It was all too common during the bubble years that began almost a decade ago to see quality community or regional banks de-prioritize their traditional businesses to reach for the fool’s gold offered by riskier lending. Very few of those stories had happy endings, and many ended like First Horizon National (NYSE:FHN), where the bank saw significant lending losses, putbacks, and the need to raise fresh capital to stay in business.
Now things are settling down and getting back closer to normal. First Horizon has retrenched around its core operations and is looking to reduce its non-strategic lending activity, while also looking to make the most of its sizable market share in Tennessee. The only real drawback to the story, aside from the risk of higher putbacks, is the fact that valuation already anticipates quite a lot of improvement.
Expenses Driving The Story
Looking back to April's first quarter earnings, First Horizon had a pretty mixed performance. While the 13% year-on-year decline in operating revenue was pretty startling compared to peers, the 1% sequential decline was pretty consistent with the sector. Net interest income declined more than most (down 6% and 5%), as the company saw a 14bp sequential decline in net interest margin due in large part to less lending to mortgage banking companies. Relative to its peer group average of about 3.5%, First Horizon's sub-3% NIM was poor. Where First Horizon did well was in its expense control. Expenses fell 13% and 6%, and that supported a double-digit sequential increase in pre-provision net revenue.
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Transitions Blurs The Numbers A Bit
First Horizon has historically had a large “non-strategic” lending business, and reducing this business is a stated goal of management. To that end, the reported numbers on the company's lending don't necessarily reflect the full story.
Loans did decline on a reported basis, which would seem to lump First Horizon in with other regional banks like Regions (NYSE:RF) and SunTrust (NYSE:STI) in terms of uninspiring lending growth. Part of the decline was due to the reductions in non-strategic lending and a large sequential decline in lending to mortgage companies, though, and that masked underlying growth trends in its core regional lending activity.
Still Trying To Clean Up Past Messes
First Horizon is in much better shape with respect to its capital and “core operations”, but it's not completely out of the woods.
During the lending bubble First Horizon originated about $27 billion in Alt-A and Jumbo securitized loans, and putback losses have dogged the company as a result. Now First Horizon has gone some time without increasing its repurchase provision, and request from Fannie/Freddie declined more than one-fifth on a sequential basis. What's more, recission rates have been stable and statues of limitations are starting to come into play. Even so, there is the risk that higher actual losses here could add turbulence to the story.
Likewise, the company's non-performing asset ratio and net charge-off ratio are higher than for many of its peers. The levels are broadly consistent with what sell-side analysts have already factored into their models, but it's worth noting that First Horizon still has some cleaning up to do.
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The Bottom Line
If First Horizon is committed to reemphasizing its regional banking operations, that should be a good thing on balance for the stock. The capital markets business will always be more volatile, but that too is a known risk.
If I have any real concern with First Horizon now, it may be that the bank is returning such a high level of capital to shareholders. It's not that I'm concerned about higher-than-expected losses from the loan book or putbacks, but rather that the bank isn't building capital with which to grow. While First Horizon is the second-largest bank in Tennessee (just a bit behind Regions and well ahead of SunTrust and Bank of America (NYSE:BAC), it has barely any presence in Georgia and a small presence in Mississippi. Then again, a relatively focused business may not be so bad on balance – it would certainly simplify a deal if a company like U.S. Bancorp (NYSE:USB) or Fifth Third (Nasdaq:FITB) wanted to expand their presence in Tennessee.
I'm a little concerned that my 12% long-term ROE target is ambitious for First Horizon. Yes, this bank routinely logged pre-crisis ROE's in the 20%'s, but this is a new world for banks. In any case, even with a 12% target, First Horizon carries a fair value of about $10. Other metrics like return on tangible common equity, return on tangible assets, and capital-adjusted ROE suggest that the stock is within about 5% to 10% of fair value today. All in all, that means First Horizon is a decent enough hold (particularly if you believe management can continue to cut expenses), but not a compelling buy today.
At the time of writing, Stephen D. Simpson did not own shares of any of the companies mentioned in this article.