Fifth Third Bancorp (FITB) 2006 Q4 法說會逐字稿

Good morning. My name is Dashanta, and I will be your conference operator today. At this time, I would like to welcome everyone to the Fifth Third's fourth quarter 2006 earnings conference call. All lines have been place on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [OPERATOR INSTRUCTIONS]. Mr. Jeff Richardson, Director of Investor Relations of Fifth Third, you may begin.

Thanks. Hello, and thanks for joining us this morning. We'll be talking with you this morning about our fourth quarter 2006 and full year results, as well as our outlook for 2007. Thus, this call contains certain forward-looking statements about Fifth Third Bancorp, pertaining to our financial condition, results of operation, plans, and objectives. These statements involve certain risks and uncertainties. There are a number of factors that could cause results to differ materially from historical performance and these statements. Fifth Third undertakes no obligation to update these statements after the date of this call. Now, I'm joined here in the room by George Schaefer, Chairman and CEO of Fifth Third; Kevin Kabat, our President; and Chris Marshall, our CFO. During the question-and-answer period, please provide your name and that of your firm to the operator. And with that, I'll turn the call over to George Schaefer.

Good morning, and thanks for taking the time to join us. I'll have a few comments, and then I'll turn it over to Kevin Kabat who has some observations, and then finally Chris Marshall will review our balance sheet, revenue and expense trends, as well as talk about our outlook for 2007.

First, you've seen a couple of days ago that I've announced I'll be stepping down from the CEO position at our annual shareholders meeting in April. The Board has named Kevin Kabat as my successor. I'll remain with the Company as Nonexecutive Chairman going forward. This marks my 36th year with Fifth Third, and it's certainly be a privilege to serve as CEO during the past 16 of those years. And Kevin is a terrific choice to head up the Company, given his experience and leadership capabilities. He's the right person for the job. I feel like I'm handing him a company that has its problems behind it. That will allow him and Fifth Third to move forward with a clean slate. I'll let Chris walk through the results, but clearly it was a tough quarter and a tough year with a charge related to our balance sheet actions reducing earnings by about $0.53. We continue to feel good about our decision to reduce the size of the balance sheet and move our interest rate positioning to a more neutral stance. And the timing worked out very well, with rates moving up here in the recent past. I believe our senior management team is the strongest it's ever been, and the team is complete, and it's the right team to lead Fifth Third into the future.

This may be the last time I'll address you as CEO, so before I turn it over to Kevin, let me take a minute or two to thank each of you for the high quality of your work and for the professionalism you all bring to this important process. The analysts that have covered Fifth Third have always impressed me, and it's been a privilege to participate in these last 64 or so conference calls with you and some of your predecessors. Your energy and insight have forced me to be even more well-prepared than I might have otherwise been, and I think our company has benefited from that immensely, so I thank you for that. I wish each of you the very best in the future. I know that many of you are long time shareholders of the Company, and we appreciate your patience, as we've worked through the issues of the past several years. And I know there are many skeptics out there who are looking for us to start producing like the Fifth Third of old. I'm confident that that's exactly what you're going to see out of this company, its management team, and our incredible team members. This is a special company, a very unique company, and I believe you will see unique things in the months and years ahead.

Now I'm going to turn it over to Kevin Kabat to talk with you about his thoughts as we head into 2007. Kevin?

Thanks, George.

George is leaving behind some very large shoes to fill, but I'm excited to take on this opportunity and the challenge. This is a very special company with a very unique legacy of success. I'm very proud to work for Fifth Third and so are my teammates. We've endured some difficulty during the past few years, but that's behind us, and we now have every intention of reestablishing ourselves as one of the best-performing banks in the country. It won't be easy, but it never has been in the past. So just to set the context, as we look ahead, this continues to be a difficult industry operating environment. We'll most likely face an inverted yield curve for a good part of '07, if not all of it, which is never easy. However, I'd say that our balance sheet is no longer unusually exposed to that kind of rate environment, and we're probably better positioned than most. We are seeing credit costs creep up, and our expectation is that we'll continue to see higher credit costs and problem loans in 2007 at Fifth Third as well as in the industry. Our borrowers in the Midwest are certainly feeling stressed. And though we have relatively small proportion of our lending in construction and development, we're feeling the impact of problems there as well. All that said, the credit environment is still reasonably good, and we expect to be -- we expect it to be manageable in 2007, as Chris will outline in our outlook.

We have a lot on our plate, prepped for implementation in 2007. We're focused on a variety of initiatives which you'll hear us talk about in coming months. I think of these as grouped into the following categories -- First, there's some businesses where we don't think we're firing on all cylinders yet, and we're focused on fixing issues and gaps there. Three areas I'd single out on the call this morning are credit cards, where we don't have anywhere near our fair share of our customer's wallets; business banking, while we're okay in that business, we've got to be better, and we recently hired John Guy from Wachovia to spearhead our efforts in that business; and then the investment advisory business. There again, we have new leadership, David Pittman heading up IA from Wells Fargo, and Howard Hammond from CitiGroup, who's heading up retail brokerage. The second category, there are some areas where we're very good, and we're going to leverage our strength in these areas -- De novos, where we're very good at building de novos, getting to breakeven quickly, and growing deposits. We're going to continue what we're doing there, if not kick it up a notch. And we're very strong in serving the middle market, and we're going to focus on markets where we're underpenetrated, as well as to look to some new cities and opportunities. And then, finally, there are some sectors that we're going to attack where Fifth Third has not been as big a player as we could be, providing services to specialized industries in a fully integrated way, meeting specialized needs. We're in the process of making some final decisions about this, and we'll be talking about it in the coming months.

I feel very optimistic about our outlook. Our management team is the strongest it's ever been. Our folks are anxious to start putting up the kind of performance we all expect of ourselves at Fifth Third, and we know that you do as well. I relish the opportunity to lead this team and look forward to talking with all of you about Fifth Third as we move forward. With that, I'll turn it over to Chris to talk about results and our outlook. Chris?

Thanks, Kevin, and good morning, everyone. Happy new year to everyone.

I've got a lot to go through, but I'm going to start with some highlights of the quarter, and then I'm going to go into a little bit more detail on the major items, and then I'll wrap up with our outlook for the year. So starting with some highlights, I'd start by saying the quarter came in generally in line with our expectations. The charges related to our balance sheet actions in November came in a little bit lower than we had forecasted, at 454 million, as it turned out, compared with the 500 million that we had included in our announcement. That difference, which equated to about $0.05 a share of reported earnings, was simply the result of better execution in our sales than we thought might develop, given the size of the position we were liquidating.

Now, relative to our mid-quarter update, I'll point out a few areas where we had significant variances, although in total, they pretty much netted one another out. On the positive side, net interest income came in a little bit better than we had expected, and several things contributed to that. Better execution on the sale of securities was one cause. We also had better than expected core deposit growth. We saw slightly better deposit pricing than we were forecasting, and we also saw a slight expansion in our loan yields. The tax rate, exclusive of the balance sheet actions we took, came in at about 29%, rather than the 30% we were expecting. So that was also a positive. On the negative side, our biggest negative variance came from an unexpected drop in consumer overdraft fees, and I'm going to discuss that a little bit more later in my comments, but at this point I'd tell you that while it's early in the quarter, we think we'll recover most of that drop in Q1. Additionally, the drop in interest rates during the fourth quarter resulted in an adjustment to our MSR valuation and amortization, which was larger than we were anticipating in November. This drove the decline you saw in our mortgage banking revenue. The swing from the third quarter cost us about $9 million, and then we recaptured about 3 million from nonqualifying hedges, which you'll see show up as securities gains. So overall, the MSR cost us 6 million sequentially on a net basis. So as you can see, the composition of our results changed a little bit, but large -- in general, they were largely in line with what we were expecting.

Now, I know you've got a busy day, and we've got a lot to go through, so I'm going to do a quick recap here of the -- of our results and try to highlight the significant elements that I think you'll be looking for as you are -- you are scanning our release. EPS were $0.12, and that included 454 million, as I said, of charges related to the November balance sheet actions, for about $0.53 a share. The 454 million included 398 million in securities losses, and on top of that, we had 17 million in losses on derivatives related to the securities we sold, and that, by the way, appears in other noninterest income. And I'd note that in our mid-quarter update, we had assumed that all of those losses would flow through securities, so there's a little bit of different geography here. And then finally, we recorded 39 million in termination charges related to financing agreements which show up in other noninterest expense. Now otherwise, and I know that's -- given the size of some of these numbers, that's a big otherwise, but other than those unusual events, our fourth quarter results were really pretty clean. We didn't benefit from any unusual items of note in the fourth quarter as we did in the third, and as a reminder, I'd just point out that our third-quarter results included about $0.03 of benefit when you sum the net securities gains of 19 million that we had. The 11 million debt retirement charge in other noninterest expense and the 8 million in pension settlement costs we had in employee benefits, and the -- along with the $10.5 million aggregate gains we had on branch sales and some out-of-footprint card accounts. And on top of that, the -- in the third quarter, the tax rate was lower. It was slightly below 28% versus the 29% we had in the fourth quarter. So when you strip all that stuff out and take a look at quarter sequentially, I think you'll see that our fourth-quarter bottom line would be slightly better with the exception of the higher provision we had this quarter, which was up about $20 million, or about $0.025. I'm going to talk more about credit in our outlook, but we don't expect to see that kind of sequential increase repeat itself in the first quarter.

All right. Let me go into a little bit more detail here. I'm going to start out with the balance sheet, and specifically I'll start out on the asset side. With regard to securities, I think our release adequately covers all the balance sheet actions we took so I won't repeat that, but I do want to highlight the results. So available-for-sale securities, starting there, they were $11 billion at period end, down from 20 billion at the end of last quarter and 22 billion a year ago. You may have noted that we sold 11.3 billion of securities rather than the 11.5 -- 11.5 we announced in November. That was strictly the result of pay downs on the securities we were targeting for sale. Our taxable security portfolio now equals about 13% of our earning assets, and that essentially represents what we need to neutralize the interest rate risk in the balance sheet and to provide for the liquidity and collateral needs of the Company. In the current interest rate environment, I'd expect us to stay right in that range. And the bottom line is that I'm hopeful that the bond portfolio shouldn't be a Fifth Third story anymore, and if so, I hope you all will join me in welcoming that.

All right. Moving on to loans. Loan growth continues to be solid, up 2% sequentially and up 7% compared to a year ago. Annual loan growth would have been 8% if we excluded the effect of the runoff in our consumer lease book. Breaking that down, commercial loan growth was also up 2% sequentially. It was up 8% versus the fourth quarter. Nothing stands out here as an outlier this quarter, but the strength over the last year has been in C&I, which is up 12% from fourth quarter '05, with commercial lease growth somewhat less. Year-over-year it's up 4%. Construction loans have been flat. One thing I'd note is that in the fourth quarter, we reclassed about $450 million of C&I loans to commercial real estate. Now, that reclassification took place at the end of the quarter, so there's no real effect on average balances, but you will see that going forward. Consumer loan growth was up 2% sequentially and up 5% year-over-year. Now that annual growth would have been 7% excluding the runoff in consumer leases. Over the fourth quarter, we see a pick up in fourth quarter -- in -- excuse me. Over the fourth quarter, we've seen a pick up in first mortgage balances, because interest rates had come down slightly. That was largely offset by refinancing in the home equity book. Credit card growth was strong; it was up 6% sequentially. It was up 25% year-over-year. And that growth has largely [technical difficulties] by just better sales results from our stores, but I'd point out that the sales results have been focused on using credit cards for overdraft protection, and that, in turn, has been a contributor to our service fee drop off -- partially a driver of that. And, then, finally, I'd say over -- in terms of other consumer loans, which are primarily auto loans, they were up 4% sequentially.

Okay. On the other side of the balance sheet, I'll start off with deposits. Core deposits were up 1% sequentially, which was actually a little bit better than we were expecting, but break that down for you. DDA growth was up 2% compared with the third quarter; savings and money market balances grew at 4 and 3%, respectively. Retail CDs were up 2%, so you'd note that this is the first quarter in quite a while where we saw core deposit growth that wasn't just totally dominated by CD growth, and with the current rate outlook, we'd expect these mixed trends to continue, which we think is a very good thing. Core deposits were up 3%, compared with the fourth quarter of '05. We had strong growth in savings and money market, moderate growth in CDs, all offsetting the decline in interest checking and slightly lower DDA balances. And I'm going to talk a little bit more about deposit pricing trends when I get to the margin. In terms of wholesale borrowings, you'll see some pretty significant drops in several categories here, and that's just really the reflection of the repayment of borrowings with the proceeds from the security sales consistent with what we told you in November.

All right. I'll wrap up the balance sheet with capital. First, we issued 750 million in subordinated debt in December, 500 million of that was a fixed rate, which we've now swapped, and 250 million of it was floating rate. Overall, the issue contributed 73 basis points to our total capital ratio, which now gets us up above 11%, which is a more comfortable range for us. I've talked to you about this being a priority for us. It was an outstanding issue we had committed to addressing with our -- for our regulators, but with the issue and the result of getting up above 11%, we now consider this issue resolved. Beyond that, the balance sheet action slightly reduced our tier one and leveraged capitol ratios, just given the way those ratios are calculated. You can figure those out, so I won't take the time now to go through the process. I would point out our tangible equity ratio is now 7.79. It's up 39 basis points from the third quarter, and that's obviously a very strong ratio. I think only one other bank is in the top 20 -- in the top 20 is higher than us. And we'd expect to work that down over time, as some of you might have expected. We are going to have a near-term target to be at about 7% by the end of 2007, if our performance develops the way we expect it to. We're going to go about moving to that target in a very, very conservative way, and I'm going to talk a little bit more about that further in the outlook.

All right. Turning to the income statement, starting with net interest income, it was up 3% from the third quarter, which is a very nice change of pace. The drivers of that increase are items that I've already mentioned, the securities sales, the slight improvement in loan yields, which were up 7 basis points, and the better than expected deposit growth that we had. In terms of deposit growth, you may note that our average cost of interest bearing deposits was up about 9 basis points. And that's really been driven by customers rolling over term deposits and continuing slower, but continuing the mix shift. But despite the increase, we feel good about deposit -- about the mix shift in the overall cost of deposits, largely because we were really able to successfully execute some localized pricing improvements in markets where we saw competition beginning to recede. And we feel really good about that. We're going to look to continue that opportunistically throughout the year right in line with our everyday great rate strategy.

Moving on to the margin, our margin performance was better than we expected, and for largely the same reasons as the better NII. We ended the quarter at 316, compared with the 299 we had the third quarter. Obviously, the margin's highly sensitive to the level of earning assets, and so the security sales are the largest driver of the improvement, although the core deposit growth and the improved spreads I mentioned also contributed there. With a stable short-term rate environment and solid balance sheet growth, and, frankly, a pretty easy comparison with 2006, we should be well-positioned to see strong growth in NII in 2007. As we mentioned in November, our interest rate sensitivity is now pretty much neutral to shifts in interest rates over the next 12 months, so we feel very good about that. Going on to noninterest income, [our fee] trends were obviously affected by the security losses we incurred. Otherwise, we had continued strong growth in processing revenue and IA and corporate banking fees were both of sequentially. The negative surprise was in deposit service fees, driven by lower consumer NSF fees.

I'd like to get a little bit further into each of the items. I'll start with the FTPS, which had solid results in what's usually a seasonally strong quarter. Processing fees were up 6% sequentially and 14% with a year ago. We feel really good about the prospects for this business, though annual growth admittedly was a little bit below the mid- to upper-teen growth we were looking for. And that was largely driven by slowing consumer spending versus what it was -- what the expectations were for this past year, given the softer economy and the higher fuel prices that we had for most of 2006. We also saw that some of our retail merchant contract additions during 2006 were slowed down a little bit. Some of those are still in the process of being converted, and we'll see the bleed over into 2007, and the slowness there was really because they were put on hold during fourth quarter because of the sales -- high -- seasonally high sales season. We probably should have been able to forecast that a little bit better than we did. But breaking that business down a little bit for you, I'd say it's really -- really comprised of three big pieces. The merchant processing business and revenue from that is about 50% of the overall processing business. That was up 12% versus the third quarter, and up 13% versus the fourth quarter last year. The second piece would be card-related revenue, which is a little less than a quarter of the business, and that was up 4% sequentially and 12% annually. That's driven by interchange among our card customers, and we expect that to pick up next year with some of the new credit card initiatives that we have scheduled to go into place. And then, finally, our financial institutions revenue represents a little over a quarter of the business, and it was essentially flat sequentially. In this segment of the business, we've entered a period where we're renewing long-term contracts that we entered into five or seven years ago, and pricing today, while it's still very good, is just not as good as it was back, again, five or seven years ago.

All right. Turning to deposit service charges. They were down 9% sequentially and 8% versus a year ago. As I've mentioned, the big driver here was consumer service charges, which were about half of overall deposit service charges. Consumer service charges were down 13% linked quarter and 10% annually due to the very significant drop off in consumer NSF fees. Now, we seem to be participating in somewhat of an industry trend here, though I think -- I think you're going to see that we're down a good bit more than others. We think about half of the drop in our case is attributable to actions we're taking to build long-term value for our customers. An example, as I mentioned, and we've been aggressively encouraging customers to enroll in overdraft protection as a means to establish deeper relationships with them and improve account retention, and, frankly, just overall customer satisfaction. We think that's the right thing to do long term in terms of building long-term value, but there is going to be some short term pain, but we're encouraged long term, because we already do see some improvement in attrition, and we think this is the big driver of it. In any case, we've seen much more normal levels of consumer service charges in the first half of January, and while it's obviously pretty early in the quarter, we would expect -- we expect to recover most of the drop off that we saw in the fourth quarter in Q1. Commercial deposit services charges were down 3% sequentially. This reflects higher compensating balances, and, therefore, obviously higher earnings credits, but as you know, those both largely offset in NII. Commercial service charges are down 5% compared with a year ago, and the year-over-year decline is really the result of higher interest rates, and, in turn, their effect on earnings credit rates, and that's also -- those things also offset in NII.

Turning to -- let me move on to investment advisory, in IA, our revenue was up 2% sequentially and 4% annually. Our results in this business have been somewhat mixed over the past year. We've seen -- we've seen really good growth in our private client group, which is our largest business, but our brokerage business and our asset management business really need to perform a lot better than they have. As Kevin mentioned, we've got new leadership here, and we've got a lot of confidence in those new leaders. We think we've got great opportunity for improvement in these businesses, and we're expecting to see it in 2007.

All right. Corporate banking revenue. Revenue was up 4% linked quarter. It was down 11% versus a year ago. The sequential growth was driven by higher FX and lease indication fees. The decline versus a year ago was the result of very strong lease indication results of about $10 million in the fourth quarter of '05. Let's see. We're seeing a lot of traction on a variety of fronts in corporate banking, specifically in loan syndications, in commodities, and in FX, so we would expect to continue to see strong growth here, though it will be -- you should expect it to be quite a bit more lumpy from quarter-to-quarter depending on market activity, than it may have been in the past. Mortgage banking net revenue was down $6 million sequentially, it was down 12 million versus fourth quarter of '05. The linked quarter decline was solely driven by changes in MSR valuation and amortization, as I mentioned, and as I've also said, that hurt this line by $9 million, and we had the $3 million pick up in securities gains. Mortgage origination and delivery revenue was consistent with the third quarter. Compared with a year ago, the decline was driven by lower income on originations and lower gains on deliveries. Now, we're down about 10% in originations, and that obviously isn't something that we're thrilled with, but I think you'd find that to be overall significantly better than the overall decline in industry originations. In other noninterest income, we had a good bit of noise here, overall, down 9 -- I'm sorry. 29 million sequentially and 18 million versus fourth quarter of '05. Now, as I mentioned earlier, that was the result of 17 million in losses on derivatives related to the securities we sold in November and December, and the 10.5 million in gains on branches and credit cards in the third quarter is really the difference of -- that would really show up in the sequential comparison. I think our securities gains and loss results are pretty clear to you.

Let me turn to expenses. Expense control, I think, was very good this quarter, and we have every reason to think that that's going to continue. Our reported expense growth was 4% sequentially and 5% versus fourth quarter '05, but it was really 1% sequentially and 2% year-over-year if we exclude a few unusual items. In fourth quarter of '06, we had the 39 million -- as I said, the 39 million in termination charges on financing agreements. In the third quarter of '06, we had the debt retirement charges of 11 million and pension settlement expenses of 8 million. And finally, in the fourth quarter of '05, we had 10 million of tax-related expenses and 9 million related to -- 9 million of expense related to a mortgage fraud that we had in Detroit. We expect to continue expenses very, very tightly with an eye toward what our revenue growth really turns out to be. We expect expense growth will be moderate on a core basis, and some of that growth is going to be driven by de novo activity and growth in our processing business, and I'll talk a little bit about that. In terms of taxes, our tax rate is very complicated this quarter, obviously, by the significant losses on our securities. If you back out the effect of the quarter's balance sheet actions, our tax rate would have been about 29% for the quarter, and the full year tax rate, excluding the balance sheet actions, also came in at 29% for the year, which was right in line with our expectations. As you'll see in our outlook, we're expecting the effective tax rate for 2007 to creep up a little bit. We expect that to be somewhere between 29 and 30%.

Turning to credit, our results were largely in line with our mid quarter guidance. Net chargeoffs were 52 basis points for the quarter, compared with the 43 basis points in the third quarter, and the 67 basis points in the year-ago quarter. Gross chargeoffs were 63 basis points, and they were 53 basis points last quarter, so recoveries were consistent between the periods. In the fourth quarter, net chargeoffs were a total of $18 million, and of that 18, commercial chargeoffs were up 11 million. Most of that increase was real estate related, and just to give you a little color in terms of size, the largest chargeoff was 5 million. That was a mortgage broker -- commercial mortgage broker. The second largest chargeoff was 4 million, and that was a commercial nursery. In terms of consumer chargeoffs, they were up 7 million, about 4 million of that increase was in our auto book and about 2 million of it was mortgage.

In terms of NPAs, our NPAs were up 44 million. 32 million of that was nonperforming loans and 12 million were in other assets in OREO. Of the 44 million increase in NPAs, about half of that was in our commercial book. Geographically, the commercial growth mostly occurred in eastern Michigan and northeastern Ohio, which is where three or four of our largest inflows were. In terms of size, the largest NPA inflows were 14 million and 9 million. And then from a line of business viewpoint, about half of the growth in commercial NPAs came in middle market, and about half were in small business and business banking. We saw no increase in NPAs in our large corporate book. Looking at loan type, commercial mortgage and commercial construction NPAs saw the biggest increase. They were up $58 million, and they were offset by significant reductions in C&I and commercial leasing. Other than the concentration in construction and CRE, we didn't see any other noteworthy increase, in terms of an industry concentration in commercial NPAs. Consumer NPAs were up 20 million, 8 million in NPLs, and 12 million in other assets and other nonperforming assets and OREO. That 20 million included about 12 million of residential real estate related assets, with a disproportionate amount of them in northeastern Ohio and eastern Michigan. Most of the remaining 8 million came in auto, and really reflects an acceleration of auto repossession process. We expect the change -- the change in this process, by the way, to result -- eventually result in higher recoveries over the next quarter or two, but in the meantime, it's putting a little pressure on our NPAs. Finally during the quarter, we sold -- we sold about 13 million in commercial NPAs, which produced a net chargeoff of about $1 million. We'll talk in a moment about our outlook, but the short version is that we would expect chargeoffs next year to be consistent with the 52 basis points we saw in the fourth quarter. We'd also expect to see NPA growth continue, given where we are in the credit cycle, but we believe we're going to see a gradual term. We don't see anything sharp occurring in the next -- next few quarters or actually all of 2007. But I want to make sure you understand that we are very, very focused on managing credit in this environment.

All right. Let me go on to the outlook. We've tried to provide significantly greater granularity in our outlook this year. As I'm sure you saw in our release, we've published our expectations for full year 2007 versus full year 2006 on Pages 5 and 6. And we're going to update our guidance each quarter as the year progresses. And as we told you, I just want to refined you, that we will not be issuing mid quarter updates as we have done over the past several years. So you may want to turn to Page 5 of the earnings release, and I will try to walk you through each item, starting with net interest income, which we expect to see grow in the mid -- I'm sorry. In the high single-digits range. Now, we expect that growth, as I said, to be in the high single digits range, reflecting the effects of our balance sheet actions in November, which we expect to add a little over 100 million in our annualized net income.

Additionally, there are a couple of assumptions related to our lease portfolio here that I'd like to go through. First, we've assumed that we'll take an after-tax charge to beginning equity of approximately $100 million related to some outstanding LILO/SILO litigation. We'll realize that charge back into earnings over the life of the leases, however, in 2007, the effect will be to reduce NII by about 25 to $30 million pre tax. Second, we've made a deposit of $350 million with the IRS to essentially stop the interest clock on the outstanding issue. The carrying costs of that deposit will reduce NII by about $19 million [end] year. I'd note here that most of the 48 million I just covered will be offset in earnings to our lower tax rate, all of about $0.015 of it that will bleed through in 2007. Now, setting those matters aside, the remainder of NII growth will be driven by loan growth, core deposit growth, and an expected relatively stable interest rate environment, though we do expect the curve to remain inverted through at least the first half of this year.

Net interest margin we expect to come in somewhere in the 335 to 345 range. We'd expect to see about 35 or 40 basis points of annualized benefit from the balance sheet actions we took. And by that, I mean prior to where we were before we took them, which was about 299. And then the IRS deposit I just mentioned is going to have the effect of reducing our margin by about 5 basis points annualized. Otherwise, we'd expect repricing activity in loan book, some upward leakage in interest bearing deposits, some improvement in the yield curve, which we would expect to see if we see it in the second half of the year. Now, obviously all that can change, but that's the market's assumption now, and we don't see any reason to have a sharply divergent view. Noninterest income we expect to grow in the high single digits, setting aside the 415 million in noninterest losses from our balance sheet actions. We'd expect mid-teens or a little bit better growth in processing fees with a strong growth in merchant and card processing, offset by somewhat slower growth in FI revenue. We'd expect deposit service revenue to grow in the high single digits, and we'd also expect high single digit growth in IA revenue. We expect a mid-teens growth in corporate banking revenue, reflecting continued growth in areas such as loan syndications, commodity, FX fees, and institutional sales, and we'd expect low double digit growth in mortgage banking. We expect to see stronger originations and delivery revenue as a result of a more stable mortgage and housing environment, and also we expect to see improvement from the new products we've recently introduced.

Expenses, we expect expense growth in the mid single digits, and there I'd say mid single digits is probably more like 5 to 7% at the high range, excluding the 50 million in termination charges we took in the third and fourth quarter. That -- the expense growth, I think, is going to turn largely on the growth we see in FTPS and de novos. And overall, our expense growth will be -- probably 50% of our expense growth will be directly attributed to a growth in processing revenue and de novos. Exactly when those stores come online and the other half -- so 2.5 to an absolute maximum of 3.5 would be from the rest of the business. Obviously, we're going to manage expenses very, very carefully this year, and as always, we're going to keep one eye on revenue growth and see how that progresses throughout the year.

In terms of loan growth, we're looking for loan growth in the high single digit range, and we'd expect commercial and consumer loan growth to be consistent in what we saw in the second half -- in the second half of 2006. The core deposit growth, we're looking for core deposit growth in the mid single digits. Obviously, the interest rate environment, and just overall competitive conditions are going to play a role here. But we've begun to see some renewed traction now that we've gotten into a more stable rate environment, so we feel really good about that. We also feel good about the success of our de novo activity. As Kevin said, we think that gives us a head start in terms of deposit growth, and we also feel really good about our everyday great rate strategy. That is working very, very well, and we have every reason to expect it to continue to work well in 2007. Net chargeoffs, we expect -- we expect chargeoffs for the full year in the low to mid 50 basis points range, compared with 44 basis points we saw in 2006 and the 45 we saw in full year 2005. We'd expect commercial and consumer charges to be roughly in the same range as they were in the fourth quarter 2006. As a reminder, that was 42 basis points for commercial chargeoffs, and 64 basis points for consumer chargeoffs. In terms of provision, we'd expect provision to exceed chargeoffs, as reserves build with loan growth, and as the cycle turns. In 2006, provision exceeded chargeoffs by about 10%. I'd expect that gap to be closer to 15% in 2007. Now, how much of that is going to depend on the credit environment, and, quite frankly, what the models tell us. But we're expecting a curve in the road here. We're not expecting any sharp turn.

In terms of our effective tax rate, we're looking for an effective tax rate of 29 to 30, as I said, in 2007, and that compares with the 29% we saw in 2006, excluding the effects of our balance sheet actions. Two things here -- The IRS deposit, as I mentioned, reduces the effective tax rate we would have seen by about a percentage point. The increase otherwise reflects just more of a normalization of our overall tax rate. In 2006, as we've previously discussed with you, we had several audit resolutions that helped lower the tax rate end year. In terms of capital, Fifth Third, as I think you'd all agree, has very strong tangible capital levels. We want to continue that on a relative basis, but we do recognize we've got some opportunity to improve our capital structure, and as I said, we've adopted a near-term target of 7% for tangible equity to tangible assets for 2007. Now, if we were in a better environment -- and, quite frankly, if we had a much stronger recent performance trend, I think a lower target might be appropriate for us, given our risk profile. But, quite frankly, we haven't demonstrated that consistent operating performance yet, and we feel that that's the appropriate thing for us to do before we reevaluate our target. And even reaching the 7% target, we expect to phase that in gradually over the course of the year, more or less evenly as our performance begins to take hold.

That seems to be pretty exhaustive. We can entertain further questions about our outlook, but I think that's as much detail as we're prepared to give you at this time, and I hope it's sufficient. Just to wrap things up, I'd say a lot of hard work has gone into preparing us for 2007. I think the management team feels very pleased about what we've accomplished, but we realize with our balance sheet issues taken care of, it's really time for us to perform now. We've got a plan to do that. We've got a number of very important initiatives underway to help us drive growth. We've taken some pretty significant steps to enhance our already very strong sales culture, and hopefully you'll see that, and at the same time, we're also taking some very strong steps to improve our customers' experience and their overall satisfaction with us. We've got a complete management team. We -- we all are happy to see George, who's going to still be with us in the chairman's role, but we're also very happy to see the decision to elevate Kevin into the CEO roll, and we just feel good as a management team where we are. We also feel good because we've got 21,000 world-class employees. And those employees, all of them, are acutely aware of your expectations and the expectations of all of our shareholders, and, quite frankly, we're really eager to demonstrate that we can meet those expectations and even exceed them.

So with that, I thank you for your attention this morning, and we'd be happy to answer any questions you have.

[OPERATOR INSTRUCTIONS]. Mike Mayo, Prudential Equity Group.

Good morning.

Good morning, Mike.

Since this is the first earnings call we have a chance to talk to the new CEO now. What kind of changes might take place in strategy, financial targets, nuances. What are you going to be focused most on, Kevin?

Thanks, Mike. A couple of things I'd say on that. One is this has been and will continue to be a very smooth transition for us. We will continue to leverage the strengths historically of this company that we're very proud of and that really does create value for us, and that's particularly in terms of our sales culture, our affiliate model. We'll continue to watch expenses as we've historically done as well. We'll also add and expand, though, an approach to full customer value experience and appreciation, and the bottom line to all that is really to grow our earnings and get back to the expectation of an industry outperformer, and that's really where we're headed from a company prospective.

When you say add and expand full customer value experience, could you elaborate on that?

By that, Mike, and you've heard us talk about it, I think, the everyday great rate strategy's a pretty good example of the kind of thing we're talking about across all of our business lines. We do an incredible job through our sales culture of driving business into the organization. We have not done a very good job of keeping those customers in the organization. By doing so and closing a little bit of the back door, we can increase productivity, we can increase revenue, and, again, we can drive the bottom line much faster.

And then lastly, as far as compensation for you and other executive management, what will be the key elements of what you would -- your managers get paid?

Again, we won't change our focus, and that comes in terms of our growth of the Company and the value we deliver through our shareholders and our earnings growth.

All right. Thank you.

All right, Mike. Thank you.

Matthew O'Connor, UBS.

Good morning.

Good morning, Matt.

If we could just drill down a bit in terms of the capital targets, then how you expect to manage to get to the 7% in terms of buy back, dividends, acquisitions? And we've done a lot of work on capital. It just seems like there's a ton of flexibility that you guys have over the next couple of years here, if you could just comment both near term and longer term with respect to that flexibility.

Matt, I appreciate your question. I think -- I'm afraid I'm going to repeat myself here, and I know you probably don't want me to do that, but we also think we've got a lot of flexibility, but quite honestly, I think we do need to demonstrate that our performance is back to the standards that we've had in the past. We're confident they're going to get there, but we want to move gradually into any change we make to the capital structure. So our intention would be to move to the 7% target probably in two steps, the first half of it in the first half the year, and if our performance is where we expect it to be, then we'll execute the second half of that, and we'll do that probably through the issuance of some hybrids, but we'll talk more about that as we get into the quarter. I recognize and understand your feeling that we have more flexibility there, and we agree that we do. If our performance is where we expect it to be, we'd expect that we will -- we'll be talking about further optimization as the year shapes up, but probably stuff that we won't do until the beginning of next year.

Okay. And then maybe just looking out the next couple of years, if you could just talk about your acquisition -- your appetite for acquisitions in terms of buys, geography, and any changes in strategy on that front versus what you've done in the past.

I don't think there's any big change here. We -- I think like everyone in the Midwest, we'd always be interested in markets that have faster growing demographics than we do, and you can take your pick. We would probably look to the southeast first, and I think we've said that in the past. The -- the reality is there's some great companies in the southeast that we would have lots of interest in, but the current pricing pretty much rule them all out. We've got to be very disciplined financially, and as we look at acquisitions, I think that's probably what's behind your question, and we will be. We are actively looking at all kinds of potentials that could unfold as the year unfolds, and we see other companies start to see some head winds that they weren't anticipating, and we'll be prepared to be a player there, but as we sit here today, there's nothing on short-term horizon that we think is high -- a high -- a reasonable probability in terms of meeting reasonable financial targets and also, just in terms of doability. There aren't that many companies out there that seem to be interested in selling themselves.

Okay.

I hope that was a good enough answer for you, Matt.

Okay. That's helpful. Thank you.

Gary Townsend, Friedman Billings Ramsey.

Good morning, gentlemen.

Good morning.

George, I enjoyed working with you. Best wishes. And Kevin, welcome aboard.

Thank you.

Thanks, Gary.

Kevin, are you looking at any other changes in just how you deliver the retail experience? Longer hours? Greater investment in the branches? Do you anticipate any changes like that? I know U.S. Bancorp is exploring those same things.

Yes, Gary, what I would tell you on that side of the distribution piece, we do have a fairly active and very good mix, in terms of our business today because of the Bank Mart distribution sprinkling so that we can deliver on that full range of our prospectus. So we feel very good and very competitive from that standpoint. We are and have been expanding our investment and our improvement in our online delivery to folks. And I think we continue to get better and better for that, and we continue to see more and more utilization and even begin to deliver product through our online delivery system. So we feel good from that standpoint. One of the things that we continue to do, and it's an historical strength that we have, Gary, here is that we continue to drive accountability down to the lowest levels in the organization, including in our -- including through the financial centers, and we'll continue that. One of the things that we have much better insight in with the technology infrastructures that we've spent in the past few years is now we can do down to the individual accountability for production, and that will help us continue to grow in that arena as well. So those are the types of things that I think will also -- have helped and will continue to drive it. The the thing you've heard us talk about, Gary, that will be a continued evolution in that arena is the expansion of our customer surveying process, which ties both our selling and productivity basis with our retention basis, which speaks to that strategy that we've been referring to and expending the customer experience. So we think that all drives a greater -- a greater bottom line for us.

Is there anything that you can specifically identify, maybe two or three things, that just have -- has kept you all from performing as well on the customer retention side as you'd like?

Well, I think two things, Gary. One is we've never measured it. And so if you don't know where your baseline is and you don't know what the expectation from the customer is, it's hard to move that number. Well, we know today, and we have specific initiatives against that learning that will continue to drive it. And the other thing that we do is we not only know that, but can now drive that down to the financial -- the specific financial center itself, and so it's very specific. And the third piece of that, then, Gary, is now you can set goals, you can set targets to be able to say this is something that's unacceptable or is acceptable to us in that vein. That's changing behavior, and it's changing the experience that our customers have at the financial services. We think that's huge.

Is there a particular metric that you'll be watching and sharing with us on an ongoing basis?

Well, the one thing we are doing is we continue to look at our Gallup surveying process that we're utilizing everywhere in the branch system today. We're measuring that monthly, and we can share some of those metrics with you, you bet.

Thank you very much.

You bet, Gary.

Kevin St. Pierre, Sanford Bernstein.

Good morning, gentlemen. A couple of questions on the -- on the credit front. With chargeoffs in the current quarter at 52 basis points and nonperformers on the rise, what gives you the confidence that you can stick in that low to mid 50 basis point range in '07?

Kevin, I think as we look out into first quarter, as an example, we would actually expect to see some improvement in the number. I don't want to parse the guidance too much. Overall for the year, we expect chargeoffs to remain stable, and I think we -- again, while it's early in the quarter, we've got reason to think that we may see some moderation in the increases we've had. So that's really the basis for our projection.

Okay. And if we have high single-digit loan growth and we have 15% provision roughly exceeding chargeoffs by -- in the neighborhood of 15%, as you mentioned, is it -- if I'm doing my math, do you expect a modest build in the reserve-to-loan ratio?

Yes.

Okay. And then finally, with the apparent youth movement in senior management here and with relatively -- maybe few or none of you -- of the new team over 50 years of age, can we assume, then, that you guys are in it for the long hall, and any speculation around a sale of Fifth Third is unfounded?

Hey, Kevin, you don't know how much I appreciate that. I have not been associated with a youth movement since I was -- for 20 years, but I'm going to go home and tell my wife that tonight. I think -- I'd let Kevin answer it. I know that a lot of us made a big commitment to come here, and we didn't -- I speak for myself. I didn't come here with a 12-month window in mind.

Kevin, I'd echo the same thing. I would tell you that none of the team that we've established here is -- are short termers or short timers from their perspective. We're here to build something and build on a heritage of great strength and a great platform. And so from our perspective, what we really want to do is we really want to -- we really want to drive off of nearly 150-year heritage of one of the strongest brands in the industry. And that's really the attraction of what this -- of what brought this team together. That's what'll keep us going as we move into '07 and beyond.

Great. Thanks very much.

Thank you.

At this time there are no further questions. Are there any closing remarks?

No, I think we're going to wrap that up. I guess I would take the opportunity to just say one thing, and that's thank you to George. I think we speak for the whole management team, again, in thanking him for his leadership as CEO and congratulating Kevin on his big move. We're all excited about it. Thanks for being with us on the call. We look forward to talking to you more as the quarter shapes up.

Thank you. This concludes today's Fifth Third fourth quarter 2006 earnings conference call. You may now disconnect.