Description
First Tennessee National Corp. - FTN
Stock Price (4/17/03): $41.72 / Market Capitalization: $5.24B / Shares Outstanding 125.7MM
2003 First Call EPS: $3.46 / 2003 P/E: 12.1x
2004 First Call EPS: $3.60 / 2004 P/E: 11.6x
Long-Term EPS Growth Rate: 11%
Book Value / Share: $13.91 / Price/Book Ratio: 3.02x
Rationale
There is no better way to benefit from the current “refinancing bubble” than to make a bearish investment in the shares of First Tennessee National Corporation. FTN has positioned itself extraordinarily well for the falling interest rate environment of the last two years and currently derives nearly 80% of its earnings from mortgage refinancing and fixed income products. While currently trading on peak earnings, a flat to rising interest rate environment will quickly turn the stock downwards as it is overvalued trading at a 52-week high and at the high-end of the regional bank group at nearly 12x 2004 and 3x book value (average 10.7x 2004 and 2.1x book value). FTN has 25%-30% downside as Wall St. will have to lower FTN’s 2003 and 2004 EPS estimates.
Description
First Tennessee National Corporation is a financial services institution with $24.8 billion in assets. FTN is separated into several divisions including a traditional regional bank, First Horizon Home Loans, First Tennessee capital markets (FTN Financial) and transaction processing including First Horizons Merchant Services and Express Processing.
Refinance Bubble
Many investors have observed over the last two year that the United States is in the midst of a “housing bubble,” but have been punished for bearish bets against homebuilder stocks such as KB Home, Lennar, Ryland and Toll Brothers. One needs only to open up the local real estate section to realize that home prices are high, but the United States is not in a housing bubble. Housing prices are merely a function of mortgage prices and low interest rates. Alan Greenspan’s Federal Reserve has been overly accommodative in cutting interest rates 11 times since 2001 to forty year lows to help the struggling US economy adjust to more normalized growth post the late-1990s. While we are not in the midst of housing bubble, these low rates have created a mortgage bubble. Yet, the real bubble lies not in new mortgages, but in mortgage refinancing which are a function of falling interest rates not low absolute mortgage rates. According to the Mortgage Bankers Association of America (www.mbaa.org), the MBA weekly index of Mortgage Refinancings hit a record of 9387 in mid-March (refi’s represented 81% of all mortgages for the week) and spent all of March above 6000. In 2002, the MBA Refi Index topped 6,000 in only one month. Prior to 2002, the index never had reached over 6000. In early and mid-March prior to the start of the Iraq war, 30-year fixed rate mortgages were trading at record lows of 5.4%. Mortgage holders rushed to refinance at these levels which have since risen to above 5.8%. According to the most recent MBA report on 4/16/03, weekly refinancing activity finally dipped below 6000 to 5547 as refi’s fell to less than 70% of all mortgages. Note the difference in the Mortgage Bankers Weekly Refinance Index and the Mortgage Bankers Mortgage Index over the last year shows the Refi Index is the bigger bubble as mortgage rates have been falling (not just holding at attractively low rates):
Average Monthly Values for Weekly Basic Mortgage Composite Index (Bloomberg: MBAVBASC Index)
3/02: 522.6 4/02: 491.4 5/02: 544.6 6/02: 633.7 7/02: 818.4 8/02: 1069.9 9/02: 1209.4 10/02: 1161.2 11/02: 1058.6 12/02: 926.9 1/03: 1149.9 2/03: 1143.4 3/03: 1515.0 4/03: 1190.6 (through 4/16)
Average Monthly Values for Weekly MBA Refinancing Index (Bloomberg: MBAVREFI Index)
3/02: 1391.7 4/02: 1328.4 5/02: 1565.2 6/02: 2148.9 7/02: 3401.8 8/02: 5190.3 9/02: 6094.5 10/02: 5887.4 11/02: 5139.8 12/02: 4237.8 1/03: 5714.1 2/03: 5878.0 3/03: 8232.1 4/03: 5854.8 (through 4/16)
Falling Average Monthly Interest Rates on 30-Year Fixed Rate Mortgages Spurs Refinancing (Source: MBA)
3/02: 7.01% 4/02: 6.99% 5/02: 6.81% 6/02: 6.65% 7/02: 6.49% 8/02: 6.29% 9/02: 6.09% 10/02: 6.11% 11/02: 6.07% 12/02: 6.05% 1/03: 5.92% 2/03: 5.84% 3/03: 5.75%
FTN Trading on Peak Earnings
First Tennessee National Corporation or FTN, is in the peak of its earnings cycle. FTN has positioned itself well for a low-interest rate US economy. In the last two quarters, the company has actually been suppressing its earnings by approximately $.20, and yet still has crushed Wall St. expectations. Because of the increased refi activity, FTN earned $.91/share in Q1 2003 vs. $.80/share expected, but re-invested about $.20 back into operations. FTN could have earned well over $1.00/share in the quarter.
FTN operates three significant divisions currently:
First Horizon
FTN’s national consumer mortgage company is operating at peak earnings as exemplified in Q1 2003 and now makes up 52% of total non-interest income up from 37% in Q1 2002 and 34% in Q1 2001. Q1 2003 revenue was $352 million, up 93% from Q1 2002. Pre-tax earnings were $119 million, up 189% from $41 million in Q1 2002 and represented 66% of total earnings. In Q1 2003, First Horizon originated $11.5 billion in new mortgages during the quarter up 117% from Q1 2002 and up 24% from Q4 2002. 79% of First Horizon’s origination volume came from refinance activity. Refinance originations increased 46% while home purchase originations (new mortgages) decreased 21% Y/Y.
FTN Financial
FTN’s capital market subsidiary has also been an exceptional performer selling bonds and government agency debt to depository institutions like banks and thrifts experiencing slowing loan growth but high deposit growth from the lack of equity market opportunities. In Q1 2003, FTN Financial generated revenue of $139.2 million (up 38% from Q1 2002 and up 10% from Q4 2002) and had pre-tax earnings of $46 million (up 27% Y/Y) representing 25% of earnings.
FTN Banking Group
FTN’s regional bank however has been suffering like many of the southern based regional banks due to net interest margin compression from low rates and lack of loan growth outside of mortgages. FTN’s banking group margin fell by about 20 bps in Q1 2003 to 3.97% and has declined about 75 bps since Q1 2002. Revenue dropped 7% to $178 million in Q1 2003 from $192 million in Q1 2002. Pre-tax earnings fell to $35.6 million in Q1 2003 from $64.9 million in Q1 2002 (partially due to an extra $9 million in marketing, technology and deferred compensation costs).
Earnings Estimates are Reliant on Continued Low Rates and Refi’s
With 66% of earnings coming from mortgages and 79% of mortgage earnings coming from refinancing it is clear that FTN will continue to trade on how well this market performs. Note that the mortgage market will likely continue to perform well as absolute interest rates are low, but the mortgage refinance market requires relative movements in rates downward to encourage mortgage refinancing. There are many factors that could cause long-term (30-year) interest rates to move up including a recovery in the stock market raising fixed income yields and/or increased government borrowing due to the ever-increasing US government deficit. The US government budget deficit at $253B is already in 2003 nearly twice the total it was in 2002 of $132B. The deficit is on pace to easily surpass the record deficit of 1992 at $290B. The weak equity markets have depressed tax revenues, the war in Iraq is a massive drain and President Bush is trying to pass tax cuts. The government borrowing will lead to higher interest rates and inflation. If 30-year rates rose to the levels seen in 2002 of 6.54% or 2001 of 6.97%, it would be hard for FTN to achieve the EPS expectations of Wall St. One particularly aggressive Wall St. broker, Friedman Billings and Ramsey, predicts FTN to earn $4.00/sh in 2004 which seems difficult unless long term rates fall in a Japan-like fashion. Note FTN’s EPS over the last few years and the Yearly Average Interest Rates on 30-year fixed rate mortgages since 2000 (mortgage rates from from MBA, EPS estimates from First Call):
2000
EPS: $1.77 (down 4% Y/Y)
Average Rate: 8.05%
2001
EPS: $2.32 (up 31% Y/Y)
Average Rate: 6.97%
2002
EPS: $2.89 (up 25% Y/Y)
Average Rate: 6.54%
2003
EPS (projected): $3.46 (up 20%)
Average Rate to date through March: 5.8%
2004
EPS (projected): $3.60 (up 4%)
Average Rate: To be determined
FTN Cross Selling Opportunity
FTN’s management is acutely aware of their success over the last 2 years and is preparing for the worst as refi’s slow and FTN Financial’s customers sense bond rates may rise and thus fear buying long term fixed income products. FTN has aggressively plowed back earnings into its own business, expanding its equity sales force and investment banking operation at FTN Financial while simultaneously taking charges now at FTN regional bank to improve operations. These attempts seem to suggest more of a sense of impending weakness vs. a sense of strength. Wall St. analysts currently believing the cross selling/paying down costs strategy of FTN also have ignored that First Horizon has massively expanded its own retail strategy to attain the mortgage growth it is now generating. This can’t just be shut down and will remain a drain on earnings as refi’s slow. Investors are currently buying FTN as a “growth story” with a Q1 2003 ROE of nearly 28% and an ROA of 2.07%. These investors will not hold the stock as First Horizon and FTN Financial slow into the 2nd half of 2003 and 2004 while the regional bank and processing divisions, regardless of reinvestment and efficiency gains, can’t offset the loss. Compare the fee income breakdown of Q1 2003, Q1 2002 and Q1 2001 to see how much First Horizon and FTN Financial can fall and how offsetting this is impossible. Note that interest income between Q1 2003 and Q1 2002 only increased from $158.4MM to $166MM which can’t offset the loss regardless of an improved net interest margin due to higher rates (total income increased from $483.4MM to $685.2MM). Fee income, at 72.8% of operating income in Q1 2003, has become to great at FTN to be offset in a flat to rising interest rate environment:
Q1 2001
Fee Income Total: $258MM
Mortgage Banking (First Horizon): $88MM (34% of total)
Capital Markets (FTN Financial): 79MM (31%)
Deposit Transactions & Cash Management: $28MM (10.8%)
Merchant Processing: $12MM (5%)
Trust Services: $15MM (6%)
Other Income: $37MM (14%)
Q1 2002
Fee Income Total: $325MM
Mortgage Banking (First Horizon): $121.3MM (37% of total)
Capital Markets (FTN Financial): 99.4MM (30.5%)
Deposit Transactions & Cash Management: $32.4MM (10%)
Merchant Processing: $10.2MM (3.1%)
Insurance: $13.5MM (4.2%)
Trust Services: $14.1MM (4.3%)
Other Income: $34.0MM (10%)
Q1 2003
Fee Income Total: $519.2MM
Mortgage Banking (First Horizon): $271.8MM (52.3% of total)
Capital Markets (FTN Financial): $139.2MM (26.8%)
Deposit Transactions & Cash Management: $32.8MM (6.3%)
Merchant Processing: $12.6MM (2.4%)
Insurance: $14.5MM (2.7%)
Trust Services: $11.4MM (2.2%
Other Income: $36.9MM (7.1%)
Clearly, the divisions below First Horizon and FTN Financial are generating insufficient revenues to offset declines at the two top divisions. Even assuming FTN Financial becomes the next great fully-integrated (fixed income and equity) investment bank (which is highly unlikely as FTN is positioned for rising rates about as well as a boutique technology investment bank in March 2000 was positioned for the Nasdaq crash) a decline in fee income at First Horizon back to Q1 2002 levels per quarter would severely impact total fee income. And this only assumes long term interest rates stay flat (negative for refi’s) or rise 50 to 100 bps into 2004 (negative for refi’s and overall mortgages).
Q1 2002 vs. Q1 2003 showed a total fee increase of $194.2MM ($519.2MM - $325) while the increase in fee income at First Horizon of $150.5MM ($271.8MM – 121.3MM) accounted for 77% of the increase. Under the bearish scenario where First Horizon returns to normal quarterly growth of $120 -$150MM/quarter, FTN could be back to earning below $3.00/share as it did in 2002 showing flattish growth in 2003 and declining EPS growth in 2004. Certainly not the 12-15% EPS growth that FTN is currently projecting.
FTN - Sum of the Parts Valuation
Assuming estimates for FTN two highly successful divisions, First Horizon and FTN Financial don’t need to be cut for 2004, a simple sum of the parts valuation for FTN shows the overvalued price investors are currently paying for FTN’s shares. FTN’s regional banking operation should be valued on a group multiple of 10.7x 2004 EPS. FTN Financial should be valued based on a group multiple for fixed-income based brokers Bear Stearns and Lehman Brothers – 12.7x 2004. First Horizon should be valued based on the 2004 P/E multiples of mortgage lenders Country Wide Credit (CFC), Greenpoint Financial (GPT) and Washington Mutual (WM) - 7.6x 2004. Finally, FTN Transaction Processing should be valued at transaction and processors multiples (CE, TSS, FDC) around 17x 2004 (which is very generous for this underperforming business). Taking net income estimates for each of these divisions (Merrill Lynch - 4/15/03), one can derive a stock price for FTN nearly 14% below its lofty $41.72 current price.
FTN Regional Banking is projected to earn $158MM in 2004 * 10.7x = $1,706 = $13/sh
FTN Financial is projected to earn $125MM in 2004 * 12.7x = $1,587 = $13/sh
First Horizon is projected to earn $172MM in 2004 * 7.6x = 1,307 = $10/sh
FTN Transaction Processing and Corporate is projected to earn -$7MM in 2004 * 17x = ($1/sh)
Summing the parts = $13 + $13 + $10 - $1 = $36
Under a more bearish scenario (i.e. flat/rising rates) the value of FTN is probably closer to the $32 range or down 23% from $42. This includes better or “offsetting” returns at FTN Regional Bank and Transaction Processing:
FTN Regional Banking would earn $165M in 2004 * 10.7x = $1,766 = $14/sh
FTN Financial would earn $100MM in 2004 * 12.7x = $1,270 = $10/sh
First Horizon would earn $120MM in 2004 * 7.6x = $912 = $7/sh
FTN Transaction Processing and Corporate would earn $7MM in 2004 * 17x = $1/sh
Summing the parts = $14 + $10 + $7 + $1= $32
Note that in 2002 FTN’s high was $41, low was $29.76 and average was $36.37. In 2001, FTN’s high was $37.49, low was $27.13 and average was $33.46. In 2000, FTN’s high was $29.31, low was $15.94 and average was $21.27. While the low interest rate cycle is unlikely to return to 2000 levels particularly soon, an investor can see the cyclical troughs from which FTN has risen.
Conclusion
There is no better way to play the impending decline in the refinancing market in 2003 and 2004 than shorting First Tennessee National. The mortgage market in the United States may continue to remain intact keeping housing prices high, but with FTN’s First Horizon deriving 79% of mortgage income from refinancing and representing the majority of the entire company’s income, if rates don’t continue to decline, the stock will fall. FTN’s aggressive attempts to expand its operations outside of mortgage and fixed income should be a signal of the impending trough that will follow this current peak.
Catalyst
Catalysts
30-year interest rates remain flat or increase slowing mortgage refinancing.
The US government itself causes interest rates to go up by borrowing and thus causing a “crowding out effect” – crowding out private loans and thus leading to higher interest rates and inflation.
The Federal Reserve leaves rates unchanged at May Fed meeting and/or hints at raising rates later in year.
Analysts recognize the high valuation and high leverage FTN has to mortgage refinancing and lower numbers/downgrade.
First Horizon experiences slowing 2nd half 2003 growth and has to lower guidance itself.