Shares of Truist Financial (NYSE:TFC) have seen a sharp upward revaluation starting in the fourth-quarter 2023 after the Federal Reserve said that it was planning to lower the federal fund rate in FY 2024. However, inflation headwinds seem to be persistent, potentially derailing the Federal Reserve’s plan to cut the federal fund rate up to three times this year. Truist Financial also recently agreed to sell the remainder of its insurance operations, which is set to lead to a large cash infusion as well as earnings accretion. As a result, Truist Financial has the potential to return more cash to shareholders in FY 2024. With shares again trading at a discount to book value, I believe the risk-and-reward setup has improved!
Previous rating
I downgraded shares of Truist Financial to hold in October 2023, after the regional bank presented its third-quarter earnings release, because of higher credit provisions and deposit headwinds. With the Federal Reserve putting pressure on higher consumer prices, cuts to the federal fund rate in the near term are unlikely, potentially boosting Truist Financial's net interest income. Additionally, the sale of the bank's insurance operations makes TFC more attractive from a capital return point of view.
Net interest income tailwinds
In the last several quarters, the pressure on the net interest incomes of regional banks has gradually increased, resulting in a broad down-trend in NII. In the fourth-quarter, Truist Financial reported net interest income of $3.6B, showing a decline of 11% year over year. With inflation accelerating for two straight quarters and reaching 3.5% in March, I believe the Federal Reserve is not going to lower the federal fund rate in the short term, which could provide support for Truist Financial’s net interest income. Higher for longer rates strongly imply that financial institutions like Truist Financial could charge their customers higher rates for their loans, potentially even boosting the bank’s net interest income (margin) in FY 2024.
In a rising rate environment, banks can charge higher rates for their loan products to their customers while they are slow to raise deposit rates. This mismatch created tailwinds for margin growth when the Federal Reserve began to raise interest rates in FY 2022. However, slowing demand for high-cost loans and rising deposit costs have led to growing NIM pressure in FY 2023, which explains the decline in Truist Financial's net interest income trend last year.
Insurance business sale to investor group
In February, Truist Financial agreed to sell its remaining insurance business -- Truist Insurance Holdings (TIH), the fifth largest U.S. insurance broker -- to a group of investors led by private equity firm Stone Point Capital. The terms of the sale of TIH imply an enterprise value of $15.5B, which calculates to a $4.8B (after-tax) gain for the bank and its investors. The transaction is expected to close in the second-quarter and is set to lead to after-tax proceeds of $10.1B. Besides boosting the bank's capital ratios (the CET1 ratio is expected to go from 10.1% pre-sale to 11.5% after the sale of TIH), the significant cash infusion could lead to a generous capital return plan for Truist Financial’s shareholders.
Truist Financial is currently paying a $0.52 per-share quarterly dividend. The stock's current dividend yield stands at 5.8%, but it has potential to grow if the bank decides to boost its capital return measures after the TIH deal closes. I can see Truist Financial returning more cash to shareholders in FY 2024 and beyond, either in the form of a higher quarterly dividend or the payment of a special dividend.
One metric that is worth watching closely
In my work on Truist Financial in October, I indicated that the regional bank has seen an uptick in its credit provisions, which suggests that the asset quality has slightly deteriorated. In the fourth-quarter, credit provisions continued to go up and reached their highest level in FY 2023: Truist Financial recognized $597M in credit provisions in Q4’23, showing a year-over-year increase of 22%. In FY 2024, a continuation of this trend paired with disclosures about weakening asset quality may result in more serious headwinds for Truist Financial’s valuation.
Truist Financial’s valuation
I recommended Truist Financial as a buy in June 2023 when shares were priced for disaster and the market was still in the midst of an unsettling regional banking crisis that was kicked off by the failure of Silicon Valley Bank. The reason why I recommended Truist Financial at the time was because of the bank’s large discount to book value. Shares of Truist Financial currently trade at a 0.91X book value and below the 3-year average P/B ratio of 1.05X. The discount to book value has recently widened again as the market responded to the March inflation report negatively.
With an improved macro outlook, I believe TFC could revalue to 1.05-1.10X book value, especially if the Federal Reserve postpones cuts to the federal fund rate. The TIH asset sale has also created a catalyst for accelerated capital returns that could result in a revaluation of the bank's shares once the deal closes. With a fair value P/B ratio of 1.05-1.10X, shares of Truist Financial have revaluation potential to $41-43. Plus, Truist Financial pays shareholders a near-6% dividend yield.
Risks with Truist Financial
Truist Financial is a cyclical bank that faces risks of an earnings contraction if the U.S. recession slides into a recession. The biggest risk is a decline in the bank’s asset quality and a continual escalation in the credit provision trend. I also see risks regarding Truist Financial’s sale of its insurance business, which may not translate to accelerated capital returns for investors. What would change my mind about Truist Financial is if the Federal Reserve were to drastically change course and cut the federal fund rate, or if the bank were to see a jump in credit provisions.
Truist Financial had a securities portfolio valued at $121.5B at December 31, 2023, and sits on a considerable amount of unrealized losses (which Fitch cited as being 'above peer'.) At the end of Q4'23, the regional bank had unrealized losses of $11.5B in its AFS ('available-for-sale') portfolio ($9.7B of which related to mortgage-backed securities) and $9.5B in its HTM ('held-to-maturity') portfolio. There is a risk of Truist Financial being forced to realize losses in a higher for longer scenario, although given the recent TIH sale, I believe this risk is very low.
Final thoughts
Truist Financial makes a better value proposition, in my opinion, after the release of the March inflation report, chiefly because the regional bank is facing a higher for longer rate environment. Additionally, Truist Financial sold its insurance business to an investor consortium, leading to a windfall profit that could either be reinvested into the company’s loan business, thereby boosting net interest income, or be distributed to the bank’s shareholders as a special dividend. I believe Truist Financial is deserving of a rating upgrade to buy given the changed macro outlook and the risk profile, given the most recent insurance sale, has improved as well!
The Asian Investor
I look for high-risk, high-reward situations. Five largest portfolio holdings: Bitcoin, SoFi, Alibaba, PayPal, Western Alliance. Early buyer of cryptocurrencies. I live in Thailand :)
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