J. Michael Jones
It helps to have powerful friends, and in the case of First Horizon (NYSE:FHN), increased confidence in the likelihood of Toronto-Dominion Bank (TD) closing its deal for First Horizon has helped First Horizon outperform in what has been a poor year for regional banks (and banking in general). At the same time, First Horizon hasn’t hurt its standalone credentials (should the deal somehow fall apart) with signs of improved execution over the last few quarters.
I believe TD Bank will get the final go-ahead from regulators to close its acquisition of First Horizon over the next three months or so, and I think there’s a reasonable chance that the close will be after the November 27 deadline that triggers an extra $0.65/share payment. That suggests around $1.60/share of upside from here (or around 6%) – not a scintillating return, but not bad for investors who don’t have more pressing ideas today.
Not A Perfect Quarter, But Not Bad Either
I’ve been critical of First Horizon’s management in the past, and I thought the company needed to show better execution, particularly where harvesting synergies from the IBKC deal was concerned. With the third quarter results in hand, there is evidence of progress, but there are still meaningful opportunities for improvement should the bank end up having to go it alone.
Adjusted core revenue rose 11% year over year and 15% quarter over quarter, beating expectations by about 3%. It’s well worth noting that many sell-side analysts take a less rigorous approach with modeling and following stocks as M&A deadlines approach, so I do take some of the sell-side models for First Horizon with a bigger grain of salt these days.
Core net interest income rose 35% yoy and 22% qoq, as the bank’s above-average asset sensitivity really kicks in. Reported net interest margin rose more than a point from the year-ago level and more than 70bp sequentially, to 3.49% versus 2.41% a year ago and 2.74% a quarter ago. Stronger average loan yields (4.35% versus 3.47% a year ago and 3.57% a quarter ago) have clearly helped, and I expect First Horizon will end up as a better-than-average performer here once all of the quarter reports are in.
Core fee income declined 32% yoy and 4% qoq, with fixed income earnings down 52% yoy and 10% qoq on a 14% qoq decline in average daily trading revenue. I expected trading to be weaker this year given the rate cycle, but I will admit to being a little disappointed that the business hasn’t held up a little better. First Horizon also saw a substantial decline in mortgage banking and title revenue (down 74% yoy and 59% qoq), and this is also as I expected previously given the slowdown in the mortgage market and the bank’s exit from the title business.
Core operating expenses declined 8% yoy and rose 1% qoq, with the bank seeing pretty solid core operating leverage as the synergies from the IBKC deal start working through. Core adjusted pre-provision earnings rose 42% yoy and 37% qoq. Tangible book value declined 11% yoy and 5% qoq, driven by mark-to-market adjustments in the company’s securities portfolio.
Mixed Loan Performance, And Funding Is A Watch Item
First Horizon reported average loan growth of 2% from the prior quarter, which at first glance doesn’t look all that exceptional next to the over 3% growth reported for “small” banks as per Fed H.8 data (it’s worth noting that “small” means “not the 20 largest domestically-chartered banks in the U.S.” in this case). Likewise with the 1% growth in commercial lending at a time when C&I lending activity has been strong (up 4% qoq for the small bank group).
Adjusted results were a little better; stripping out the impact of PPP loans and mortgage warehouse loans, average loan growth bumps up to 4%, with 4% growth in C&I lending. Whether this is the right way to look at it or not is up to investors to decide; mortgage warehouse lending has long been a core part of First Horizon’s business, so I wouldn’t just ignore it. That said, 4% growth in underlying non-warehouse lending is not a bad result, and First Horizon has been delivering the strength I expected to see in areas like asset-based lending and franchise financing.
Credit quality is, not surprisingly, quite good now. I didn’t see anything in the numbers that concerns me, and I’d note that credit quality in the commercial portfolio looks quite good right now.
I’m less happy about what First Horizon reported with deposits. On an average balance basis deposits declined 8% yoy and 5% qoq, notably worse than the flat performance of the larger comp group. Non-interest-bearing deposit performance was likewise weak, with a 4% qoq decline. Deposit costs jumped 15bp, from 10bp last quarter (and 11bp last year) to 25bp, including a 24bp yoy and 25bp qoq increase in interest-bearing deposit costs.
Still, it’s not all bad news for First Horizon here. Optimizing the deposit base has been part of management’s plans post-IBKC, and while it’s a stretch to compare First Horizon to larger banks (and I haven’t had the time yet to go through all of the regional bank reports to date), I’d note that PNC (PNC) and U.S. Bancorp (USB) saw worse increasing in their interest-bearing deposit costs, while Wells Fargo (WFC) did better (up only 16bp qoq). I am still concerned that deposit betas will be higher than expected through this cycle, and First Horizon’s loan/deposit ratio is creeping up, but so far this seems to be under control, even if I would have liked to see a stronger result in non-interest-bearing deposit retention.
The Outlook
For at least the next three months I think the close of the TD Bank acquisition of First Horizon is more important than the underlying financials. While there has been plenty of “noise” around this deal (including a U.S. Senator attempting to scuttle the deal on accusations of “aggressive sales practices” from TD Bank), I do believe the deal will get approval, and First Horizon management expects the deal to close during TD’s fiscal Q1’23 (which runs from November 1, 2022 to Jan 31, 2023).
Should the deal not close before November 27, First Horizon shareholders will get an extra $0.65/share in consideration. I believe that TD Bank is fully prepared to close the deal as soon as final regulatory approvals are secured, so whether the deal closes before that deadline is not really up to TD Bank’s management.
Were the deal to fall apart, I still believe that First Horizon would generate mid-single-digit long-term core earnings growth, supporting a standalone fair value in the low-$20’s.
The Bottom Line
Whether or not these shares are worth owning today depends a lot on the alternatives that investors have. A roughly 6% or so return over three months (assuming the deal can close within the window management expects) isn’t bad, but it also brings the risks that the deal close is delayed further or that the deal collapses altogether. While the market reaction to a deal collapse would be ugly in the short term, First Horizon does still have its merits, including what appears to be a better recent trend of execution that should serve investors well in a go-it-alone outcome.
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