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Solid Quarter for Truist as Strong Fee Growth ShinesMorningstar's Analysis Solid Quarter for Truist as Strong Fee Growth Shines Eric Compton Senior Equity Analyst Analyst Note | by Eric Compton Updated Jul 15, 2021 Narrow-moat-rated Truist Financial reported solid second-quarter results, beating FactSet consensus EPS of $0.98 with reported EPS of $1.16. These results equate to a return on average tangible equity of 18.9%. Adjusted for items such as merger-related restructuring, ROTCE would have been 24.7%. While most peers have found the bottom for net interest income), Truist’s NII remains under pressure due to purchase accounting accretion, which will continue for some time. Fees had a strong performance, with adjusted noninterest income up 11% sequentially and 13% year over year, despite the second quarter of 2020 being a record quarter for the bank. Truist also released reserves of just under $600 million, which was even better than last quarter. This led to a provisioning benefit during the quarter. Expenses continue to be elevated due to merger-related items, but the bank remains on track to meet its expense-saving goals. Overall, we thought results were good for the bank, with fee income coming in strong and expenses remaining on track. After incorporating these results, we are maintaining our $61 fair value estimate. Business Strategy and Outlook | by Eric Compton Updated Jul 15, 2021 BB&T and SunTrust have completed their merger, forming Truist, which we believe will drive the next step up in profitability for the franchises. BB&T brings its conservative lending culture and solid community banking operations, along with its unique insurance brokerage capabilities. SunTrust brings its own unique investment banking franchise, Robinson Humphrey, into the merger, along with its digitally focused consumer lending operations, namely its LightStream platform. While dealing with the economic fallout of COVID-19 will eat up time and effort, we still think Truist can remain focused on executing a successful integration, merging the cultures, and finding cost savings and revenue synergies. Progress thus far supports the thesis that there have not been any material disruptions to progress. Before the merger, BB&T had largely digested its previous acquisitions, and the bank had been firing on all cylinders. We like BB&T's conservative lending culture, one of the best under our coverage. In addition to the bank's traditional lending businesses, we believe BB&T's ability to generate fee revenue is attractive, most notably through its insurance brokerage operations. Truist has only been adding to its strength in insurance with the acquisition of Regions Insurance Group as well as multiple smaller acquisitions in 2020. We like the strength of SunTrust's investment banking group and believe the bank will have room to increase noninterest revenue over time. We also like the bank's strategy of focusing on its core, corporate client base and bringing more investment banking offerings and expertise to generate more fees. SunTrust also offers investment management and trust services, and is building out further treasury and payments platforms, which should add to fee income over time. Overall, we like the progress that Truist has made on its integration efforts. We expect cost savings to really start falling to the bottom line in 2021 and to continue through 2023. We believe management's goal of become a top-tier bank from the standpoint of efficiency and return on tangible equity is realistic, and we expect Truist to be a top performer in the coming years. Economic Moat | by Eric Compton Updated Jul 15, 2021 After the combination of BB&T and SunTrust (BB&T had a narrow moat rating, SunTrust had no moat), we are assigning a moat rating of narrow to Truist. BB&T was the larger of the two franchises, and we see material cost savings and therefore operating improvements from the merger. With superior credit efficiency (stemming from BB&T's operations), operating efficiency in the top quartile of U.S. regionals under our coverage (particularly after incorporating cost savings from the merger), and a decent cost of deposits, Truist deserves a narrow moat rating, in our view. We forecast Truist earning returns that exceed its cost of equity of 9% going forward. We believe bank moats are derived primarily from two sources: cost advantages and switching costs. We see cost advantages as stemming from three primary factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting, with regulatory costs being a final factor that must also be considered. BB&T has generally had superior underwriting as displayed by its net charge-off ratio and provisioning amounts through the most recent financial crisis. It is often only during a downturn that the true nature of a bank’s loan portfolio is revealed. During the heart of the crisis in 2009, when many U.S. regionals were experiencing provisioning levels of over 100% of net interest revenue, BB&T's peaked at roughly 60%. Avoiding these types of significant losses helps preserve returns on equity over the long term. We believe BB&T's superior credit culture will stay intact after the merger, helping Truist institute similar internal policies and abilities. We believe the implicit switching costs in retail and commercial banking also help Truist maintain its deposit base and its banking relationships. While switching is nominally free, the benefits are often unclear: Bank products are similar across firms, checking accounts are nominally free, and costs come through cross-sold products along with miscellaneous fees and fines. Moreover, switching is viewed by customers as troublesome, especially for customers--like those of Truist--who purchase multiple products from a bank. Truist does have credit card services as well as trust and wealth management, investment banking, and insurance operations, all helping to increase the number of services it can provide for each client. From an operational standpoint, we forecast that Truist will have an efficiency ratio in the low 50s. This will be driven by BB&T's historically good operating efficiency as well as the material cost savings we see coming from the merger. Truist is now one of the largest regional banks under our coverage, and we see this scale driving material improvements in operating efficiency, further bolstering the moat. Truist has significant nonbank operations, most notably its insurance brokerage business (from BB&T). For insurance brokerage, the size and depth of the network matter, and Truist is the fifth-largest broker in the world by revenue. We believe this is an attractive business for Truist and its network is an asset. We calculate that Truist earns margins on this business comparable with some of the largest players and that this segment boosts overall returns on equity for Truist, complementing its moat. From a systemic standpoint, we believe the U.S. banking system has improved over the last decade, as capital levels supporting the banking system are at all-time highs. Further, regulation has become considerably stronger in the past several years. The U.S. banking market is quite fragmented, and Truist must compete with a variety of regional and community banks as well as large money center institutions, although this fragmentation has gradually decreased since the 1990s. While the banking sector is intensely competitive, the largest banks by asset size have generally been able to earn higher returns on equity for the last several decades, and still do so today. Our outlook is generally positive from a macroeconomic and political standpoint for the U.S. banking system, as the U.S. is still the world's leading democracy, has increased GDP at a steady pace for years, and maintains the world's reserve currency, all of which contribute to banking stability. Truist is not large enough to be considered a global systemically important bank and therefore avoids some of the more onerous regulatory capital requirements. However, it is large enough to be subject to the Federal Reserve's annual stress tests because it has more than $250 billion in assets. The bank is only subject to the modified liquidity coverage requirements. We do not view Truist’s regulatory burden as relatively disadvantageous compared with the other U.S. regionals in its peer group. Truist’s size is large enough to help scale some of these costs and is small enough to avoid some of the extra costs faced by its largest peers. Further requirements will be triggered once Truist surpasses $700 billion in assets. Fair Value and Profit Drivers | by Eric Compton Updated Jul 15, 2021 After updating our projections with the latest quarterly results, we are maintaining our fair value estimate of $61 per share. This incorporates a 100% chance of a 26% statutory tax rate and also incorporates rate hikes in late 2023. This values Truist at roughly 2.3 times tangible book value as of June. Our base-case scenario assumes that the bank's efficiency ratio eventually declines to 52% as management exercises discipline on costs and continues to make technological gains. Net interest income will be messy for the time being as Paycheck Protection Program-related NII and purchase accounting accretion play out, but we see the net effect being a decline in NII through 2023. We also forecast that rates will stay low for years before normalizing higher. We see net charge-off ratios normalizing to 0.5%. Despite the pressure from the pandemic, we expect that Truist is already more than reserved for the losses that will transpire, resulting in much lower provisioning for the next year or two. We expect noninterest income to grow at a mid-single-digit compound annual rate of 3%-4%. This leads to an average return on tangible equity of 15% for our forecast period compared with our cost of equity of 9%. Risk and Uncertainty | by Eric Compton Updated Jul 15, 2021 Truist has been an active acquirer of other banking institutions. BB&T had recorded over 25 bank acquisitions alone since 2000, with SunTrust also recording some of its own bolt-on deals during the same time period. Thus, Truist faces the risk that its deals could eventually destroy shareholder value via overpaying or poor integration. We don't view this as likely, as Truist has generally been a smart acquirer. The latest merger between SunTrust and BB&T likely presents the highest execution risks to date, given the relative sizes of each firm. Watching the cultural integration while expense savings are pursued will be key. We view the macroeconomic backdrop as the other primary risk to the bank. Truist’s future profitability will largely be determined by the interest-rate cycle as well as the effects of credit and debt cycles, all of which are not under management’s control. In addition, Truist is subject to the Federal Reserve's annual stress tests. From an environmental, social, and governance perspective, commercial banks are expected to have strong product governance. Predatory or discriminatory lending practices are examples of poor product governance, which can affect certain banks at times. We view most product governance and social risks as manageable and incorporate a steady level of operational expenses related to compliance and litigation in our models. Outside of the rare, headline-grabbing scandals, we don’t see social risks as having a material effect on our valuation. Banks also lend to sectors that can come under more scrutiny at times, like gun manufacturers or energy. Commercials banks don’t directly have a large environmental footprint and governance practices are in line with most companies. We assign our U.S. regional banks a medium uncertainty rating. We believe this best captures the spread between our bear and bull cases. Capital Allocation | by Eric Compton Updated Jul 15, 2021 We give Truist a Standard capital allocation rating. In our opinion, the company’s balance sheet is sound, its capital investment decisions are standard, and its capital return strategy is appropriate. Truist is currently in line with management's targeted common equity Tier 1 ratio of 10%, and we view this as appropriate. We view the company's capital investments as standard. Historically, BB&T generally avoided investing capital in value-destroying products and did well during the financial crisis of 2008, while pursuing acquisitions that generally created better scale. We think the merger between BB&T and SunTrust will be the most transformative yet for the bank. We assess the company’s capital return strategy as appropriate. Truist, like most banks, returns more capital through share repurchases than dividends, which makes sense for a company whose earnings can be volatile and where dividend cuts are best avoided. Kelly King has been chair of BB&T/Truist since January 2010 and CEO since January 2009. King is a longtime BB&T executive who served as chief operating officer before ascending to the CEO job. King has done an admirable job leading BB&T through many acquisitions and different credit environments. He will remain CEO of Truist through late 2021 and will remain on the board of directors through 2023. William Rogers is Truist's COO and will take over as CEO following the planned transition from King. Rogers had assumed the CEO role of SunTrust in 2011 after serving as chief operating officer in 2010. He has been with SunTrust since 1980, and we believe he has the necessary experience to effectively run the bank. We are positive overall on the merger between SunTrust and BB&T and believe this move will add value for shareholders. While a merger of equals is fraught with risk, given how the deal has been structured and how management will be equally shared, it appears the banks are approaching this the right way. We also believe management (particularly for BB&T) has maintained a more conservative underwriting culture, helping maintain a credit cost advantage over time. Finally, we like management's latest focus on investing in technology (one of the major reasons for the merger), increasing automation behind the scenes (and therefore operating efficiency), and also a willingness to further optimize the bank's branch footprint. |
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