Trading around 15x 2016 EPS with a dividend yield of around 2%, First Horizon National Corp. (FNH) is not particularly cheap. But the management team is talking about growth. And some of the basic capital and cost metrics of the bank suggest growth is well within its scope. The recent results and analyst call highlighted three prospective sources of growth for investors to be aware of: (1) greater balance sheet leverage; (2) improvements in operating leverage; and (3) share buybacks. To my mind, there are good chances of these working together to drive shareholder value creation.
The core of the leverage opportunity at FHN is really the capital position, which, for a bank of its size (total assets stand at $28 billion), is extremely comfortable at 9.8% CET1 capital adequacy (3Q'16). On Friday's results call, management agreed with one analyst's view that the company is sitting on a "pile of capital", and the CEO is currently minded to deploy capital for growth - whether organic or through acquisition - rather than emphasize capital return. Incidentally, an interesting aspect of FNH's language around this point is the company's emphasis on consideration of the personnel it acquires in a potential acquisition as one of its growth factors beyond the accretion math.
To get an idea of what might be possible in terms of leverage, it's useful to look at the last twelve months, over which time the effects of higher risk-weighted assets over stable capital have been impressive. Basically, FNH has achieved materially higher leverage (though still within a robust margin of safety in terms of capital ratios). The highlighted areas in the table below show how this has allowed 13% growth in net interest income against <5% growth in regulatory capital deployed. The math suggests that this should be repeatable if FNH finds the right targets. A CET1 ratio of slightly under 9% would be fine for this bank.
(Source: Company data)
The third quarter saw a strong rise in loans of 17% YoY, which reflected the acquisition of a book of restaurant franchise loans. The central expectation is for mid-to-high single digit organic growth from here, which I would regard as reasonably conservative given the bank's small size and capital position vis á vis the prevailing system growth rate of 9.4% (Fed data for first week of October). This will allow loans to grow faster than total assets, which will have a mixed effect on net interest margin, and I would expect revenue to grow slightly ahead of assets.
Owing to the higher revenue base, FNH enjoyed very favourable cost/income dynamics at 3Q with a 6% positive underlying difference in the annual growth rates between the two lines. Management has previously given quantified cost guidance quarter to quarter, but now intends to avoid specific "dollar" targets and instead aims to grow business volumes at ever-improving operating leverage. This makes it somewhat harder for analysts to forecast operating profit, but the overall direction of travel is obviously positive for investors. With a 70% efficiency ratio, FNH is like a number of community banks in the $25-30 billion total asset range, and better operating leverage should come naturally as the bank builds scale.
What if acquisition opportunities don't present themselves? In that scenario, the bank would be comfortably overcapitalised, and if the management team can't execute its preferred means of expansion by buying other risk assets, it will be able to return capital. However, even in a normal organic growth scenario, just 30bps of capital annually for buybacks would grow EPS by a further 2% to augment the organic growth available to the bank. Here is a simple model of the kind of scenario I am describing:
The above is a base-case scenario that leaves FNH a bit below 12x EPS in 2018. If the stock can attain a 15x P/E by then, investors will get 25% capital appreciation with a further 4% or so of dividend return from here, which is attractive on an annualised basis. To get a lot more than that out of the stock, you need management to execute on its desire for acquisitive growth, which I find a realistic scenario.
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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.