Regions Financial: Low-Cost Deposit Franchise For A Bargain Price

| About: Regions Financial (RF)
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Regions Financial Corp. (RF) is a southern based regional bank that is overcoming the disastrous consequences of the Financial Crisis, to emerge as a healthy and viable banking franchise. Regions problems really began when, in better times, the company acquired Union Planters and AmSouth in the middle part of the last decade. In the era when 'bigger meant better' Regions permanently hurt shareholders through these expensive acquisitions, which ultimately resulted in a $6 billion goodwill impairment. Regions has been hamstrung through its concentrated exposure to construction and real estate loans, particularly in the hard hit southern region. Construction loans have gone from 15% of the total loan portfolio in 2008 to about 1.5% currently. While many regional banks have rallied due to the improving housing market, improved credit metrics, and buoyant mortgage origination market, Regions has lagged behind because of the steeper fall from grace it took relative to peers during the turmoil of the last couple of years.

The key to understanding Regions competitiveness and future profit potential is based on the company's attractive regional footprint to the demographically growing Southeast, and its low-cost deposit base, which provides Regions with the capability of earning above average net interest margins. On 7-24-2012 Regions reported 2nd quarter earnings that were quite solid at $0.20 diluted EPS, equivalent to $284MM in net income. The quarter was not without its share of noise as the company bought back the Series A preferred stock from the U.S. Treasury, which had a $0.05 per share or $45MM negative impact on earnings, but it will be a benefit moving forward reducing the company's cost of funds. In addition Regions sold their Morgan Keegan brokerage to Raymond James Financial Inc. (RJF) for about $1.2 billion. Pre-tax pre-provision profits were $503MM, up from $438MM and $443MM from the last quarter and last year's second quarter respectively.

Through shrewd timing on equity issuances and asset dispositions Regions Financial has secured its future with a very strong capital base. The projected Basel III Tier 1 common ratio is 8.0% at quarter end, while the Tier 1 capital ratio and Tier 1 common ratio are 11% and 10% respectively. Regions Financial trades at a discount to its $10.23 per share book value, and is currently sitting right around its $6.69 tangible book value. The improvement in credit costs has been very strong and fairly consistent as seen from the tables below:

One of the problem areas for Regions has been their Real Estate Held for Sale segment which shockingly produced a $26MM gain this quarter, reflecting asset value improvements. After taking the painful medicine Regions Financial now sits at a normalized level of loss provisions, and the bank can now focus on growing the loan portfolio in a responsible manner, while reducing funding costs to reduce pressure on net interest margins. With a conservative loan-deposit ratio of 80.1%, Regions Financial has the wherewithal to grow its balance sheet. In the quarter total outstanding loans decreased less than 1%, while total loan production increased 15% quarter over quarter. Commercial and Industrial loans grew 4% from the last quarter and 9% YoY. Indirect auto loan production was up 15% QoQ and average loan balances were up 6%. Total consumer loan production totaled $2.8 billion up 24% QoQ. The mortgage business is exploding with the HARP II program expected to increase mortgage volume by $1 billion in 2012. Mortgage revenues were up 17% QoQ and 80% YoY.

Regions Financial generally generates between 33-38% of revenue from fees. Meanwhile the bank is upgrading its technology in an effort to emphasize cross-selling, and I believe that in the current low interest rate environment Regions should try and target a 50-50 split between fee and spread revenues. Regions net interest margin was 3.16% in the quarter, and the company's management believes that they should be able to hold this steady through the expiration of some higher cost deposits. Regions has about $95 billion in deposits costing 32 bps, down from 53 bps YoY. In the 3rd and 4th quarters of 2012 $2.9 billion and $3 billion in CDs yielding 1.2% and 2.1% respectively mature. In 2013 $4.6 billion and $1.9 billion of CDs will be rolling off yielding 1.8% and .8% respectively. These maturities will be extremely beneficial as the going rate for new CDs is about 20 bps. Regions has about a $27 billion securities portfolio to offset the difference between deposits and loans with a duration of roughly two years. While these securities will likely be reinvested into lower yielding securities, the beneficial funding cost reductions should at worst come close to offsetting. This huge low-cost deposit base is illustrative of a bank with some solid franchise value, which an investor is getting for free at a price right around tangible book.

Return on assets in the 2nd quarter was 0.92% and return on tangible equity was 12.4%. Regions has made an effort to cut costs but I believe the company can go further than the 62.8% efficiency ratio attained in the 2nd quarter. Many banks are required to keep extra personnel around to combat higher servicing and compliance issues and Regions has not been exempt. Even in a low interest rate environment I believe that Regions should be able to obtain a 1-1.25% ROA, and can certainly get to a 15% return on tangible equity. This would peg normalized earnings per share at about $1.00 based on current asset levels which I expect to grow steadily. Assuming a future 30% dividend payout on $1.00 of earnings would equate to about a 4.5% dividend yield at current prices, while leaving $0.70 a share for stock buybacks and growing tangible book value. Regions currently yields a paltry 0.6% as it has been focused on building up capital.

One strategy that an investor might want to employ would be to buy the stock while selling the January 14 $10 call for $0.50. This would generate a cash yield of 7.4% in the 542 days till the trade expires, plus any dividends that Regions ends up paying. Meanwhile the significant discount to the strike price enables 49% of upside potential from the current price. At $10 Regions Financial would be trading around current book value, and near 10 times normalized earnings. Due to Regions low-cost deposit base, the bank would be an ideal takeout candidate for a company such as Capital One Financial Corp. (COF) or Discover Financial Services (DFS) that may choose to enhance its deposit franchise. Many analysts are using an inflated cost of capital for Regions Financial based on the recent history of capital raises, but those days are over and I have no doubt that the company will out-earn its cost of capital moving forward. Management must focus on boosting efficiency and avoid acquisitions outside of any attractive FDIC purchases.

Disclosure: I am long RF.