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Guest Post: “Long case for Fifth Third Bancorp” by Ryan Yamada

**Note from Jeffrey: Not seeing much in this market you can hold for more than a couple hours, so haven’t written about any opportunities for investments or longer term trades. Here’s one from my college buddy Ryan Yamada. Ryan’s got a great blog, Sunburnt Sky, on Politics and Macroeconomics. Take a gander. **

LONG CASE FOR FIFTH THIRD BANCORP (FITB) by Ryan Yamada

Note: This is not a rigorous analysis on either the fundamental or technical side. It’s simply an observation based on the price action of other sizable regional banks following events similar to those experienced by Fifth Third Bancorp.

Introduction:

Fifth Third Bancorp (NASDAQ:FITB) this last week is a regional bank headquartered in Cincinnati, OH, with about $67.3 bn in assets, and $41.1 bn in deposits, according to the FDIC as of Oct 28, 2008 (Thursday). I compared the figures with the June 30, 2008 report from FDIC and they are comparable: assets: $67.3 bn; liabilities: 61.8 bn; deposits: $41.6 bn; equity capital: $5.43 bn. Stock prices, incidentally, are also comparable (June 30: $10.18; Oct 28: $10.72) for the two dates.

The last few weeks have been nuts for the entire market. But in particular, regional banks are seeing a lot of volatility, and increasingly, sharp increases in share price.

SunTrust: assets: 171.5 bn, liabilities: 152.2 bn, deposits: 120.9bn, equity: 19.3 bn

PNC: assets: 128.3 bn; liabilities: 116.3 bn; Equity capital: 12.1 bn

Price increases are event driven:

Here are a few events that dramatically changed the outlook for FITB:

Aug 1: First Priority Bank is closed by the FDIC – SunTrust receives $254m in deposits (at zero premium) and purchases an additional $36m in cash-equivalent assets (total of $290m).

Sep 30: IRS rules that acquirers of weak banks can apply “losses on loans and bad debts” without limits.

Oct 24: PNC Financial Services Group Inc. announces acquisition of National City Corporation for $5.6 bn, increasing its deposit base by $90 bn and potentially earning offsets on $5.1 bn in taxes from loan losses associated with National City.

Oct 26: FITB announces that it has applied for capital from the Treasury’s Capital Purchase Program (CPP).

Oct 27, 2:28pm, Reuters: Fitch announces a downgrade of Issuer Default Ratings on municipal bonds to A from A+; Fitch had downgraded the IDRs of FITB to A+ and F1 in June 18, but these downgrades were erroneously not passed through to the ratings of muni bonds supported by FITB. In other words, some of them were downgraded from AA- to A. (http://www.reuters.com/article/bondsNews/idUSWNA768820081027)

Oct 28, 12:20 pm: FITB to accept $3.45 bn as part of the Treasury’s CPP. Treasury receives senior preferred securities with 5% dividend for first 5 years and 9% thereafter. Shares are callable at par after three years. 10-year warrants on common stock on 15 percent of the preferred stock investment ).

Oct 29., 2:17 pm: Ladenburg Thalmann analyst Richard Bove cuts outlook on concerns about poor lending habits.

2008 estimate: 16 cents/sh (from 53 cents/sh)

2009 estimate: 94 cents/sh (from $1.30/sh)

Oct 31, 6:21 pm: FITB to accept $227m in deposits and $36 in assets from the FDIC, receiver for Freedom Bank. The additional deposits from Freedom Bank give them about a 59% larger deposit base in the Bradenton-Sarasota-Venice Metropolitan Statistical Area.

Important dates coming up:

Nov 4: Presidential election

Nov. 14: Companies must notify Treasury by 5 p.m. EST if they want to apply for the Capital Purchase Program.

Let’s look at the following events and see what similar events for other banks did for their share prices:

1. Capital Purchase Program funds
2. Acquiring deposits from FDIC-seized banks
3. Acquisition of weaker rivals with sizable deposit banks and losses that can be credited to acquirer’s future capital gains.

1. Capital Purchase Program Funds

FITB announced on the 28th that it would receive $3.45 bn in funds from the US Treasury’s Capital Purchase Program (CPP). Under CPP, the Treasury receives senior preferred securities with 5% dividend for first 5 years and 9% thereafter. Shares are callable at par after three years. Furthermore, the Treasury receives 10-year warrants on common stock on 15 percent of the preferred stock investment .

The new funds give FITB options above and beyond their relatively bleak choices prior to the announcement.

According to CNN, Fifth Third had announced in June a capital plan that included raising its capital ratio targets, including a Tier 1 ratio of 8-9 percent. The recent Fed infusion would push Tier 1 to 11.5 percent. FITB’s Chairman/President/CEO Kevin Kabat also indicated that they may postpone plans floated in June to sell “non-core assets”. In other words, the Treasury funds will help them avoid trying to unload assets at fire sale prices.

There was an immediate impact on share prices. FITB was off session lows of $8.15 and was trading at 8.50 when news broke – the stock price jumped 13.5% to $9.65, and then followed the broader market’s large gains to close at $10.76, up 26.5% from levels prior to the news. Tuesday’s price rise translated into a 1.3 billion increase in shareholder equity. The government warrants are callable in 10 years, so their immediate impact is non-dilutive. The preferred shares, while receiving a dividend, are non-convertible, unlike FITB’s June issue of $1.1 bn in convertible preferred stock.

The dividend due to the government on the infusion is about $172.5 m per year. To pay off just this dividend, FITB can either make loans of $2.88 bn ~6%. Subtracting required reserves of $288 m, this leaves $3.16 billion for acquisitions and loan loss reserves. Alternatively, FITB may try to acquire weaker competitors at discounted prices, in the model of PNC’s takeover of National City Corporation at a discount.

Note that this infusion represents a 65% gain on FITB’s asset base, compared with a 28.9% gain on PNC’s asset base. Consequently, I would expect an overall move from 1-2.25 times the size of the move from PNC’s gains.

As a rough estimate, let’s take the $3.16 bn, and subtract the amount by which stock equity has already increased ($1.3 bn). This leaves $1.86 bn. Even if 50% of that goes to loan loss reserves (and is used for that purpose), that still leaves $930 million. And, assuming that FITB finds no better use for it than to sit in a digital safe somewhere, that still represents an increase of 14.8% in net equity (based on Friday’s closing market cap of $6.27 bn). So, very conservatively, I can estimate an additional appreciation of +15%

(Summary: +15-66% because of additional equity capital)

2. Acquiring deposits from FDIC-seized banks

I calculated the impact of the additional deposits relative to existing deposits and assets, and how it could affect net assets (in the unrealistic event that FITB chose to loan out all the cash).

Freedom Bank FITB pct chg 10x ($mm) asset growth potential ($mm)
Deposits ($mm) 254 41604 0.70% 2900 4.13%
assets purchased/ total assets ($mm) 36 67272
FDIC cost ($mm) 80-104

For comparison, I look at a similar action taken in June when Suntrust took over First Priorty bank, also located in Florida.

First Priority Suntrust pct chg 10x ($mm) asset growth potential ($mm)
Deposits ($mm) 227 119800 0.22% 2690 1.52%
assets purchased/ total assets ($mm) 42 177400
FDIC cost ($mm) 72

How did Suntrust perform after that? The chart below illustrates it best.

In terms of raw numbers, it looks like STI appreciated 15.2% over the week prior to the announcement, a premium of 6.4% over XLF (+8.8%) and 13.1% over the S&P500 (+2.1%). On Monday, after the announcement, STI closed for a gain of +1.9%, outperforming XLF and S&P 500 by 2.3% and 2.9%, respectively. Over the week after the announcement, it rose by 8.0%, a premium of 4% over XLF (+4.0%) and 3.5% over the S&P 500 (+4.5%) over the next week.

It’s not to say that all of the Suntrust movement was due to the deposit acquisitions, but a search of news stories indicate that most other important events happened outside that time period. (For example, a disappointing Q2 report happened on Jul 22, while the announcement that the dividend would not be cut happened on Aug 12. (The dividend was subsequently cut on Oct 27.) So, I would argue that at least a large portion of the price action, relative to the overall markets, was in response to this particular piece of news about the acquired deposits. (If talk surrounding the other news did affect the price action this day, then it would’ve affected it negatively, and the analysis would price in even greater gains from the deposit acquisition.)

A comparison to the week’s actions prior to the FDIC announcement for FITB is more complicated, especially since so much news happened. Here’s a chart with some of the important news events highlighted.

During the last week, FITB rose by 28.1%, while XLF rose 14.1% and the S&P by 14%. However, looking at just the action over the last three days, FITB rose only +0.8%, while XLF rose +3% and the S&P 500 fell 2.2%. So while FITB performed 3% better than the S&P over those last few days, it lagged XLF by 2.2%.

I’ll also note that FITB experienced a 6% increase in the last 15 minutes of trading, a full 2% more than XLF and 4% more than the S&P 500. There was a slight pullback after-hours, then another spike after the announcement.

Note that the asset growth potential supplied by the additional deposits is 3 times that enjoyed by Suntrust on a percentage basis. FITB is also taking the deposits at a slight premium (1.16%), while Suntrust took them without one.

Using the STI price action as a guide, we might reasonably expect FITB to outperform XLF by 4% and the S&P 500 by 3.5% over the next week. If I adjust for the last-minute spike, FITB could be expected to outperform XLF by about 2% and lag the S&P 500 by around 0.5%.

(Estimate contribution: +2% rel. XLF; -0.5% rel. SPY)

  1. Acquisition of weaker rivals with sizable deposit banks and losses that can be credited to acquirer’s future capital gains.

As mentioned above, Suntrust probably has at least $3.16 billion of the Treasury CPP funds for acquisitions and loan loss reserves, and potentially more from its recent increase in share equity, its issue of preferred securities, and its spare cash on hand. FITB may try to acquire weaker competitors at discounted prices, in the model of PNC’s takeover of National City Corporation at a discount.

That’s why FITB has the potential for a short-term trade on the long side. Yes, long-term the new deposits and CPP funds will help them make more loans. But in the near-term, it gives them ammunition to take over their weaker neighbors, particularly banks that have (1) sizable deposits, (2) don’t yet have access to CPP funds, and (3) are in trouble because of bad loans. National City Corporation had all three properties, and since the present environment favors the shareholders of the acquirer rather than the target, this spells short-term appreciation for FITB shares.

Note that PNC jumped 3.5% on Friday, Oct 24, while XLF fell 6.5% and the S&P fell 3.5%. The NCC acquisition allowed PNC to outperform by 10% the XLF and 7% the S&P 500. Since the deal was announced, PNC has essentially traced both XLF (0%) and slightly outperformed the S&P 500 (+3%). It is up in nominal terms 17% since the announcement.

It’s difficult for me to estimate how much of the gain was due to the Treasury CPP funds, and how much in response to the acquisition of NCC. I will estimate, as I did above, that the increase in Treasury funds led to an increase in NAV. PNC has assets of $128.3bn; liabilities of $116.3bn, and therefore an equity capital of $12.1 bn. Applying a similar sort of analysis as before, PNC will need to pay about $175m in interest on the preferred shares to the Treasury each year for the next five years. Assuming it can make new loans of about $2.9bn, it needs to set aside $292m for reserves, leaving it with $3.2 bn in additional equity. Applying 50% of that to loan loss reserves, and 50% to shareholder equity, I come up with an increase in equity capital of 26.5%.

PNC’s share price did not jump 26.5%, or anywhere near that amount. The combined value placed by the market is 17%. As a guide, then, only 2/3 of the equity capital increase has been priced in, and none of the increase from what is widely being considered a good acquisition deal for PNC.

Since I don’t know how much of the price increase can be accounted for by each component, I am going to say that the short-term gains from BOTH the CPP funds AND the acquisition of a weaker rival with the three criteria listed above translates into a gain roughly equal to 2/3 of the initial equity capital increase. The market is either pricing in an inability for the new banks to make new loans, keep existing loans current, or successfully acquire rivals at a discount, or otherwise have greater difficulty financing their loans than I have assumed here.

Let me further build in a margin of error by saying that FITB may find a deal only about 60% as good as the NCC deal. This translates into an anticipated increase in FITB of 60% x 66% = 40% of the increase in equity capital supplied by CPP.

This still means that when FITB announces its 60%-as-good-as-PNC’s-NCC deal, FITB’s combined appreciation over its price prior to the CPP announcement should be an increase of 40% from its Tuesday noon price of 8.50, taking it to 11.90. This represents a $1.25 or 11.7% premium over Friday’s close.

Political Risk?

The PNC-NCC deal has caused some uproar in the halls of Congress, so there is some political risk that stricter guidelines might be placed on CPP funds. I’m not sure how difficult it would be to do that retroactively, however. Congress might push through something, but that would be after the Nov 4 elections, and likely after the deadline of Nov 14 for banks to apply to CPP anyway. Based on this, I would assume that retroactive restrictions on CPP funds would be difficult, if not impossible. In the unlikely event that greater restrictions could be made on subsequent tranches of the $700 bn, this would affect new applicants, and therefore put FITB and other early recipients at a relative advantage.

Let’s summarize:

Short-term gain from CPP+acquisition: +11.7%

Short-term gain from acquired deposits: -0.5%

Combined with an expected bump Monday of about -0.5% from the news of new deposits combined with the last-minute rally, and I would anticipate at minimum 11% upside for FITB, corresponding to a share price of $11.93 in the very near term, assuming no market appreciation or depreciation.

Naturally, the price targets increase for broader market gains, and decrease for market losses. Since I anticipate modest losses or gains, I will play it safe and enter into a position at prices below $11.00 and will likely sell out following announcement of an acquisition by FITB.

I would also hurry. Barron’s mentioned FITB in a recent article, and while I would hardly consider buying on news from Barron’s, it will mean that more people will be looking at this stock and coming to similar conclusions.

Disclosure: none, though author intends to be long FITB.

**Disclosure: No positions.**

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