Fifth Third Bank 2005 Annual Report Download - page 25

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Fifth Third Bancorp 23
OVERVIEW
This overview of management’s discussion and analysis highlights
selected information in the financial results of the Bancorp and
may not contain all of the information that is important to you. For
a more complete understanding of trends, events, commitments,
uncertainties, liquidity, capital resources, risk factors and critical
accounting policies and estimates, you should carefully read this
entire document. Each of these items could have an impact on the
Bancorp’s financial condition and results of operations.
The Bancorp is a diversified financial services company
headquartered in Cincinnati, Ohio. The Bancorp has $105.2 billion
in assets and operates 19 affiliates with 1,119 full-service Banking
Centers and 2,024 Jeanie® ATMs in Ohio, Kentucky, Indiana,
Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania
and Missouri. The financial strength of the Bancorp’s largest banks,
Fifth Third Bank and Fifth Third Bank (Michigan), continues to be
recognized by rating agencies with deposit ratings of AA- and Aa1
from Standard & Poor’s and Moody’s, respectively. Additionally,
the Bancorp is recognized by Moody’s with a senior debt rating of
Aa2. The Bancorp operates four main businesses: Commercial
Banking, Retail Banking, Investment Advisors and Fifth Third
Processing Solutions (“FTPS”).
Fifth Third believes that banking is first and foremost a
relationship business where the strength of the competition and
challenges for growth can vary in every market. Our affiliate
operating model provides a competitive advantage by keeping the
decisions close to the customer and by emphasizing individual
relationships. Through our affiliate operating model, individual
managers, from the banking center to the executive level, are given
the opportunity to tailor financial solutions for their customers.
The Bancorp’s revenues are fairly evenly dependent on net
interest income and noninterest income. During 2005, net interest
income, on a fully taxable equivalent (“FTE”) basis, and
noninterest income provided 54% and 46% of total revenue,
respectively. Therefore, changes in interest rates, credit quality,
economic trends and the capital markets are primary factors that
drive the performance of the Bancorp. As discussed later in the
Risk Management section, risk identification, measurement,
monitoring, control and reporting are important to the
management of risk and to the continuation of the strong financial
performance and capital strength of the Bancorp.
Net interest income, which continues to be the Bancorp’s
largest revenue source, is the difference between interest income
earned on assets such as loans, leases and securities, and interest
expense paid on liabilities such as deposits and borrowings. Net
interest income is affected by the general level of interest rates, the
relative level of short-term and long-term interest rates, changes in
interest rates and changes in the amount and composition of
interest-earning assets and interest-bearing liabilities. Generally,
the rates of interest the Bancorp earns on its assets and owes on its
liabilities are established for a period of time. The change in market
interest rates over time exposes the Bancorp to interest rate risk
through potential adverse changes in net interest income and
financial position. The Bancorp manages this risk by continually
analyzing and adjusting the composition of its assets and liabilities
based on their payment streams and interest rates, the timing of
their maturities and their sensitivity to changes in market interest
rates. Additionally, in the ordinary course of business, the Bancorp
enters into certain derivative transactions as part of its overall
strategy to manage its interest rate and prepayment risks.
The Bancorp is also exposed to the risk of losses on its loan
and lease portfolio as a result of changing expected cash flows
caused by loan defaults and inadequate collateral, among other
factors.
Noninterest income is derived primarily from electronic funds
transfer (“EFT”) and merchant transaction processing fees,
fiduciary and investment management fees, banking fees and
service charges and mortgage banking revenue.
Net interest income, net interest margin, net interest rate
spread and the efficiency ratio are presented in Management’s
Discussion and Analysis of Financial Condition and Results of
Operations on an FTE basis. The FTE basis adjusts for the tax-
favored status of income from certain loans and securities held by
the Bancorp that are not taxable for federal income tax purposes.
The Bancorp believes this measure to be the preferred industry
measurement of net interest income as it provides a relevant
comparison between taxable and non-taxable amounts.
Fiscal 2005 was a challenging year. The continued flattening
of the yield curve, reduction in contribution from the largely fixed-
rate securities portfolio, increased operating costs largely related to
sales force additions, technology and de-novo investments and
elevated charge-off experience in the fourth quarter contributed to
nominal earnings per share growth and flat revenue performance
for the year. The Bancorp did, however, continue to experience
strong loan growth as well as a rebound in deposit growth trends
following the implementation of the new deposit pricing strategy in
the second half of 2005. Although net interest income will
continue to be negatively impacted in 2006 by the overall
contribution from and continued reductions in the securities
portfolio, the benefits from the recent investments in the banking
center distribution network, sales force expansion and technology
infrastructure should drive improved financial trends in 2006.
The Bancorp completed its acquisition of First National
Bankshares of Florida, Inc. (“First National”), a bank holding
company with $5.6 billion in assets located primarily in Orlando,
Tampa, Sarasota, Naples and Fort Myers, on January 1, 2005. The
Bancorp completed its conversion activity associated with the First
National acquisition in the first quarter of 2005. As of December
31, 2005, the Bancorp’s Florida affiliates have 86 full-service
locations, of which 74 were acquired as part of the First National
acquisition.
The Bancorp’s net income was $1.55 billion in 2005, a two
percent increase compared to $1.53 billion in 2004. Earnings per
diluted share were $2.77 in 2005, a three percent increase from
$2.68 in 2004. The Bancorp’s dividend in 2005 increased to $1.46
per common share from $1.31, an increase of 11%.
Net interest income (FTE) decreased two percent compared
to 2004. The net interest margin decreased from 3.48% in 2004 to
3.23% in 2005 largely due to the rise in short-term interest rates,
the impact of the primarily fixed-rate securities portfolio and mix
shifts within the core deposit base. Noninterest income was flat,
predominantly due to the $157 million pre-tax gain recognized in
2004 on the sales of certain third-party sourced merchant
processing contracts. Excluding the impact of the pre-tax gain,
noninterest income increased eight percent largely due to an 18%
increase in electronic payment processing revenue. Excluding the
impact of 2004 debt retirement charges, noninterest expense
increased 11% compared to last year, primarily due to increases in
marketing, information technology, volume-related bankcard costs
and the significant investments in the sales force and retail
distribution network. Compared to 2004, average sales personnel
increased by approximately 1,400 and 63 new banking centers have
opened, excluding relocations, as well as the 70 net new Florida
banking centers as a result of the acquisition of First National.
Credit quality metrics deteriorated during the fourth quarter of
2005 with full-year net charge-offs increasing 19% over 2004 as a
result of certain commercial airline bankruptcies and an increase in
consumer bankruptcies declared prior to the recently enacted
reform legislation. Despite a ratio of .67% in the fourth quarter of
2005, net charge-offs as a percent of average loans and leases
remained at .45% in 2005. Nonperforming assets as a percent of
loans and leases were .52% at December 31, 2005 compared to
.51% at December 31, 2004.