First Horizon's Crippling Issues May Be Coming To An End But Not Time To Buy Yet

| About: First Horizon (FHN)
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Despite being centered in the relatively economically insulated southeast (specifically Tennessee), First Horizon National Corp (NYSE:FHN) has been hobbled by weak revenues and past legal costs. In the past, FHN's operation and stock performance have been hurt by any economic weakness to unexpectedly large degree. FHN's net revenues declined by an average of 13% annually between 2008 and 2012, and while the revenue decline for full year 2013 will only likely be around 7%, the bank is still clearly not a top performer. This underperformance is fully reflected in the share price though with shares trading slightly over 1X tangible book value.

Despite this long history of underperformance though, First Horizon seems to finally be bottoming operationally with headwinds from a declining net interest margin and costly legal shackles looking less formidable. In fact, with interest rates rising substantially over the last year, it is very likely that the net interest margin has now bottomed. Further, FHN is tightening up its cost controls (non-interest expenses should be below managements $925mm run rate goal this year), and this combined with wider margins should drive expanded earnings in 2014 (my estimate is for $0.88 against ~$0.75 in 2013). Evidence of this improvement in historical baggage was pretty clear in the firm's third quarter report where it reduced net loan charge-offs by 33% vs. the second quarter, and 75% vs. the year-ago levels.

Memphis TN based-First Horizon operates First Tennessee Bank with offices throughout Tennessee and to a minimal degree in surrounding states. While the firm does have a capital markets group (FTN Financial), this division contributes relatively little to firm profits overall. Instead most of the firm's revenue comes from traditional banking activities; commercial and industrial loans, residential and commercial real estate loans, holding government issued bonds ranging from Treasuries to municipal bonds.

Investors could be forgiven for being a little perplexed by First Horizon over the last few years. While the firm paid off its $866 million TARP loan in a timely fashion with a debt issuance and a secondary equity offering in late 2010, the bank has still struggled to make progress since then. In fact, the 26 million share secondary offering in 2010 was issued at $10.50 a share, only around $1.50 less than where shares trade today despite a nearly 50% move for the broader markets over that time frame. Similarly, while FHN restored its cash dividend in 2011 (2008-2010 dividends were paid in common stock), the dividend was only restored to a quarterly $0.01 per share and it took until July 2013 for the company to return to a more normal quarterly $0.05 per share.

Again though, the redeeming feature for prospective and current investors is that much of this bad news seems to be priced into the stock already. Thus when the company finally shows definitive evidence of a revival, the stock should shoot higher. Management is clearly dissatisfied with the current performance having set a long-term ROE target of 15-20% (compared with 7% in the third quarter of 2013) and an efficiency ratio of 60-65% (78% in the third quarter).

So when could First Horizon start to recover?

Simply put, a recovery could have started already and the stock could move higher if this is verified over the next couple of quarters. Net interest margins stand a good chance of moving higher when the firm reports 4Q2013 or 1Q2014 (~3% in Q3), but the old legal liabilities are still holding the company back. A resolution of these may be on the horizon too.

First Horizon faces a number of crisis-era legal issues. First the bank had to set aside a considerable amount of capital for GSE-related (Fannie Mae and Freddie Mac) mortgage repurchase requests, and while these reserves now look sufficient, there is still on-going litigation related to FHA-insured mortgages from the bank as well as private label securities. The bank is likely to be reluctant to return large amounts of capital to shareholders until these issues are resolved. That day could be coming soon though as management commentary leads me to believe that settlements over the HUD inquiry (on FHA insured loans), and private label securities litigation are approaching. These settlements will probably cost FHN somewhere in the range of $400-500 million (pre-tax) based on other settlements (UBS/JPM) that have been reached, yet this would still only remove about $0.85 a share from TBV on the bank after accounting for other measures FHN can take (like selling its sizeable stake in Visa Class B shares which are currently held at below market prices).

The last important thing to remember as it regards First Horizon is that the bank is one of the most interest rate sensitive names in the regional banking space. The firm's 3Q2103 net interest margin of 2.97% reflected a 65% floating/35% fixed rate break-down in the portfolio. This gives FHN significantly more upside to rising rates than most banks (where a 35%/65% split is not uncommon). The value for FHN investors is in the core banking business (i.e. excluding mortgage company loans and the firm's $3.2B national portfolio of mortgages).

In summary, while First Horizon's core business is seeing reasonable mid-single digit growth, this progress has been masked by the legacy issues I mentioned above. As these masking agents become less significant for the firm over time, FHN's underlying growth should begin to shine through. This improvement should be especially evident if the Fed continues tapering as expected and long-term rates rise as a result. While the short-term outlook for the firm is still muddy, the long-term looks reasonably bright. Given this, the day for an investment in First Horizon could be right around the corner, but it's not quite here yet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.