First Horizon Still Muddling, But Still Holding Upside Too

About: First Horizon National Corporation (FHN), Includes: RF, STI
by: Stephen Simpson, CFA

It has been quite a while since I've written about First Horizon (NYSE:FHN), but this Tennessee-based regional bank continues to operate under a cloud. The market remains concerned about the impact of the company running off its non-strategic loan book and its as-of-yet-unresolved mortgage repurchase liabilities. With that, the shares have nearly doubled since late 2011, but still significantly lagged regional peers/comps like Regions (NYSE:RF) and SunTrust (NYSE:STI).

There aren't a lot of clear bargains left in the banking sector, but I believe First Horizon could be an outperformer as it continues to clean up its business. Not only does First Horizon have additional cost-cutting leverage, but the bank's trading operations and core lending are still in doldrums that I do not believe will persist indefinitely. Moreover, I think the quality of the company's past mortgage loans will serve it well in repurchase settlements. All told, while the performance over the next year is not likely to be scintillating, I'll argue that fair value is around $13 today on the basis of the company's long-term profitability potential.

Fourth Quarter Results Had A Lot Of Ugly To Them

First Horizon did not have a great fourth quarter, as adjusted operating earnings were about three to four cents below the average sell-side estimate. It wasn't a terrible quarter, but it did highlight the ongoing challenges in the company's core operations.

Operating revenue fell 3% sequentially, worse than the median regional bank result (basically flat). Net interest income fell 1% on a very slight sequential improvement in net interest margin, but fee income fell 5% on lower trading and mortgage-related revenue. Expenses were down about 2% ex-items, but core adjusted pre-provision earnings fell about 8% in a quarter where most regionals were flat.

Credit quality was alright, with non-performing assets down 10% and the NPA ratio down 30bp sequentially. Charge-offs ticked up slightly (an NCO ratio of 0.44% vs. 0.41%), but it looks like a fair portion of that was from the non-strategic portfolio. Lending remains weak, as even though adjusting for the run-off of the non-strategic book brings the loan growth from flat to about 1%, that's still below the average.

Unlike most of its peer banks (including SunTrust and Regions), First Horizon has a sizable capital markets business (bond trading). Unfortunately, the fourth quarter's average daily revenue here was a very weak $820K, well below the long-term target of $1 million to $1.5 million.

Repurchases And New Regs Still Hanging Over The Stock

First Horizon did reach an agreement in principle with Fannie Mae for mortgage repurchases in the third quarter of 2013, and there were no additional provisions for that this time around. The overall pipeline of requests declined sequentially by more than a third (to just under $200 million) and the company had realized losses of $98 million in the fourth quarter and a reserve total of $195 million.

It still remains to be seen how matters will go with the FHFA and private securitizations. For the most part, these settlements are being handled from the top down, with the larger banks settling first. While that's not great for the sentiment on FHN shares, it may not be so bad for the company. First Horizon's mortgages continue to perform better than the industry - more than 90% of the loans in question are outperforming the industry on 60-day delinquency rates and more than 70% are outperforming on a cumulative loss basis. That leads me to believe that First Horizon may get better terms (a high single-digit percentage of face) than the double-digit terms that JPMorgan (NYSE:JPM) and UBS took.

There's also likely still some concern about how the Volcker rule might impact First Horizon. The company does have some sizable balances in trust-preferred securities, but the details matter. Because most of these are structured as loans with First Horizon as the creditor/originator, not as an investor like Zions (NASDAQ:ZION), I believe that puts them outside the scope of the rule.

Room To Grow The Core Business

At the core of its operations, I think First Horizon is still in pretty decent shape. The company's efficiency ratio is still much too high (nearly 90% as reported, and in the mid-70%'s adjusted), but the bank believes it only needs one branch every three to five miles in metro areas versus the current footprint of every one or two miles, so further branch closures and expense cuts should be manageable.

First Horizon also has some good long-term growth opportunities in its specialty lending operations. Importantly, this is not the same sort of lending that the company is now running off (as non-strategic), and there are good opportunities in areas like asset-backed lending and corporate banking. First Horizon is also looking to grow its basic branch business, as the company's #5 market share in Nashville (versus #1 in Memphis and Knoxville) is a situation to address. First Horizon is also starting to selectively target higher-growth markets in Mid-Atlantic states like Virginia, North Carolina, and South Carolina.

How Much Better Can The Company Do?

I'm expecting a highly competitive lending environment, the non-strategic run-off, the mortgage settlements, and the overall "meh" banking environment to keep First Horizon's ROE in the high single digits for the next couple of years. With that, the return on tangible asset and equity ratios that underpin "fair" multiples to tangible book value aren't going to look so great.

Looking down the road, though, I am forecasting 15% return on equity on a long-term basis. That's at the low end of management's goal (imputed from their guidance/target for return on tangible common equity of 15% to 20%), but it still supports a fair value of a little more than $13 today and assumes buybacks of $100 million or more a year in a couple of years.

The Bottom Line

First Horizon is a somewhat difficult recommendation right now. On one hand, I think the underlying operational quality of the bank (or more importantly, its future prospects) deserves a higher price and makes the shares worth buying/owning. On the other hand, I know what it's like to own a stock that is under a cloud and these shares may not perform all that well until there is more clarity on the mortgage settlements. For patient investors, I think this is still a name worth considering, but those more focused on short-term results may not be so interested.

Disclosure: I am long JPM, . 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.