Truist Financial Has Fallen To 'Cheap For A Reason' As Management Credibility Evaporates

Challenging times are the real test for management teams, and Truist (NYSE:TFC) management has thus far come up short in my view. While there has been nothing typical about the last three to four years, investors pay management teams handsomely to navigate the unexpected, and while it hasn't been all bad for Truist, the ongoing failures to deliver on the promises of the SunTrust deal continue to weigh on results and valuation, while four downward revisions in four months have seriously damaged management's credibility on the Street.

I do believe that Truist still has meaningful franchise value from here and I believe the share price reflects a lot of what is wrong with the story (both in terms of perception/confidence and real underlying fundamentals). That said, I think the Street will require some evidence of bottoming results and/or a solid plan to drive improved operating leverage before the shares can rerate meaningfully.

A Small Miss By Truist Financial On Lowered Expectations

Second quarter results weren't that bad next to sell-side expectations, but when you consider that those expectations were lowered multiple times going into the quarter, and management once again lowered guidance for the remainder of 2023, the overall picture is less promising - particularly so when you consider that there are a lot of aspects to the business that should be driving (or at least allowing for) better-than-peer results.

Revenue rose 5% year over year and fell 3% quarter over quarter in the second quarter, a slight miss (equivalent to about $0.01/share) relative to Street expectations. It's still somewhat early in the reporting season, but about half of peer banks have beaten revenue expectations so far.

Net interest income was not impressive, rising 7% yoy but falling 6% qoq (in line with revised expectations). Better growth in earning assets (up over 1% qoq) was offset by weaker net interest margin, as NIM fell 26bp qoq to 2.91% (or down 25bp to 2.85% on a core basis).

Non-interest income was the main driver of the modest revenue miss, with this line-item up about 2% yoy and 2.5% qoq on an adjusted basis, missing by about a penny. Insurance saw over 9% yoy organic growth, but mortgage banking, investment banking/wealth management, and cards/payments were all weaker than expected.

Core operating expenses rose 5% year over year and about 1.5% qoq, missing by around 1% (or $0.03/share). Operating efficiency has been an issue for Truist for a while now, and I'll come back to this in a moment. Pre-provision profits declined 2.5% yoy and 10% qoq, missing by about 3% or $0.03/share. Provisioning was a little higher than expected and at the bottom line Truist missed by about $0.04-$0.05/share on core operating earnings (depending on which reporting service you use).

Another Guidance Cut, Another Hit To Credibility

Management once again lowered guidance for the remainder of the year, lowering the revenue growth target from 3% to 1%-2%. Management blamed higher deposit betas and weaker loan growth, but I find the notion that these drivers are "surprising" to be hard to accept - I've been writing for close to 18 months that deposit betas in this phase of the cycle where likely to be higher than expected, and management has had plenty of time to adjust.

I'm frankly more troubled by the expense guidance, as managed increased its opex target to the high end of the range. At this point, then, Truist could well top out as the highest of its peer group in terms of opex growth in 2023 (around 7%) and operating leverage is actually looking negative at this point.

Management has absolutely not delivered on the promised synergies of the SunTrust deal in my view - the efficiency ratio is almost 900bp above the target given at the time of the deal (around four years ago now), and while management is talking about taking steps to drive improved operating leverage, it sounds like little more than "trust us" at this point, as management's comments suggests they're only now starting to formulate a new plan.

How much of this issue can be laid at the feet of current management is of course debatable - it's looking more and more to me as though prior management underinvested in technology and ran a model that was more focused on maximizing near-term results at the cost of longer-term competitiveness - to that end, rivals and regional newcomers like Pinnacle (PNFP) seem to have had some success hiring away productive employees and/or poaching clients.

On top of all of that, Truist is looking to increase back-office spending in the insurance business to support independent operations. It looks more and more as though the ultimate goal here is to float the remainder of the business through an IPO and while the merits and issues of that decision are a topic for another day, it's another headwind for operating leverage.

Mixed Trends Elsewhere

In terms of the balance sheet, I believe "mixed" is a good word to use.

Deposit performance wasn't too bad, with total deposits down 4% yoy and up slightly on qoq basis, including better-than-average performance in non-interest-bearing deposits (down 18% yoy and down more than 5% qoq). Deposit costs were up sharply (up 142bp yoy and 40bp qoq) but were a little better than the peer group, and NIB retention has been relatively solid next to the likes of Bank of America (BAC), Citizens (CFG), Commerce Bancshares (CBSH), PNC (PNC), U.S. Bancorp (USB), and Wells Fargo (WFC).

Likewise, loans have held up. Loans were down slightly from Q1'23 on an adjusted end-of-period basis, and Truist continues to outperform the sector in C&I lending (up 1% qoq in a quarter where the sector was down about 1%).

There are other issues, though. Truist has a decent insured deposit position, but one of the weakest cash/deposit ratios (around 7%). It's also true that unrealized security losses are very large next to tangible capital (over 40% on available-for-sale securities), though unrealized gains on the insurance business do offset that.

Credit is still okay, but the trend is not positive. Non-performing loans jumped 28% qoq on pressure in commercial real estate and the adjusted charge-off ratio rose 5bp qoq to 0.42%, with C&I up 8bp to 0.23% and CRE up 53bp to 0.62%. It's worth remembering, though, that compared to its peer group Truist has only modest (sub-10%) CRE exposure, and the weak office CRE market is a bigger risk to companies like M&T (MTB), PNC, and Zions (ZION).

The Outlook

I want to see a more concrete and dynamic plan from management to drive operating leverage without compromising Truist's ability to benefit from the ongoing growth in its operating footprint. I don't really expect much until late this year, though, and I think that's a headwind for the stock price.

As far as capital goes, between the new Basel IV rules, new regulations to follow after the collapse of Silicon Valley Bank, and an FDIC special assessment, Truist will need to continue building capital and I expect little to no growth in capital returns to shareholders through 2024.

Factoring in all that has changed since my last update on the company, my earnings expectations for 2023, 2024, and 2025 are substantially lower than before. Higher funding costs have driven a lot of this, as has a weaker macroeconomic outlook, but shortfalls in operating leverage and the need to build/retain more capital has done some damage as well. At this point, then, I'm expecting sub-3% growth longer term growth in core earnings. The potential to do better is there, but this is a "show me" story at this point.

Between discounted core earnings (which includes single-digit ROEs for the next five years), ROTCE-driven price/TBV, and a forward P/E approach, I believe fair value is now in the neighborhood of $40.

The Bottom Line

If $40 is in the right neighborhood for fair value, there's meaningful upside in this shares. That upside is tempered, though, by a risk of further earnings guidance cuts and ongoing underperformance that sees Truist lose even more momentum to competitors in its operating footprint. At this point, then, I do see valuation as undemanding but I also see the risk of a value trap if management can't step up, deliver a plan to drive better results, and then execute on that plan with some alacrity.