On the whole, banks are pretty fully-valued right now. There are a few worthwhile buys here and there, but the sector as a whole has recovered and run into the headwinds of interest margin compression and weak loan growth. Fifth Third (Nasdaq:FITB) looks like an exception, though. Although Fifth Third is seeing margin compression and loan pressures, few banks can match Fifth Third in 2013 when it comes to its ability to raise dividends and execute significant share buybacks. Couple this with organic growth plans in high-value areas like the Southeast, and Fifth Third stands out as an interesting bank investment candidate.
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First, The Bad News
Between the company's 10-Q and presentations at industry conferences, the news regarding Fifth Third's operating environment hasn't been all that positive. While the company is seeing negative loan repricing abate, there is growing loan price pressure in C&I and auto lending. This is not surprising given the commentary of banks like Comerica (NYSE:CMA), PNC (NYSE:PNC), and Bank of America (NYSE:BAC) regarding their intentions to grow lending, but as it represents more than 50% of Fifth Third's loan book, it's a threat nonetheless.
Fifth Third is also seeing some difficulty in cutting costs as much as it would like. Historically, Fifth Third has a pretty competitive efficiency ratio (a measure of a bank's operating expenses), but it sounds like the efficiency ratio is going to remain elevated in 2013 – probably on the order of 60% or so. Longer term, management believes that returning to the mid-50%'s (lower is better) is still possible.
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Returning Capital Could Drive Sentiment
Although I think Wall Street tends to overvalue capital returns from banks (dividends and share buybacks), the reality is that the Street likes it and Fifth Third is in a position to provide it. In a world where weak lending margins, weak loan growth, and sub-optimal expense leverage are going to limit reported earnings growth, buybacks are a way to boost earnings per share.
Fifth Third has already talked about accelerating its repurchase program, to the tune of more than $500 million and 30 million shares. What's more, Vantiv (Nasdaq:VNTV) recently closed on a secondary offering that allowed Fifth Third to sell another 15.6 million shares of Vantiv (while still owning a roughly 28% stake).
I still see these transactions as a mixed blessing. On one hand, I'd like to think that Fifth Third can use this capital to grow the business – whether by making loans (not so easy now, though) or opening branches in new markets or expanding the fee-generating business lines. On the other hand, the bank already arguably has more capital than it can effectively deploy given current circumstances. What's more, buybacks could boost the the company's fair value as much as 10% by the end of 2013.
The Bottom Line
Fifth Third is not the only quality bank that has options outside of core banking to improve its standing with investors. U.S. Bancorp (NYSE:USB) is likewise poised to return meaningful amounts of capital to shareholders, while also leveraging its fee-generating businesses and cutting costs. KeyCorp (NYSE:KEY) and First Horizon (NYSE:FHN) also seem to have the opportunity to improve reported earnings growth through buybacks, though the quality there isn't quite at the Fifth Third/USB level.
Fifth third is a quality bank with a footprint that has grown from its Midwest roots into the more attractive Southeast markets of Georgia, Florida, and North Carolina. It also happens to be a relatively undervalued bank even after a 50% climb over the past year.
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Using an excess equity returns method and an assumed long-term return on equity of 12.5%, Fifth Third would appear to be worth almost $21 today. I will grant that a 15% discount to fair value is not a huge bargain, but as I said before, there aren't many quality banks trading all that cheaply anymore. I do have some concerns that bank stocks in general will be middling performers given the weak loan environment, but if there can be outperformers in the regional space (particularly among the quality companies), I like Fifth Third's chances to be among them.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.