% in Q1 due to increased deposit costs). This factor should not cause a “bank run” for FITB but could hamper its dividend should its net interest income continue to be strained by rising deposit costs.
Overall, should employment and inflation remain stable, I do not believe FITB has notable downside risk or upside potential. An increase in either inflation or unemployment could create significant issues for FITB due to its high focus on cyclically exposed loans. Today’s extremely low manufacturing PMI and inverted yield curve historically indicate a recessionary increase in unemployment and loan losses. Further, abnormal factors facing the energy industry may soon cause a sharp rebound in inflation. Thus, I am slightly bearish on FITB simply because I believe there is a high probability for a larger loan loss increase and a larger decline in its AFS securities portfolio. That said, FITB’s overall risk is likely much lower than many banks today, so I would not bet against the stock.
