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Fifth Third Bancorp’s (FITB - Analyst Report) third-quarter adjusted earnings of 42 cents per share exceeded the Zacks Consensus Estimate of 39 cents. Results also came in ahead of the year-ago earnings of 40 cents.

Better-than-expected results reflected improved net interest and non-interest income. Moreover, enhanced credit quality was a positive. However, a decline in the top line is a concern.

Including debt extinguishment costs of 2 cents related to the redemption of trust preferred securities (TruPS), negative adjustment on the valuation of Vantiv warrants of one cent, additional charges of 2 cents associated to an increase in mortgage representation and warranty reserve gain on the valuation of the warrant Fifth Third holds in Vantiv as well as income on the sale of certain Fifth Third funds of a cent, the company reported net income of $354 million or 38 cents per share in the reported quarter. In the year-ago quarter, net income was reported at $373 million or 40 cents.

Total revenue came in at $1.70 billion, substantially higher the Zacks Consensus Estimate of $1.57 billion. However, revenue inched down 1% year over year, reflecting a decline in interest income, partially offset by non-interest income.

U.S.-based Vantiv was formerly known as Fifth Third Processing Solutions (“FTPS”), a payment processing company. Fifth Third had spun-off FTPS in 2009 after which a joint venture was initiated between Advent International and Fifth Third Bank – a subsidiary of Fifth Third. The company was named Vantiv in June 2011. Notably, Vantiv Inc. (VNTV - Snapshot Report) opted for an initial public offering of Class A shares on the company. The offering was completed in March 2012.

Quarter in Detail

Fifth Third’s net interest income came in at $907 million, up 1% year over year. The improvement was driven by higher average loan balances, run-off in higher-priced CDs and mix shift to lower cost deposit products, partially offset by lower asset yields. Net interest margin came in at 3.56%, down 9 basis points (bps) from the year-ago period.

Excluding loans held-for-sale, average loan and lease balances increased 5% year over year. Average core deposits climbed up 4% year over year.

Fifth Third’s non-interest income marginally grew 1% year over year to $671 million. The increase was attributable to higher mortgage banking and corporate banking revenues. These positives were partially mitigated by lesser net gains on investment securities, card and processing revenue as well as service charges on deposits.

However, the company’s non-interest expenses advanced 6% from the year-ago quarter to $1.0 billion. In the quarter under review, the company experienced $26 million of debt extinguishment costs related to the redemption of TruPS; $22 million of additional costs associated with the increase in the mortgage representation and warranty reserve; $5 million benefit from the sale of affordable housing investments; and $2 million of expenses related to the sale of Fifth Third funds.

In the year-ago quarter, expenses included $28 million of costs related to the termination of certain Federal Home Loan Bank (FHLB) borrowings and hedging transactions. Excluding these items, expenses advanced 5% from the prior-year period due to higher compensation costs.

Credit Quality

The company’s credit metrics improved in the reported quarter. Net charge-offs were $156 million or 75 bps of average loans and leases compared with $181 million or 88 bps recorded in the prior quarter and $262 million or 132 bps in the prior-year quarter. This marked the lowest level since the third quarter of 2007.

Provision for loans and leases descended 8% sequentially and 25% year over year to $65 million. Total nonperforming assets, including loans held-for-sale, were $1.5 billion or 1.73% of total loans, leases and other real estate owned (OREO). It fell 11% from the prior quarter and 30% from the prior-year quarter.

Capital Position

Fifth Third’s capital ratios were a mixed bag in the reported quarter. The Tier 1 common equity ratio increased 34 bps on a year-over-year basis to 9.67%. The tangible common equity to tangible assets ratio was 9.10% (excluding unrealized gains/losses) and 9.45% (including unrealized gains/losses) compared with 8.63% and 9.04%, respectively, in the prior quarter.

The Tier 1 capital ratio declined 111 bps year over year to 10.85%. The Leverage ratio increased one bps to 10.09% and the total capital ratio declined 149 bps to 14.76% in the quarter.

Fifth Third posted an increase in both book value and tangible book value per share. As of September 30, 2012, book value per share was $14.84 and tangible book value per share was $12.12, up from $13.73 and $11.05, respectively, as of September 30, 2011.

Capital Deployment Activity

In August, 2012, Fifth Third entered into a share repurchase agreement with a counterparty, whereby Fifth Third would purchase roughly $350 million of its outstanding common stock. During the reported quarter, this transaction reduced the company’s share count by 21.5 million shares. Fifth Third anticipates the settlement of this transaction on or before November 26, 2012.

Our Take

Going forward, with a diversified traditional banking platform, Fifth Third remains well poised to benefit from a recovering economy along its footprints. Its traditional commercial banking franchise, diverse revenue mix, improved credit quality and enhanced capital position serve as positive catalysts for the stock. Further, we believe that its dividend growth story will boost shareholders’ confidence in the stock.

However, a low interest rate environment, regulatory issues as well as competitive pressures are the headwinds.

Fifth Third currently retains a Zacks #2 Rank, which translates into a short-term Buy rating. However, considering the fundamentals, we maintain a long-term Neutral recommendation on the stock.

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