First Horizon Shares Weaker On A Less Distinguished Third Quarter

Summary

• First Horizon's third-quarter results weren't bad, but the Street didn't like the NIM miss, nor the higher credit losses.
• First Horizon's trading business is providing a counter-cyclical boost, and although the mortgage warehouse lending boom-let may be ending, cost leverage is still possible.
• Low- to mid-single-digit long-term core earnings growth can support a high teens fair value, and First Horizon should continue to grow PPOP despite sector-wide spread compression in 2020.

First Horizon (NYSE:FHN) still doesn't seem to be getting its due, but arguing with the market only gets you so far in the short term. Although the shares had done slightly better than the peer group going into the quarter, a sell-off on the earnings report has pulled the relative performance back to the peer group.

I continue to believe that First Horizon has some useful near-term offsets to spread pressure, including a counter-cyclical trading business and cost leverage, and I like the long-term ramifications of a management team that is keenly focused on out-earning its cost of capital in all parts of the business. These shares could languish without beat-and-raise quarters, but I believe they trade at a double-digit discount to fair value and offer appeal for more patient investors.

A Back-To-Earth Performance That Disappointed The Street

First Horizon didn't have a bad quarter, its core earnings were a penny above expectations, but the report was definitely less exciting than the second-quarter result, and investors didn't like the weaker trends in spread margin and credit.

Revenue rose 7% yoy on a core basis and 2% qoq, coming in about 2% above expectations. Net interest income declined close to 2% in both periods, missing expectations slightly due to a weaker NIM - down 5bp qoq on a core basis and 13bp on a reported basis and about 6bp lower than expected.

Spread compression was expected, but First Horizon saw lower purchase accounting accretion than expected and lowered its forward NIM guidance by about 5bp. Loan yields declined 22bp qoq, while total deposit costs declined only 2bp. First Horizon's deposit cost experience was consistent with what I've seen from other banks this quarter, but the loan yield weakness was more pronounced.

Fee income jumped more than 26% yoy and about 9% qoq, and this line item beat expectations by more than 7%, with fixed income up 18% qoq on a 9% qoq increase in daily revenue. Although fee income/trading beats are often regarded as lower quality by bank stock investors, I don't quite agree in this case, as First Horizon's counter-cyclical trading business is an invaluable offset to the rate-cycle-driven spread pressures.

Operating expenses were a little lower than expected (on a higher revenue number), and First Horizon's efficiency ratio was more than a point better than expected. Core pre-provision profits rose 2% qoq and beat expectations by about 4%, while tangible book value rose 14% yoy and 3% qoq.

Mixed Results Too From The Balance Sheet

First Horizon's loan and credit performance was likewise mixed.

Loans rose more than 14% yoy on a period-end basis and about 10% on an average balance basis, both of which were better than expected. With lower rates driving increased refinancing activity (something that boosted loan demand at First Republic (FRC)), First Horizon saw strong growth in its mortgage warehouse lending business, with loans up 138% yoy and 32% qoq. Net of the mortgage warehouse business, overall lending was up 4% yoy and 5% qoq - not a bad result when the average smaller bank saw 1.3% qoq loan growth in the third quarter (as per Fed Reserve data).

C&I lending was a little soft, growing 10% yoy but flat qoq, but that was only slightly worse than the average smaller bank. CRE lending was strong, up about 10% qoq, while consumer mortgage lending was down slightly.

Credit quality wasn't as robust. The net charge-off ratio rose from 0.02% last year and 0.07% last quarter to 0.19% this quarter. Although I suppose that's a significant increase, it was tied to two commercial credits. Moreover, I think this highlights the issue that many banks with strong credit quality like First Horizon are now facing - charge-offs can't get any lower, and even just one or two bad credits in a quarter can drive higher charge-offs and provisioning expenses. That credit is no longer a tailwind is not a surprise (I've been talking about this for multiple quarters), but actually seeing it appear in the numbers doesn't help sentiment.

On the deposit side, First Horizon did see okay results in its non-interest-bearing deposit gathering, with qoq growth of just under 4% and yoy growth of around 1.5%. Deposit growth lagged loans on an EOP basis (down 1% versus 5% loan growth), and this is okay - First Horizon had some flexibility with its loan/deposit ratio, and management may as well use that to run off some higher-cost deposits when it can.

The Outlook

Even though First Horizon wasn't really a "NIM outperformance" story, the market didn't like the NIM miss, nor the guidance reduction of 5bp for NIM. I'd note, though, that First Horizon management's estimates are predicated on two more rate cuts, whereas most bank managements are factoring in one additional cut. First Horizon did increase its loan growth guidance, but I expect mortgage warehouse lending to decline next quarter.

First Horizon did also increase its operating cost savings target (by $35 million relative to Q2), and I think this is an underappreciated positive development. I also want to reiterate that First Horizon is an intensely capital cost-conscious bank; if a piece of business won't earn its cost of capital, it doesn't do the business. This leads First Horizon to walk away from more business than its peers, and I'd suspect that it also leads to less-sticky relationships with customers (looking at every piece of business as opposed to "taking one for the team" within the context of a longer-term relationship). Still, I suspect many of First Horizon's peers will regret some of the loans they've been making recently, and this could be a tortoise-versus-hare sort of situation.

I haven't really made any significant modeling changes after this quarter (just fine-tuning in line with the reported results and management guidance), and neither my discounted core earnings nor ROTE-driven P/TBV valuation models change much as a result.

The Bottom Line

I believe First Horizon should trade in the high teens, and I expect it to continue to generate pre-provision profit growth through 2020 and 2021, a time when I think many peers will see contraction. The market doesn't seem to care, though, and I think more contrarian-minded investors may want to check this name out more closely.

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.