A Sour Sentiment Toward First Horizon Could Mean Opportunity

About: First Horizon National Corporation (FHN), Includes: CMA, PNC
by: Stephen Simpson, CFA

First Horizon's second quarter results were roundly disappointing, with weaker core interest income, very weak trading results, and higher than expected expenses.

First Horizon's net beta is still attractive, but deposit costs rose more than expected in the second quarter and loan growth is not all that impressive.

First Horizon shares look undervalued, particularly if management can drive better-than-expected underlying performance, but the next couple of quarters could produce lackluster results.

"Worse than Wells Fargo (WFC)" isn't a title anybody wants to hold or share these days, but First Horizon's (FHN) share price performance over the past year and year-to-date does have it trailing that larger scandal-plagued rival. Granted, other similarly-sized banks like Signature (SBNY) and FNB (FNB) have been no great shakes over the past year either, but investors really didn't like what they heard from this Tennessee-based mid-cap bank this quarter.

I think this could be an opportunity for long-term investors to consider First Horizon, but the next few quarters could make for a tough holding period, as it is hard to see what would really drive a meaningful turn in performance or sentiment. First Horizon is a well-placed Southeastern bank active in most of the attractive, major MSAs, and one with a good net beta and specialty lending franchise, but the current performance trajectory isn't getting the job done and the valuation isn't so cheap that it's a can't-miss prospect.

A Relatively Rare Ugly Quarter

First Horizon's second quarter results weren't a disaster by any stretch, but in a quarter that has generally seen okay-to-good quarterly reports from banks, it's an outlier and an under-performer. While weaker fixed-income trading revenue was the biggest source of disappointment, underlying core net interest income was underwhelming, adjusted expenses were high, and deposit cost inflation looms as a bigger threat, while loan growth is more in the "okay" range.

Revenue rose 33% year-over-year, boosted by the CBF acquisition, and just 1% sequentially. Net interest income improved 3% sequentially as flat earning asset balances were offset by modest (6bp) core NIM improvement (versus 10bp stated improvement). Loan yields were up nicely, but deposit costs were also up not-so-nicely, pinching the spread leverage.

First Horizon's fee income was the real disappointment, with total reported revenue down 4% sequentially on a 25% qoq drop in average daily revenue from the fixed-income trading operations. Capital markets revenue has been falling at First Horizon for a long time now, but this is literally the worst quarterly result in over 10 years and revenue is now at a level where the company can't really scale back expenses any further to preserve profitability.

Acquisitions always muck up expense comparisons, but opex growth of 24% (flat qoq) looks high even on an adjusted basis and including higher than expected acquisition/integration expenses. Although pre-provision profit did grow on a sequential core basis, the 4% growth was underwhelming relative to expectations.

Loan Growth Is Still "Meh", And Spread Leverage May Be At Risk

Like Comerica (CMA) (which operates a model similar in some respects), First Horizon continues to see middling loan growth offset by good net betas that are giving it some earnings juice from these recent rate increases. Also like Comerica, though, I expect concerns about deposit cost inflation to be one of the bigger negative takeaways from this quarter.

Loans rose a little less than 2% on an end-of-period basis and about 1% on an average basis, making First Horizon's performance not so impressive relative to the 1% sequential growth at large banks and the 3% growth at small banks (as per Fed data). C&I lending was alright, up 4% qoq as reported and up over 2% on a core basis even when excluding a major jump (32%) in mortgage warehouse lending. CRE lending declined 2%, consistent with Comerica, PNC (PNC), and many other banks that have scaled back their efforts in the face of sharp CRE lending competition. Consumer real estate lending was also down, albeit fairly slightly on an EOP basis.

I haven't seen every bank's second quarter earnings yet, but I believe First Horizon's loan yield improvement will be among the best in its weight class; loan yield improved 28bp sequentially (versus 37bp at Comerica and 14bp for PNC and Wells Fargo), as First Horizon continues to benefit from having the majority of its loans on a variable rate basis. Loan beta spiked over 110% (from 92% in the first quarter) and the cumulative beta is a very healthy 70%-plus.

On the other hand, deposit costs also rose more than expected, with the yield on interest-bearing deposits increasing 28bp from the first quarter. Although First Horizon's low-30%s cumulative deposit beta is still pretty solid on a relative basis (particularly relative to its loan beta), the quarterly beta spiked up as First Horizon, like Comerica, had to make some deposit pricing adjustments to remain competitive and retain deposits.

The Opportunity

Although it will probably be more of a 2019 driver, the CBF deal should give First Horizon some solid expense synergy-driven earnings momentum. I also like the basic backdrop of an asset-sensitive C&I lender that is active in three-quarters of the top Southeastern MSAs, where population and household income growth are expected to be above the national average. Likewise, I like a strong core deposit franchise anchored by strong share in cities like Memphis, Knoxville, and Chattanooga.

In the near term, though, I am worried about repeats of this quarter's weak fixed-income performance, higher-than-expected expenses, and higher-than-expected deposits costs, particularly as it seems clear from management's mid-single-digit growth guidance that loan growth won't come riding to the rescue.

I've lowered my expectations for First Horizon's near-term earnings growth, but I still believe high single-digit long-term growth is attainable, supporting a high-teens fair value on a straight discounted basis. Running those earnings through to an EPS-P/E approach, I likewise believe a high teen's fair value is fair with a forward P/E of 13-14x. First Horizon's near-term ROTCE also supports a fair value in this range, with a multiple of 2.3x actually a little below what the market is otherwise willing to pay for similar ROTCEs.

The Bottom Line

A high-teens fair value suggests that First Horizon is undervalued, but not significantly moreso than a company like PNC that doesn't have these execution issues. By the same token, PNC doesn't have the potential kicker of an acquisition, as First Horizon could be an attractive target given its exposure to the Southeast and its quality C&I lending and deposit franchises. There's definitely room for improvement here, but that improvement probably won't come quickly, so investors looking to take advantage of this downturn in sentiment will need to have some patience to see it play out.

Disclosure: I/we 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.