Fifth Third Bancorp Q3 2022 Earnings Call Transcript

Quartr
Provided by Quartr
October 20, 2022

There are 14 speakers on the call.

Operator

Good morning. My name is Dennis, and

Speaker 1

I will be your conference operator today. At this time, I would like to welcome everyone to the 5th Third Bancorp Third Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer I would now like to turn the conference over to Chris Dahl, Director of Investor Relations. Please go ahead.

Speaker 2

Good morning, everyone. Welcome to 5th Third's Q3 2022 earnings call. This morning, our President and CEO, Tim Spence and CFO, Jamie Leonard, will provide an overview of our Q3 results and outlook. Our Chief Credit Officer, Richard Stein and Treasurer, Brian Preston, have also joined us for the Q and A portion of the call. Please review the cautionary statements in our materials, which can be found in our earnings release and presentation.

Speaker 2

These materials contain information regarding the use of non GAAP measures and reconciliations to the GAAP results as well as forward looking statements about 5th Third's performance. These statements speak only as of October 20, 2022 and 5th Third undertakes no obligation to update them. Following prepared remarks by Tim and Jamie, we will open the call up for questions. With that, let me turn it over to Tim.

Speaker 3

Thanks, Chris, and thank you all for joining us this morning. Before we turn to our financial results, I'd like to take a moment to express our sympathies for all those across the State of Florida who are impacted by Hurricane Ian. I would also like to thank our employees for answering the call to take care of our customers and communities in the state. In the day since the hurricane made landfall, our employees have made nearly 90,000 customer wellness calls, reopened all our branches and staff with 5th Third Financial Empowerment Bus to enable customers who lost power and Internet access to apply for FEMA disaster relief. For those of you listening today, your resilience in the face of this natural disaster is awe inspiring.

Speaker 3

Thank you for living our core values. Turning to the financials. Earlier today, we reported 3rd quarter results that reflect our commitment to strong performance through the cycle. We generated record adjusted revenue of $2,200,000,000 up 10% year over year. Credit quality remains strong reflected in charge offs at the low end of our previous guidance.

Speaker 3

We also generated 10 points of positive operating leverage compared to the year ago quarter and achieved one of our lowest adjusted efficiency ratios over the past decade at 53%. Most all of our core return measures have remained in the top quartile among peers, including an ROA of approximately 1.3% and its ROTCE excluding AOCI of nearly 18%. We also produced strong organic growth during the quarter, sustaining a record pace and adding new quality relationships in commercial and growing new households by 3% across our footprint in consumer. Our 2 recent FinTech acquisitions, dividend and provide each chief record quarterly origination levels. Turning to the balance sheet, loan growth was solid across our franchise.

Speaker 3

Our commercial loan production remains well diversified and supported by the bank's Within our regions, loan production in our Southeast and other expansion markets roughly equaled our Midwest markets. Among our verticals, new production was strongest in energy, including renewables, with a 70% increase in origination volume compared to the year ago quarter. Small business production was led by Provide, which doubled year over year. Average consumer loans were up 1%, led by dividend finance, A top 5 national residential solar lender and a return to growth in home equity. Dividend recently announced several key national partnerships, which will continue to accelerate growth in the future.

Speaker 3

Switching to deposits, consistent with prior guidance, our Q3 end of period balances were stable with average balances down nearly $5,000,000,000 due primarily to the full quarter impact of our delivered exits in the 2nd quarter. In consumer, we grew households 3% year over year led by our Southeast markets, which grew 8%. We generated consumer transaction balance growth of 5% compared to last year and opened our 1 millionth momentum banking account in the quarter. In commercial, our deposit franchise is anchored by our peer leading treasury management business. We ranked number 2 through number 9 nationally in most TM payment types is shown in annual cash management survey.

Speaker 3

We have a strong deposit base and new relationship growth engines in both our consumer and commercial business lines, and we expect deposits of production momentum that we built during the Q3 to produce growth in the 4th quarter. Turning to the income statement. The strength and diversification of our fee based businesses throughout the bank has helped to partially offset the market headwinds All banks are experiencing. In commercial, our gross treasury management revenue increased 6% compared to the year ago quarter, led by our Expert AR and Expert AP Solutions. Our capital markets revenue associated with helping clients head share exposure to rates, Commodities and foreign exchange increased 30% compared to the year ago quarter.

Speaker 3

In consumer, we generated Strong mortgage revenue growth this quarter in an otherwise challenging environment, thanks to the strength of our mortgage servicing operation. 5th Third is a low cost, high quality servicer, one of the only banks to be recognized as both a Fannie Mae Star servicer and a HUD Grade A servicer. The actions we took to grow our MSR portfolio nearly 30% since the end of 2019 will continue to pay dividends going forward. Finally, in Wealth Management, excluding tax payments, we have generated positive AUM inflows in every one of the past 13 quarters, and we were recognized this quarter as the best private bank for high net worth clients, Private Digital Banker and Global Private Banker Magazine. We continue to focus on maintaining our culture of prudent expense management across the company, while investing in organic growth and tech modernization initiatives.

Speaker 3

In the Q3, we made meaningful progress in our technology and platform modernization journey. We successfully migrated our core platforms to a new data center and have now virtualized over 90% of our servers, strengthening network resiliency, increasing speed and capacity and improving the experience for both our customers and employees. In the Q4, we'll relaunch our mobile app and a new cloud based architecture and several improvements to the user experience. Credit quality remained strong throughout the bank. Our charge off ratio was 21 basis points for the quarter and our non performing asset ratio declined compared to the prior quarter.

Speaker 3

We remain cautious with respect to the broader economy given persistent inflation, the Fed's aggressive monetary policies and global growth concerns. We've continually improved the granularity and diversification of our loan portfolio with a focus on high quality relationships and companies with more diversified resilient business models. We continue to proactively monitor our portfolios for signs of potential stress. And regardless of what comes, I'm confident in our ability to outperform peers through the full economic cycle. With respect to capital, we announced a 10% increase to the quarterly common dividend in September.

Speaker 3

We continue to accrete capital with strong PPNR growth and expect to achieve a 9.25 percent CET1 by year end. We also expect to resume share repurchases in the Q1 of 2023 subject to economic conditions. We continue to make decisions with the long term in mind, hold ourselves accountable to what we say we are going to do and invest in product and service innovations that generate long term sustainable value for customers, communities, employees and shareholders. With that, I will now turn it over to Jamie to provide additional detail on our Q3 financial results and our current outlook.

Speaker 4

Thank you, Tim, and thank all of you for joining us today. We are pleased with our Q3 results. We generated strong loan growth in both Commercial and consumer categories and generated record adjusted revenue. NII was positively impacted by higher market rates. Fee income was resilient despite the market related headwinds and expenses were well controlled while we continued to reinvest in our businesses.

Speaker 4

Consequently, we achieved a 53% adjusted efficiency ratio. Also excluding net Securities losses related to 2 legacy venture capital investments. We generated core PPNR growth of 13% compared to last quarter and 27% compared to last year. Net interest income was approximately $1,500,000,000 a record quarter and increased 12% sequentially and 26% year over year, primarily attributable to the benefit of higher market rates, Growth in commercial loan balances and the full quarter benefit of securities purchased in the 2nd quarter. Our NIM expanded 30 basis points during the quarter, While interest bearing core deposit costs increased 32 basis points to 41 basis points in total this quarter.

Speaker 4

This equates to a cycle to date deposit beta of 16% thus far on the first 2 25 basis points of rate hikes. Total reported non interest income decreased just 1% sequentially. We generated improved mortgage banking and leasing business fee income, which was offset by softer results in market sensitive businesses, including capital markets and the impact of higher earnings credit rates in treasury management. Non interest expense increased 5% compared to the prior quarter, driven by an increase in compensation and benefits expense, including the impact of the July minimum wage increase to $20 per hour, higher technology and communications expense reflecting our focus on technology modernization initiatives and the full quarter impact of the dividend finance acquisition. Expenses in the quarter included a $7,000,000 related to the mark to market impact of non qualified deferred compensation with a corresponding offset in securities losses.

Speaker 4

This compares to a $27,000,000 benefit in the prior quarter. Excluding the NQDC impacts from both periods, Total non interest expense increased $35,000,000 or 3%. Non interest expense was flat compared to the year ago quarter, despite the impacts of our FinTech lending acquisitions of both Dividend and Provide. Moving to the balance sheet. Total average portfolio loans and leases increased 2% sequentially.

Speaker 4

Including held for sale loans, Total average loans increased 1% compared to the prior quarter. Average total commercial Portfolio loans and leases increased 2% compared to the prior quarter. With muted payoffs and a Stable revolver utilization rate of 37%. Period end commercial loans increased 1% sequentially and 14% compared to the year ago quarter. Average total consumer portfolio loans and leases increased 1% compared to the prior quarter, driven by dividend finance, which as a reminder is recorded in other consumer loans, as well as growth in residential mortgage.

Speaker 4

This growth was partially offset by a decline in indirect secured consumer loans. At quarter end, dividend loan balances were approximately $1,400,000,000 Average core deposits decreased 3% compared to both the year ago quarter and the prior quarter, impacted by the intentional runoff of excess and higher cost commercial deposits in the 2nd quarter and lower Consumer interest checking balances in the 3rd quarter. Compared to the year ago quarter, average commercial transaction deposits decreased 10%, while average consumer transaction deposits increased 5%, reflecting our continued success growing consumer households. We grew our securities portfolio approximately $1,000,000,000 during the 3rd quarter compared to $6,000,000,000 in the prior quarter. We currently expect security portfolio balances to remain generally stable through the rest of the year.

Speaker 4

We have continued to focus on maintaining structure in the investment portfolio to provide stable and predictable cash flows. Our overall allocation to Bulleit and Lockout Structures at quarter end remained at 67% And our duration declined to 5.5 in the current quarter compared to 5.8 in the prior quarter. Moving to credit. As Tim mentioned, credit trends remain healthy and our key credit metrics remain well below normalized levels. For 8 consecutive quarters, the net charge off ratio was flat sequentially at 21 basis points.

Speaker 4

The ratio of early stage loan delinquencies 30 to 89 days past due remained relatively stable sequentially and the amount of loans 90 days past due was approximately 2 thirds of what it was a year ago. We continue to closely monitor central business district hotels, non profit healthcare, including senior living and Office CRE. We are also monitoring exposures where inflation and higher rates may cause stress, including the impact of changing consumer discretionary spending patterns, as well as the ongoing monitoring of the leverage loan portfolio. From a balance sheet management perspective, we have continually improved the granularity and diversification of our loan portfolio with a focus on high quality commercial relationships and on homeowners, which are 85% of our consumer portfolio. We maintain the lowest overall portfolio concentrations in both commercial real estate and in non prime borrowers among our peers.

Speaker 4

Through the dividend and provide acquisitions, we added granular fixed rate loan origination platforms. We have also focused on positioning our balance sheet to deliver strong stable NII through the cycle. Our strong deposit franchise, our securities and cash flow hedge portfolios, as well as the additions of dividend and provide lending capabilities should continue to position us to drive strong outcomes. In the cash flow hedge portfolio, we have added an incremental $5,000,000,000 since The combined securities and cash flow hedge positions will support NII through the end of the decade. Moving to the ACL.

Speaker 4

Our ACL build this quarter was $96,000,000 primarily reflecting loan growth as well as a slightly worsening economic outlook relative to June. Dividend Finance loan growth contributed $63,000,000 to this ACL build. Relative to the Q2, the Moody's GDP growth forecasts are slightly stronger, while the unemployment and home price forecasts have weakened in both the baseline and downside scenarios. Given our expected period end loan growth, Including stronger production from dividend finance, we currently expect a 4th quarter build to the ACL of approximately $100,000,000 assuming no changes in the underlying economic scenarios. The impact of the expected dividend loan originations to the ACL should be in the $80,000,000 to $90,000,000 range due to our improved loan growth expectations.

Speaker 4

Our economic scenarios incorporate several key risks that could exacerbate existing inflationary pressures and further strain supply chains, including continued aggressive rate hikes and quantitative tightening and labor supply constraints becoming more binding than originally anticipated. Our September 30th allowance incorporates our best estimate of the economic environment. Future baseline unemployment estimates may begin to be increasingly impacted by the Fed's aggressive monetary policies. Moving to capital. Our CET1 ratio ended the quarter at 9.1% compared to 9% in the quarter.

Speaker 4

The increase in capital was primarily due to our strong earnings capacity, partially offset by RWA Growth reflecting robust organic business opportunities. Moving to our current outlook. For the Q4 of 2022, We expect average total loan balances to be stable to up 1% sequentially. We expect commercial loans to grow 1%, reflecting strong pipelines in Middle Market and Corporate Banking and assuming commercial revolver utilization rates remains stable at 37%. We expect consumer balances to be stable down 1%, reflecting our decision to lower auto loan production to enhance our returns on capital and lower residential mortgage balances, partially offset by dividend loan originations of around $1,000,000,000 in the 4th quarter.

Speaker 4

From a funding perspective, we expect average core deposits to increase 1% to 2% sequentially. However, we do expect Some continued migration from DDA into interest bearing products. Wholesale funding balances should be stable given Expected core deposit growth relative to our earning asset base. Shifting to the income statement. We expect 4th quarter adjusted revenue growth of 6% compared to the 3rd quarter, excluding the 3rd quarter security losses associated with Legacy Venture Equity Investments.

Speaker 4

We expect NII to be up approximately 5% sequentially, Assuming a 75 basis point hike in November and another 50 basis points in December, we expect a cumulative deposit beta of around 30% by year end. This should result in interest bearing core deposit costs rising from 41 basis points in the 3rd quarter to the mid to high ninety basis point area for the 4th quarter. We expect 4th quarter adjusted non interest income to be up 6% to 7% Compared to the Q3, we're stable excluding the impacts of the TRA. We have a strong M and A advisory pipeline and expect to continue generating Strong financial risk management revenue, which we expect will be offset by earnings credits and softer top line mortgage banking revenue given the rate environment. We expect total adjusted non interest expenses to be up 3% to 4% compared to the 3rd quarter, reflecting continued investments in talent, technology and our Southeast branch expansion.

Speaker 4

Our guidance assumes we opened 17 new branches, 16 of which will be in our high growth Southeast markets. Our 4th quarter guide implies stable expenses for 2022 on a full year basis compared to 2021 and 8% adjusted revenue growth excluding securities losses resulting in PPNR growth in the high teens. This will result in a mid-50s efficiency ratio for the full year, a 4 point improvement from 2021 and a 4th quarter efficiency ratio in the 51% to 52% range. We expect 4th quarter net charge offs In summary, with our PPNR growth engine, disciplined credit risk management and commitment to delivering strong performance through the cycle, We believe we are well positioned to continue to generate long term sustainable value for customers, communities, employees and shareholders. With that, let me turn it over to Chris to open the call up for Q

Speaker 2

and A. Thanks, Jamie. Before we start Q and A, given the time we have this morning, we ask that you limit yourself to one Operator, please open the call up for Q and A.

Speaker 1

We'll pause for just a moment to compile the Q and A roster. And your first question is from the line of Scott Siefers with Piper Sandler. Please go ahead.

Speaker 5

Good morning, guys. Thanks for taking the question.

Speaker 3

Good morning, Scott.

Speaker 5

I was hoping you guys could sort of address Maybe Jamie best for you. Kind of walk through the puts and takes with Dividend Finance. I think since that close, the origination Expectations have been great and continue to increase, but so do the reserve build expectations. So maybe just some thoughts on how much longer will those Related reserve builds last and how is the overall accretion from that transaction trending relative to what you would have thought at announcement?

Speaker 4

Yes. Thanks for the question, Scott. It's a good one and timely because the dividend expectations On loan growth have continued to go up and up. Their performance continues to be very strong from a Loan origination standpoint, when we bought them, they were 5th in market share and our best estimate is that they're top 3 in market share now today and It's certainly a booming business given the rising energy costs. So with that, we had originally modeled A 5 year earn back on the acquisition that they'd be profitable in 2023 ex the ACL and in 2024 with the ACL and they're certainly tracking ahead of those expectations.

Speaker 4

Obviously, the challenge During this quarter and as we look ahead given their strong loan growth is the ACL build. The ACL build and the credit performance is in line with How we modeled the portfolio with the annual loss rates We're speaking at a 1.25 charge off rate give or take, but given the long dated nature of the asset, it results in a Much higher ACL build than some of our other loan categories. And so we're going to be Providing at a pretty healthy rate in dollars given their strong loan production and that could be $80,000,000 to $90,000,000 next quarter and Perhaps every quarter in 2023 given that we expect $1,000,000,000 or more per quarter from them. So I guess that's a long answer to say. It's a good problem to have in the long term because it's a high returning Asset both from NII perspective, but also return on the capital.

Speaker 4

It's just the unfortunate cost of providing Life of loan losses at origination.

Speaker 5

Yes. Okay. Thank you for that color. And then maybe the follow-up. You guys have Really good comment on the Tier 1 and are anticipating reasonable share repurchase early next year, but the TCE ratio continues From the AOCI, maybe if you can sort of just discuss the extent to which TCE, if at all, weighs into your capital decisions.

Speaker 5

I think one of the emerging questions at the market is, if investors are going to sort of rally behind share repurchase from A low starting point of TCE. So just curious to hear your thoughts there.

Speaker 4

Well, thanks for the question because as you know, I do have some opinions on this topic and bear with me a moment while I walk through it because we run the company Looking at metrics that both include and exclude AOCI and we've been showing you both sets of metrics for better or for worse Consistently over the past decade, whether that's ROTCE or tangible book value per share or TCE. And when you look at the tangible book value per share, Excluding AOCI, we actually grew it in the quarter and for the year even with the Dividend Finance acquisition. So really when it comes down to the lower TCE ratio and the tangible book value per share, including the AOCI, it really does come down To how the AOCI is moving. And so when Brian and I talk about this and have been thinking through it, We think we're really mixing 2 issues into that one question. The first question when you parse it out is really based on How do I feel about our investment portfolio's positioning and performance?

Speaker 4

And I would answer that as I feel very good about how we are positioned And especially how we're positioned relative to peers. Would it have been great to time the market perfectly and hit the very best entry points? Of course, but our 2 years of patience definitely paid off for us. On a relative basis, we continue to have one of the highest yielding portfolios And among the lowest unrealized losses as a percent of total securities in the industry. So the potential TCE and AOCI issue from this perspective ultimately comes down to whether you have a low quality or poorly structured investment Portfolio that will incur losses in the future, we do not.

Speaker 4

We will accrete 45 to 50 basis points or about $1,000,000,000 of TCE per year going forward and do not expect to incur any losses in the portfolio. And as we've always said, Given the high composition of floating rate loans on our balance sheet, the investment portfolio should act as a shock absorber in a falling rate environment. And we believe the nice duration and structure that we have in the portfolio will do just that. So then the second question That gets mixed into this is then should we be putting securities in HTM instead of AFS. And as we said before, as a Category 4 bank, the election to put the security into AFS or HCM really doesn't impact regulatory capital other than a small deferred tax asset impact, more does it change the economics or the risk of an investment.

Speaker 4

For the largest banks, clearly, there's value to minimizing the risk of regulatory capital volatility by using the held to maturity bucket. For banks like us, we believe the benefits of maintaining some flexibility to manage the portfolio through a volatile environment Really does create value for us through the cycle. And given that there's no change in the actual value of the security simply based on the accounting classification of which the portfolio that we put the security is in. So it really does come down to do we think the company From a TCE or value perspective is worth less by simply fair valuing one line item in the balance sheet Or is it worth less because we placed a security in AFS? And the answer to that, we believe is clearly no.

Speaker 4

So our goal is always optimize the balance sheet to deliver long term real economic value and not make So with that, I apologize for what may have just been the longest answer in the 3 earnings calls. But as you might imagine, we feel strongly about those topics.

Speaker 3

And if I can put a point on it, no, it does not factor into The decisions that we make on a day in, day out basis on the way that we run the company or as it relates to capital return.

Speaker 5

Perfect. No, I appreciate that color. It's an Interesting issue to say the least and it's having kind of wide ranging ramifications. I really appreciate that.

Speaker 6

No problem.

Speaker 1

Your next question is from the line of John Pancari with Evercore. Please go ahead.

Operator

Good morning.

Speaker 3

Good morning.

Operator

Wondering if you can give us a little more color on your thoughts on deposit growth. I know that you indicated that you do expect growth in the 4th quarter, maybe you can help size up That level of growth and then how do you think about growth into 2023, particularly given that you've completed the deliberate Deposit balance exits that you had talked about. So how are you thinking about 2023, Maybe also in the perspective of the non interest bearing mix as a percentage of the total, how you expect that shifting as well? Thanks.

Speaker 3

Yes. Brian, why don't you address the first part of the question and then I'll talk a little bit about why we think we can grow deposits in 2023.

Speaker 6

So go ahead. Yes. I mean,

Speaker 7

our goal is always to grow deposits and take share every year. We've obviously got strong consumer household growth, our investments in our Southeast markets, our leading TM business. We have confidence that we can take share. We obviously have some full year headwinds on average balances due to the excess commercial balances. We intentionally let runoff in 2Q, But we do expect to grow from these 3Q levels.

Speaker 7

From end of 4Q, probably up 1% to 2% kind of range. You obviously have normal seasonality That we should expect to benefit from a commercial perspective as we also continue to grow households and grow our commercial relationships.

Speaker 3

Yes. I think I just would add, John, to put a point on it. We do feel good about our ability to grow deposits for the remainder of this year. And as Brian said about our ability to grow deposits on an ongoing basis, if you just step back and look at the engines that drive deposit growth The integration of the branch and the digital offering has been very powerful for 5th Third, right? And over the course of The past few years, the investments we've been making in the Southeast have really accelerated and that is Evident in the rate of growth that we see in those markets, like I mentioned, 8% household growth is an example there.

Speaker 3

The only bank that has built more branches in the last 3 years in the Southeast and Fifth Third is JPMorgan Chase, Okay. So we have a very fresh branch network. We have another 20 plus branches that will be open before the end of this year and are on pace to do another 35 next year, all of which are in really high growth markets. I mentioned the 1,000,000 Momentum Banking Household, it was opened in the Q3 of this year. I don't think I could overstate the way in which That sort of a product offering changes the nature of the relationship with a customer.

Speaker 3

Like if you just assume the checking account has a $5,000 average balance, A point of interest on $5,000 equates to about $4 a month. And I mean, think about how many other You spend more than $4 a month and get less value than we're providing now in momentum as it relates to helping you to manage cash flow and achieve savings goals and move money efficiently and otherwise. And I think that is going to be Very powerful driver of growth. It just makes those core retail deposits stickier than they were in the past. And lastly, then we've talked about The treasury management business and you shared in some of our investor conference presentations, this ratio of turnover to average balances in commercial.

Speaker 3

So You just look at ACH volumes over average balances and compare that across banks in our peer group, 5th Third has by far and away the highest turnover, which is a really good thing because what that means is that the balances that are sitting here Are being used to support the cash flow velocity of the business as opposed to being treated like an investment alternative, right? And so if you take that as the foundation of the deposit business here and take into account that how hard it is to build Those sorts of capabilities over a period of years, that's going to be a pretty powerful moat for the bank going forward. And I think we'll be able to grow from there.

Speaker 4

And then John on your DDA mix question, we look back the last tightening cycle, our total DDAs to total core deposits Dropped 5 points from 35% to 30%. This cycle, we started at 38% and we model a similar 5% decline I should say we're forecasting a 5% decline and then we actually model in the rate risk disclosures in the presentation additional migration even beyond that. So We're assuming a similar mix shift as last tightening cycle. But as Tim mentioned, our product lineup is certainly different and better And the treasury management market share certainly has improved since the last cycle, but either way, we feel good about how we're forecasting it and think it'll be manageable.

Speaker 8

Got it.

Operator

Okay. Thanks, Jamie. And then secondly on credit, if you could just give us some color on the drivers of the Higher loan delinquencies in the quarter, it looks like both 90% to 8% and 30% to 89% went up. And then separately, maybe just thoughts on the Trajectory of the loan loss reserve ratio excluding what you're doing with dividend finance, do you expect additions here on the underlying reserve beyond that portfolio? Thanks.

Speaker 9

Yes. It's Richard. I'll start with the delinquency, Amit, and I'll let Jamie talk about the ACL changes. Look, starting from a small base, we had a couple we have a couple of deals rolled into delinquency, you have a couple of roll out. There's really no trend.

Speaker 9

There's no pattern with respect to industry or borrower type. I think it's just a little bit of seasonality in terms of or a little bit of just a small change in

Speaker 4

terms of borrower impact as we get through the end of the quarter. On the ACL, the Driver of the coverage ratio this quarter was certainly dividend more than anything else, but the other impact being A little bit worsening in the Moody's scenario. So from here, if dividend loans You'll continue to grow and be an outsized portion of our originations and that coverage ratio just because of that loan mix shift We'll continue to increase, but otherwise you wouldn't expect the ACL coverage ratio To go up or down unless the economic scenario changes or the credit profile improves or worsens more than what we've currently have modeled.

Operator

Okay, great. Thanks again, Dave.

Speaker 1

Your next question is from the line of Michael Mayo with Wells Fargo. Please go ahead.

Speaker 8

Hi. Can you start off the call talking about virtualizing 90% of your workload? I missed some of what you had Say, but what does that mean for your efficiency ratio, 53.3 percent? Where do you think a terminal efficiency ratio is? How much do you have in stranded costs and on the other hand, the inflationary costs that hurt your expenses?

Speaker 8

So I guess I'm looking for Longer term expense and efficiency guidance and the implications of some of these tech moves.

Speaker 6

Yes. I had you in

Speaker 3

mind as we were writing that paragraph, Mike, in terms of the data centers and virtualizing applications. That I think the way to think about what we are getting to at this point is we have talked for many years now about the opportunities that we have To use the cloud, whether it was private or public, to take some of the load off of legacy mainframe Infrastructure and to put it into an environment that allow it to be much more scalable and resilient over time. And we hit a couple of important milestones In the quarter in that regard, hence the commentary about the data center move and having virtualized now 90%, a little over 90 Long term, I think we feel very good about The ability to drive efficiency on the maintenance and network infrastructure side of the IT business, But we also intend to be able to continue to invest on an ongoing basis at new front end application development and in building new capabilities The products and services. So I think what we said in the past is the technology spend has been growing at, call it, 10% on an ongoing basis that you should expect that sort of growth to continue, but that it would be offset by our ability to eliminate manual Processes and drive automation into the company.

Speaker 3

And if you look at banks in totality, people expense is about half of our total on an annual basis. So there's still a lot of opportunity in front of us in a 3 to 5 year timeframe to substitute technology for work that has to be done manually today. That's where I think the efficiency opportunities are. And as it relates to the long term, A 53 percent efficiency ratio, I believe, is at least as we were looking at it this morning, the best of any of the commercial banks over $1,000,000,000 that are reporting. So I feel really good about where we're at, at the moment and the intent is to be able to run the company in that sort of 53% to 55 Percent range on an ongoing basis.

Speaker 8

Okay. So how many data centers do you have left? And is

Speaker 9

it your goal to eventually have

Speaker 3

No, we'll have to.

Speaker 6

We'll have to. We'll always have to.

Speaker 3

There's a lot of things to run certain applications and then be able to store data In your own private environment, you need to have redundancy.

Speaker 8

Okay. And so with the moves that just happened, Can you size those cost savings or those savings are simply going to help self fund your new tech investments?

Speaker 3

They'll be the mechanism to fund the new tech investments.

Speaker 8

Okay. All right. Thank you. Yes.

Speaker 1

Your next question is from the line of Betsy Graseck with Morgan Stanley. Please go ahead.

Speaker 10

Hi, good morning.

Speaker 3

Good morning.

Speaker 10

I just wanted to ask a couple of questions. One, I heard The commentary around deposits earlier and the outlook for deposit growth from effectively benefiting from the new branches, etcetera, that you've I've been putting in, could you just give us a sense of that branch Trajectory from here and what you're anticipating over the course of the next year or 2. And then also give us a sense as to what your deposit Pricing strategies are as well for the next several quarters?

Speaker 3

Yes, sure. I'll take the branch Projectory, Brian, you can handle it. I think we have been running on a pace to open, call it, 20 to 30 new branches a year. We'd like to see that be in the more of the 30% to 40% range. So we'll hit mid-20s this year.

Speaker 3

The expectation is to end up somewhere between $30,000,000 $35,000,000 next year and to have the $30,000,000 to $40,000,000 a year range Be what we run-in the Southeast markets until we achieve the market position that we want to be able to achieve in each of the MSAs that we are focused on down there. Now on a net basis, the branch network has not been growing that fast because we have taken advantage of opportunities As customers have done more of the transactional activity online to thin out or relocate Branches in the legacy network, which has provided a basis for funding, several of the investments We're making down in the Southeast. Brian, you want to talk about rates?

Speaker 7

Yes, absolutely. Thanks, Tim. We continue to feel good about what we've been able to do on the The pricing is obviously starting to get more competitive, especially in the commercial portfolios. But we feel good about the 30% cumulative beta that we Have talked about for that first 300 basis points in hikes. Certainly, as rates move higher from here, we're going to continue to see some increase in betas.

Speaker 7

We've previously talked about maybe that next 100, 125 basis points of hikes, those betas will get over 50%. But we think we're going to be able to manage to below percent cumulative beta from here, certainly a little bit higher on commercial than on the consumer side. But we recognize as rates move higher, You are going to start to see more consumer beta flow through as well.

Speaker 10

Right. Yes. I noticed Up to your CD offers and matched JP, which is I know a competitive positioning that you've got in a lot of your footprint. So That's helpful color on the From Here beta that you're looking for. Maybe you could just give us a sense on Loan growth trajectory, because one of the things obviously we're all thinking about is dollars loan growth and dollars deposit growth and Any expectation that you would need to lean on wholesale funding a little bit more.

Speaker 10

I did notice in the quarter, your averages went up, but In wholesale funding, but that looks like it was action that you took at the end of 2Q. So maybe just give us a sense as to how you see that all trajecting? Thanks.

Speaker 3

Yes. So Betsy, from my standpoint on loan growth, I think the guide in the 4th quarter is Stable to 1% on a quarter over quarter basis. That feels like a pretty good benchmark, right, if you were Start on something for where we see loan growth going. We have really strong production coming out of dividend, As we mentioned and are very pleased with the performance there and also strong production on Provide. On C and I more broadly, I think we have been deliberate About moderating production over the course of this past year, you can see that in the numbers.

Speaker 3

But the production itself is Still really good. It's more granular than it had been in the past, which is an important strategic priority for us. What I think I don't see a catalyst for Is a material move from here on utilization rates, right? And against the strength in the FinTech platforms And good core middle market production in C and I, you're going to have the drag from the slowdown in the auto production and mortgages that I think we started on perhaps earlier than others and therefore will make its way into the numbers faster than you may see it In other places. Against that, the goal is always to grow deposits.

Speaker 3

We like to be able to grow deposits faster than loans. That is a Tenant of the way that we try to grow the company, that doesn't always happen in any one quarter, but we do expect Q4 1% to 2% deposit growth. And while we're still in the early stages of the planning process, we intend to grow deposits next year.

Speaker 7

Yes. And Betsy, from an overall funding perspective, Our wholesale funding portfolio as a percent of our asset base is obviously down a decent amount from where we were pre COVID. It was kind of closer to 9% Of total assets pre COVID from a long term debt perspective, that number is down to more like 6% right now. Our loan to deposit ratio Still near those historic lows. And so over time, we do expect to have more structure in our liability base as well as a little bit more Long term debt.

Speaker 7

So even if we were to see some moments of loan growth faster than deposit growth, we have confidence in our ability to fund it. And Adding some of that structure to our balance sheet is a decent place to be as well.

Speaker 10

Right. Now I noticed your liquidity sources, it's a very Folsom slides, I really appreciate that. Thank you.

Speaker 1

Your next question is from the line of Ken Usdin with Jefferies. Please go ahead.

Speaker 11

Hi, thanks. Good morning. Just a couple of questions on the B side. Understanding your guide is flat to the 727, I just want to understand, Tim, in your intro, you mentioned that mortgage servicing will continue to be a benefit. So Is the mortgage business hanging from here going forward?

Speaker 11

And then the second question is just can you flush out a little bit for us just the impact of Earnings credit rates on service charges and what type of impact that could have going forward as well. Thank you.

Speaker 4

Yes. Hey, Ken, it's Jamie. I'll take that one. Since we've had long discussions over the years on the strength or lack thereof in our mortgage business and Happy to report that the 3rd quarter was a very nice mortgage performance, 4th, the 3rd. I do think from a top line perspective, volumes will be down given the environment into the 4th quarter.

Speaker 4

But what You're seeing in the strength of the business is really that servicing revenue shine through. And as Tim mentioned in his prepared remarks, We're one of the top servicers rated in the industry and the improvement in that Revenue stream is part of why we beat the outlook for the Q3 and will help support the mortgage Fee business going forward, we were running the mortgage banking in the first half of the year, total mortgage banking fees, I think in the 1st 6 months of the year, we're $80,000,000 and we're going to grow that 60% over the back half of the year, Simply driven by the strength of that mortgage servicing business that we operate. So we feel good about that. That's a run rate. Servicing fees net of MSR decay should be around $40,000,000 to $45,000,000 a quarter Going forward and that's going to be a 10% yielding asset for us.

Speaker 4

But again, the top line will be a little bit Challenge for the net net assuming no MSR valuation changes, I would expect the mortgage banking fee line to be in that $60,000,000 to $5,000,000 range in the 4th quarter.

Speaker 11

Okay. And sorry, on the service charges with regards To the ECR impact there and does that continue to how does that actually trend going forward?

Speaker 4

Yes. When we look just at the Q4, the top line fee equivalent, as Tim mentioned, we have a very Strong pipeline and good business. And so top line will be growing 2% or so. But to your point, the earnings Credit, just given the rising rate environment, will result in total service charges being down 2% to 3%. And We have earnings credits moving similar to the deposit betas and so they'll continue to edge higher As the Fed keeps moving on rates.

Speaker 11

Okay. If I can just ask one more just on your Slide 24, You added $5,000,000,000 more swaps since the end of the second quarter and we can see how you've laddered that all out. Just Can you help us just understand as you start to look past 4Q in terms of NII, can you continue to show positive NII growth given Yes, the positive beta comments you made earlier and just the trajectory of the protection that you've put on to the balance sheet. Thanks, Jamie.

Speaker 7

Yes, Ken, it's Brian. Thanks for the question. Based on where we stand today, we feel good about our exit rate NIM in 4Q 2022 Carrying over into 2023 with some upside as our balance sheet continues to benefit from the 2022 hikes. We've previously talked about that 4Q NIM In that kind of $3.35 to $3.40 range. Assuming a $4.50 terminal funds rate, we think our NIM will peak in Mid-340s in the first half of twenty twenty three.

Speaker 7

We do expect to give some of that upside back as deposit repricing lags catch up. But given the balance sheet actions we've taken to date to monetize our asset sensitivity, we expect we can maintain a 3.30 plus NII 3.30 plus NIM over the next couple of years, even if rates were to fall 200 basis points. Obviously, 2023 and beyond results are subject to Significant uncertainty given the economic outlook. And we'll give you additional color on 2023 expectations as part of our Q4 earnings in January.

Speaker 11

Great. Thanks a lot, Brian.

Speaker 3

Yes. If I'm just going to throw one editorial comment in here, Ken, because you hit on 2 of the topics We're spending a lot of time talking about internally is, I think perhaps because we operated for 15 years in a near 0 interest rate environment, people forgot about what long term drives performance in the banking business. And if there's anything that the current Point in the cycle is reminding us is that deposits matter and that diversified fee income business lines matter And that interest rate risk and credit risk management matter. And by those measures, if you look at where We are right now. I mean, the company has been around for 164 years, and this is literally going to be its best year Ever in terms of profitability and the strength of some of these fee lines, like mortgage servicing, Right.

Speaker 3

Like what we have been able to do on top line with treasury management and the quality of the deposit base coupled with The prudence that I think our treasury, which has done really an outstanding job here and that we have in the credit organization is going to set 5th Third up to be able to perform very well regardless of what

Speaker 1

Your next question is from the line of Erika Najarian with UBS. Please go ahead.

Speaker 6

Hey, Erika.

Speaker 10

Hey, good morning. Actually my questions have been asked and answered. Thanks so much guys.

Speaker 3

Thank you.

Speaker 1

Your next question is from the line of Matt O'Connor with Deutsche Bank. Please go ahead.

Speaker 3

Hey, Matt.

Speaker 12

Good morning.

Speaker 8

Any impact to the dividend finance business from recent legislation? I guess it's called the Inflation Reduction Act, but there's a lot of Climate initiatives in there that, I know helped some broader areas, but any impact to that business in terms of volumes and Reducing the credit versus what you thought it would have been before?

Speaker 3

Yes, it will be a tailwind for the business. When we underwrote the business and entered into the agreement to buy dividends. The assumption we were using in our base case was that the federal tax credits would expire And the actions in the Inflation Reduction Act are only going to help support it.

Speaker 8

Okay. And then, as you think about how big this portfolio Can get or you're willing to let it get. Obviously, there's a lot of room to run. But if you're originating over $4,000,000,000 a year and it's pretty long duration, the

Speaker 7

Yes. I mean, we obviously, there's a lot that can change over the next couple of years as outlooks and things adjust and rate expectations change. But As we look at it now and given the capacity that we have on the consumer side because we are going to continue to let our auto portfolio run Getting that portfolio north of $10,000,000,000 doesn't cause us any concerns. And we also know that there is a pretty robust market, whether it's securitizations or whole loan markets where we're going to have the ability to manage the portfolio risk associated with these assets. So we feel good about our options associated with it.

Speaker 8

Okay. And then actually just following up on my first question, I'm a little slow, so that is always a long week. But The benefit of these credits, does this increase the volume, reduce the kind of Long term expected credit cost or what's in or a little bit about?

Speaker 3

It increases the volume. The way to think about it is that from the homeowners' perspective, clearly there's An incentive to impact your own personal carbon footprint, but these decisions ultimately get made on an economic basis. So the trade off that the homeowner is making is the cost to install the panels and then to service the debt attached to that relative to the cost to pay an energy bill for energy that you buy from a utility company on a month to month basis. So anything that reduces the installation costs on the side of solar or that increases the cost Of buying energy off of the grid is beneficial to the size of the overall market is the way to think about it, Matt, dividend being one of the largest players, anything that positively impacts the TAM for residential solar positively impacts the outlook from an origination perspective. So that's where I expect The benefit primarily to be as it relates to the extension of federal tax credits.

Speaker 8

That makes sense. And obviously, higher energy prices Would there be an opportunity to securitize or like figure out a way Increase the ability to originate even more without keeping on balance sheet over time, maybe it's more 3, 5 years now?

Speaker 3

I think Brian mentioned that dividend has been a top 5 originator. Jamie mentioned that we believe it's a top 3 originator today. The other players in the top 5 are all funding through whole loan transfers or securitizations. So there is a very liquid market for the asset. We have the ability to run at an origination level that is above and beyond what we would hold in the portfolio if we elected To do it, but as you said earlier, we have a long way to run between where we're at today and where We would stop and add very attractive yields from the standpoint of NIM enhancement and overall credit performance.

Speaker 8

Got it. Okay. Thanks so much.

Speaker 6

Yes.

Speaker 1

Your next question is from the line of Gerard Cassidy with RBC. Please go ahead.

Speaker 13

Hi, Tim. Hi, Jamie.

Speaker 3

Hey, Gerard.

Speaker 13

Tim, you talked about 5th Third is one of the most active branch openers in the Southeast along with JPMorgan Chase. Can you give us some color On the cost of opening, I know each branch is different, but a typical cost of opening a branch, what type of Deposit level you need to reach to make it breakeven and how long does it take you to reach to get to that deposit level if you use deposits as the measure for breakeven.

Speaker 4

Yes, Gerard, it's Jamie. Thanks for the question. We've really reduced the square footage in the branches so that The cost between land and construction is much lower than it used to be and it can range from $3,000,000 to $4,000,000 of Book value, maybe a few hub branches would go higher than that. But for the most part, that's where The investment cost is and as you know, the people side, the staffing is about half of the cost of operating A branch. And so you start to make money when you get into the $25,000,000 plus Deposit range and so that usually takes us 2.5 years or so, sometimes 3, sometimes 2, but Our recent de novos are tracking well against the model and actually are outperforming on a household growth basis.

Speaker 4

So that's Part of the reason why we're continuing the strategy and as we look ahead to next year, we did 22 new branches This year in total and we should do 35 or so next year primarily in the Southeast.

Speaker 13

And Jamie, when you get to that breakeven point, how much longer does it take to get to a return on investment or a return on equity, however you measure it, To have it at the level that you're very satisfied

Speaker 4

with. Yes. 5 years is really where Leading up to the 5 year mark, you then become profitable flip over probably at that 4.5 On a cumulative basis and then the earnings power really starts to accumulate beyond that.

Speaker 13

Very good. And then as a follow-up, yes, go ahead, Tim.

Speaker 3

I was going to say that these are investments with extremely high term If you look at the branches that we have across the network today, it is especially In the world where I think we have done a very good job of being able to integrate the digital investments that we make and the access to a human being in the local Right. We've talked a lot about the ways in which we're using analytics and other direct connection points to make sure that that's a seamless experience for customers. It just has proven to be a very strong long term recipe to grow the franchise. And The longer the Fed stays up, the faster the breakeven on those branches materializes and the more attractive that the returns look like, right?

Speaker 13

Yes, very true. Thank you. As a follow-up on credit, obviously, your credit quality is very strong similar to your peers. Maybe just remind us why are the customers, I mean, you look at all the economic outlooks you mentioned, Jamie, about Moody's, It was a little worse than what you had in the prior quarter in terms of building up the reserves. How is it that credit just remains so strong In view of these crosscurrents, particularly in the housing market starting to weaken.

Speaker 13

And then second, as part of this, Can you just share with us also about the used car prices? Obviously, they're finally starting to come down. You guys are in that market. And how does that impact maybe Future charge offs or delinquencies if prices continue to fall down.

Speaker 3

Yes. I'm going to let Richard provide more specificity. But, George, if you just Step back and look at it, because this is the conundrum that I think we find ourselves in as we look forward and think about how we run the business relative to the signal we've got today. On the consumer side of the equation, if you look at 5th Third consumer checking and deposit balances, They are essentially exactly where they were, about between 60% to 80% depending on the cohort you're looking at above where they were at in February of 2020. And that ratio has stayed more or less perfectly constant Since the 3rd stimulus check, okay.

Speaker 3

So there were with a temporary spike as tax refunds came in this past year, that money got spent down by and large over Summer, but it restabilized in that sort of 60% to 80% range, 1. 2, at least in our case, Such a significant percentage of our consumer exposure is to homeowners, right? It's 85% of total exposure and 75% of our credit card And auto customers are homeowners that they had an opportunity to lock in historically low Fixed rate mortgages and to manage housing costs in the past couple of years that I will allow them as long as they're seeing 4% to 5% wage inflation, which is kind of where we've been running to manage 7%, 8% headline CPI pretty well, right? And the byproduct of that is the liquidity buffers there and they have leverage over their costs in a way that others didn't. I think equivalently, Richard and I Have been out together in several markets recently talking directly with customers.

Speaker 3

And what we hear by and large is that customers have been able demand has Very strong and the customers have been able to exercise pricing leverage and to push input costs Through to their customers, right? I think the dynamic In fact, with them and in each case that they all remain more concerned by is, although supply chain pressures have eased a little bit, They're still concerned about the stability of global supply chains and are making investments to support that. And then labor is the other primary constraint right now. And there again, I think where there is good activity going on, a lot of it is going on to fund CapEx to drive labor productivity, so that labor requirements can go down at a given level of Demand. Now, first principles would tell you that with the Fed moving as rapidly as it is and with rates having headed The direction they have, that at some point here, the rate cycle has to turn into a credit cycle.

Speaker 3

And that I think is the reason why we've been Maybe more cautious in terms of some of our actions than it feels like we hear other people being Because we just think that's prudent at this point in time. But I mean, Richard, do you want to talk a little bit about some of the other specifics?

Speaker 10

Yes. I think the one

Speaker 9

thing to add on commercial, Gerard, is remember there's a loss emergent period. So it takes a little while for the stress to ultimately roll through loss. And I think what we see and Tim articulated a lot of it is our customers are adapting and they've had to adapt honestly for about 3 years now. Let's To go back to 2019, the tariffs were a challenge for a lot of supply chains and manufacturing. They had to They've learned that.

Speaker 9

You had COVID, you've had inflation. And so, we see resilient business owners do what they do and that's Adapt to the challenges and run their business as well. And I think that's part of the conversation and that's what we get from Our relationship managers talking to customers to really get good insight to what's happening on the ground. And I think as Tim said, there's more strength there from a fundamental Effective than perhaps people would otherwise believe. Now to your question on auto, I think the answer is auto is going to be a really Classic example of a normalization.

Speaker 9

And again, you've got a shorter generally shorter duration in terms of the asset and the loss emergence period. Have two things that are happening at the same time. 1, clearly, you can see it with Manheim, used car prices are down 10%, 12% and trending down, normalizing. At the same time, we're going to be rolling into originations where we bought it or customers bought at higher card prices. So We don't really see anything abnormal except for an acceleration of this intersection between car values And the originated loan to value getting back to something that looks more normal.

Speaker 9

Again, it's a super prime book for the most part. We're disciplined on the underwriting. The resilience when you look at things like delinquencies continue to be very, very good. In fact, they're at Continue to be at seasonal lows. So I think it's just this intersection of prices coming down and loan origination prices coming up.

Speaker 13

And then just one quick follow-up on that. During this financial crisis with housing and many times houses fell below The mortgage value and people, if they were unemployed and couldn't afford it, walked away from the house. If auto loans really go upside down and loan to values Start to get up to 120%, 130% because of the Mannheim number keeps falling. Have you guys seen any History of people literally just turning the keys over to the car because the loan is upside down or is that really not a factor in the auto market?

Speaker 9

It's certainly not a factor today. In fact, Gerard, if anything, think about where auto prices have gone. You're seeing we're seeing customers and we see this across the spectrum that we don't lend into. They don't want to have to go turn their car in and buy a new one. It's too expensive.

Speaker 9

So they're doing a lot of things To keep their car and to stay current or work through with the lenders. We don't see a lot of that because we don't really have that situation given The quality of our consumer, but right now, I think people if they have a job, they want to keep their car, they don't want to go buy new.

Speaker 13

Great. Okay. Thank you.

Speaker 8

Thank you.

Speaker 1

Today's final question will come from the line of Bill Carcache with Wolfe Research. Please go ahead.

Speaker 3

Hey, Bill.

Speaker 12

Hi, good morning. Thanks. Hey, good morning. Tim and Jamie, I really appreciate hearing your thought process on the earlier question about TCE. Would your response to that question change If we had a credit cycle and the Fed wasn't able to lower rates due to inflation, so the securities portfolio wasn't able to add as much of a Shock absorber, as you described earlier.

Speaker 12

And then to bring that back to the broader question, is there a point where decreases in TCE would become a concern for you in that scenario in particular?

Speaker 4

Well, I guess first off, we've been Accreting capital just through the strong earnings power of the company, that's going to continue. As Tim mentioned, CET1 will grow In the Q4, so obviously that will help the TCE ratio and then when we pick up the buybacks next year, We'll run the company at that 9.25 CET1 level. That's our expectation. If there's a credit cycle, credit events, I think we will be very happy that we have the portfolio we do given the structure as well as the duration that we have. So I'm not worried about the performance of the investment portfolio.

Speaker 4

I would say that it's probably the best portfolio in the industry. So we feel good about that.

Speaker 12

That's helpful. Thank you. And separately on the funding side, can you speak to your ability to Bring off balance sheet client funds back on balance sheet and the potential amount That is available in theory?

Speaker 4

Yes. Right now, there's about $4,000,000,000 in our client liquidity portal. And Then there's also opportunity within the Wealth and Asset Management business. But again, that would just come down to the Willingness to pay 100 percent beta type of pricing and at this point in time there's no need to do that. But if we wanted To match money market rates, we could certainly bring more deposits back onto the sheet.

Speaker 3

Very

Speaker 12

helpful. Thank you for taking my questions.

Speaker 3

Thanks, Bill. Thank you.

Speaker 1

At this time, I would like to turn the call back over to Chris Doll for any Closing remarks.

Speaker 2

Thanks, Dennis, and thanks, everyone, for your interest in 5th Third. Please feel free to contact the Investor Relations department if you have any follow-up questions. Dennis, you can now disconnect the call.

Speaker 1

Thank you. Ladies and gentlemen, this does conclude the 5th Third Bancorp 3rd quarter 2022 earnings conference call. Thank you for your participation. You may now disconnect.

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Earnings Conference Call
Fifth Third Bancorp Q3 2022
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