First Horizon Corp (FHN) 2006 Q2 法說會逐字稿

Welcome to First Horizon National Corporation's second quarter earnings conference call.

Today's call is being recorded.

In addition, you can listen along simultaneously at www.shareholder.com/FHNC/mediaregister.CFM?mediaID=21172.

Hosting the call today for First National Corp. is Ken Glass, Chairman and Chief Executive Officer, and Marty Mosby, Chief Financial Officer.

They're also joined by Jerry Baker, Chief Operation Officer, and Dave Miller, the new Director of Investor Relations for First Horizon.

Before we begin, management has asked me to inform you this conference call contains forward-looking statements involving significant risk and uncertainties.

A number of factors could cause actual results to differ materially from those forward-looking information.

Those factors are outlined in the recent earnings press release, and more in the most current 10-Q and 10-K.

First Horizon National Corporation disclaims any obligation to update any forward-looking statements that are made from the time to time to reflect future events or developments.

At this time all participants have been placed in a listen-only mode.

But the floor will be open for your questions.

Sir, you may begin.

Thank you, operator, and good morning to everyone.

As the operator indicated, I have Marty Mosby and Jerry Baker here with me today, and for the first time, our new Investor Relations manager, Dave Miller, who will be working with you closely going forward.

Mark Yates has been promoted and will manage our loan securitization processes.

I know that you have enjoyed working with Mark over the last 4 years, and we're all excited about his new role here at First Horizon.

Dave Miller has been leading our marketing efforts in Tennessee for several years.

He was instrumental in the development of our customer data warehouse, which has become a key tool supporting our targeted marketing initiatives in Tennessee and in our national expansion strategy.

I am confident that Dave's involvement will enhance our communications to the marketplace.

Together, we'll give you our take on the second quarter performance and try to answer any questions that you might have.

Given the continued flattening of the yield curve, I would characterize our second quarter performance as solid, with no great surprises either way.

Our earnings from continuing operations increased 8%, and this quarter's earnings per share of $0.82 increased 6% over last year's second quarter.

This is a result of success in 5 key areas. 1, the continued expansion of our national strategy. 2, continued market share gains in Tennessee, as we take advantage of the consolidation of a couple of our competitors. 3, growth in capital markets, other product revenues. 4, the implementation of our efficiency efforts.

And 5, the initial impact of the long range benefits from the utilization of proceeds from the Merchant divesture.

Now, I would like to take a second to -- I would like to take some time on each of these 5 areas.

First, let me give you an update on our national expansion.

In 2000, the year 2000, we had cross-sold 17% of our national customers an additional product.

And that's the national mortgage customer base.

And we believed our strategies could ultimately grow that penetration to 40%.

At the end of the second quarter we achieved that milestone.

We have now sold 40% of our mortgage customers at least 1 additional product.

We expect this to continue to improve as we continue to execute our strategies.

One area of opportunity to grow this penetration is our strategy of cross-selling deposits to this customer base.

This last quarter, 16% of our mortgage -- originated mortgage customers opened a deposit account.

A year ago, 2% of those customers made that decision.

In total, our strategy to leverage our nationwide mortgage platform by cross-selling banking products and construction lending now accounts for nearly $100 million in quarterly revenues.

As expected, the largest market position -- or our latest market position report shows that we continue to gain share in Tennessee by leveraging our leadership position in the 5 major metropolitan areas across the state, we have taken advantage of the opportunity created by significant competitor consolidations that are impacting more than 25% of the households in this state.

As a result, First Tennessee experienced 84 basis points of market share gains over the last 12 months, as the second straight year of more than doubling our normal gain of targeted customers.

Today, 21% of targeted households in our trade area consider First Tennessee their primary financial institution.

That's 8 percentage points higher than our next closest competitor.

As a result of the growth achieved in both our national expansion and our Tennessee franchise, our Retail/Commercial Banking business segment has performed significantly better than the rest of the industry.

Revenues in that segment have sustained their momentum, growing 10% compared to second quarter of 2005.

The primary drivers of this growth were year-over-year loan growth of 19%, and deposit growth of 11%.

Each of these respective growth rates is more than double the current industry rates.

Capital Markets experienced its third straight quarterly improvement in pre-tax earnings and almost doubled its earnings from the prior year level.

Other product fees increased 33%, or $16 million over the second quarter of last year, and were up 35% over first quarter levels.

Now, let me turn it our earnings enhancements.

As the yield curve continues to make the operating environment more onerous, we're managing the controllable aspects of our businesses.

Our current focus has been on achieving our efficiency initiatives and utilizing the proceeds from the Merchant divesture.

At year end, I shared with you that we had an efficiency target of $50 million for 2006.

At the end of the first quarter following our sale of the Merchant Processing business I reported we expected to add $30 million to the bottom line this year by utilizing the proceeds from that sale.

Together, these create an earnings enhancement target of $80 million for this year.

Well, after achieving $9 million of efficiencies in the first quarter, we added another $10 million in the second quarter, and currently have 25 initiatives in various stages of implementation.

Also, this quarter we were able to use proceeds from the Merchant Processing sale to produce $10 million in core earnings, in addition to the $2 million we picked up in the first quarter.

I believe we're well on the way toward achieving our $80 million goal.

Now I will turn it over to Marty to to go over the details of the quarter with you, and I will be back with some closing thoughts, and take your questions.

Good morning.

As Ken reported earlier, our earnings per share grew 6% over last year's second quarter to $0.82 this quarter.

Additionally, return on equity continues to be above industry averages at 17%.

Now I would like to highlight each business segment's respective performance.

The Retail/Commercial Bank pre-tax earnings, excluding the impact from the Merchant Processing divesture, grew 9% or $10 million over last year's second quarter.

However, I would note that this quarter's earnings included an $8 million write-down of construction loans in our One-Time close program, which I will describe in more detail shortly.

Revenue growth over the second quarter of last year has been created by increases in both net interest income and fee income.

Since the second quarter of last year, that interest income has grown 9% as loans grew 19% and deposits have increased 11%.

Compression in net interest margin of 7 basis points over the last 12 months has offset some of this balance sheet growth.

However, net interest margin improved a couple of basis points in each of the last 2 quarters.

Fee income has increased 12% over the last year, as deposit and cash management fees, as well as wealth management fees, have experienced growth.

The efficiency ratio in Retail/Commercial Bank improved 120 basis points from the fourth quarter, excluding the impact from this quarter's write-down and adjusting for divesture gains.

We implemented efficiency initiatives to create an improvement of approximately $5 million, including the closure of a remittance processing location, consolidation of support functions, and ongoing reductions in discretionary spending.

These efficiencies more than offset investments in our national market expansion and contributed to this improvement in the efficiency ratio.

As expected, asset quality trends have begun to migrate from their historical low levels.

Recent levels of non-performers and net charge-offs have been significantly below historical averages.

As a result, some deterioration is expected as our loan portfolios begin to season, and this economic expansion matures.

Initially this normal progression will be somewhat irregular, as any incremental additions have a relatively large impact on our low base.

In general, the current level of watch list and classified assets improved from the first quarter to the second quarter, and all of our loan portfolios continued to perform better than our standards.

So far, deterioration has been isolated to circumstances with individual borrowers, and we believe doesn't reflect systemic underwriting issues with the various loan portfolios.

As I mentioned earlier, we experienced an $8 million expense due to the write-down of suspected fraudulent loans.

These construction loans were in our One-Time close program and were identified late last year as a pool of loans we put on the watch list due to suspected fraud.

Over the last 9 months we've been working out of this portfolio of approximately $134 million in commitments, and we experienced no loss in this portfolio prior to this quarter.

This quarter's loss resulted because of circumstances surrounding a small portion of these loans recently began to deteriorate.

As we had discovered this issue last year, we strengthened our processes and have experienced no additional originations with this particular issue.

We've also been working through circumstances with each of these loans and have reduced this portfolio by over 50%, with most of those remaining currently in the final phases of construction or already completed and in repayment.

A specific non-performing loans which required a write-down this quarter to current net realizable values, reflect current appraised values, including estimated costs of liquidating these properties.

The next business line I will discuss is Capital Markets, which showed significant improvement in net interest, expense and fee income from other products, overcoming the continued slow demand for fixed income products.

Other product fees increased 33%, or $16 million over the second quarter of last year, and were up 35% over first quarter levels.

Increases in investment banking and structured finance activities were the primary drivers of this growth.

Net interest income also improved this quarter, experiencing $5 million less in negative carry, even though the yield curve is significantly flatter than it was in the second quarter of last year.

The primary driver of this gain was improved execution that has decreased the level of non-earning assets.

As a result of this revenue growth and approximately $2 million of expense efficiencies created since the fourth quarter, Capital Markets efficiency ratio has improved significantly.

Moving on to Mortgage Banking, this quarter reflected the seasonal and operational improvement in profitability that we were expecting, as Mortgage Banking earnings improved $35 million from the first quarter level.

Despite this rebound, Mortgage Banking earnings still experienced a 30% decline over last year's second quarter, and as you have heard reported by many of the mortgage bankers, the operating environment remains relatively tough within this industry.

In the second quarter, origination income increased $35 million over this year's first quarter, and increased 12% over last year's second quarter.

By comparison, the Mortgage Bankers Association is forecasting a 14% decline in total originations in the second quarter of 2006 versus the second quarter of 2005.

First Horizon Home Loans has grown origination income by maintaining its pricing discipline as servicing values have increased, enabling an improvement in origination margins.

Although this has helped to sustain the profitability of origination channel, it i has unfavorably impacted our ability in the short-term to continue to gain market share.

Thus, First Horizon origination volume experienced a 21% decline versus the previously mentioned 14% decline experienced in the market.

Our total servicing portfolio grew 9% year-over-year to $99.3 billion in the second quarter.

This was the primary driver of an increase in total mortgage servicing fees of 17% over the same period.

In addition, servicing costs per loan declined almost $1.50 or 3%, to down to almost $50 per loan.

While the underlying servicing profitability continues to progress, net results from servicing hedging and write-off of MSR values created a challenge this quarter.

This quarter we experienced net hedging losses of approximately $4 million and an increase in our run-off rate of 1 percentage point over the first quarter.

This increase in run-off rate accompanied by an increase in servicing values had approximately a $15 million unfavorable impact on this quarter's Mortgage Banking earnings.

The continued flattening in the yield curve compressed the spread on the mortgage warehouse loans another 33 basis points this quarter, now totaling 122 basis points over the last 12 months.

As a result of this compression and an 11% decline in average warehouse levels, Mortgage Banking net interest income has declined 34% since the second quarter of 2005.

Mortgage Banking expenses were down 4% since the second quarter of last year, corresponding to the decline in mortgage fees.

Key drivers of this decline were the reduction of variable expenses and 2 consolidation efforts completed this quarter.

Notably, the consolidation of our correspond and origination platform into wholesale channel and the closing of unprofitable mortgage branches.

Additionally our efficiency initiatives have achieved $1 million of fixed costs and discretionary spending reduction since the beginning of this year.

Since the fourth quarter net interest income in the Corporate segment has improved $4 million.

This reflects approximately $6 million of benefit from the restructuring of the investment portfolio that was executed in the first quarter.

The second quarter reflected the full benefit of this initiative, as the yield on the overall investment portfolio improved to 5.53% this quarter, over 100 basis points higher than the fourth quarter levels.

Corporate revenue was also favorably impacted this quarter by a $2.5 million securities gain from the receipt of cash from our Mastercard stock, as an IPO was completed in the second quarter, as we completed the sale of the subsidiary stock that resulted in a $4 million tax benefit or a $6 million pre-tax impact this quarter.

Capital ratios remain well within management guidelines, and shareholder equity to asset ratio has actually improved 9 basis points since the first quarter, and 56 basis points since the second quarter of last year.

Book value per share continues to grow at a double-digit pace, increasing 11% since the second quarter of last year to $19.59.

In summary, our earnings from continued operations grew 8% in the second quarter as compared to last year.

This resulted from 4% growth in revenues, while expenses grew 3%.

Excluding the impact of this quarter's fraud loss, expenses grew only 1%.

Our core strategies, coupled with earnings enhancements, have created revenue growth despite the challenges of a difficult operating environment.

Additionally, our continued focus on efficiency has held our expenses relatively flat, even as we fund investments in our future.

I hope these details have been helpful.

Dave and I will be available to answer your questions, and look forward to introducing each of you to Dave during that time.

Thanks for your attention and, Ken, I would like to turn it back over to you now.

Okay.

Thank you, Marty.

Let me wrap up by saying that it is obvious that the yield curve pressure is still with us, and in fact has continued to worsen.

We don't expect any immediate relief of this.

Regardless, we will continue to focus on executing our strategies and achieving our earning enhancement targets.

I would like to take this opportunity to point out that in the face of this yield curve that has continued to flatten more than 100 basis points since this time last year, our outstanding team of employees has produced this growth in earnings.

I can't say enough about the hard work, the long hours, and the dedication to our customers that made this result possible.

You've heard me say many times, our culture is our competitive advantage.

Going forward, since I have broken my crystal ball, all I can say is that once the yield curve stabilizes, then we'll begin to see additional improvements in our reported earnings.

Thank you for your attention, and I will now attempt to take your questions.

[OPERATOR INSTRUCTIONS] Kevin Fitzsimmons, Sandler O'Neill.

I apologize if you gave this detail already.

I got on the call late.

But on the pool of construction loans with the fraud issue, can you just -- it looks like you quantified it, $7.9 million, but what line item specifically is that in?

And is that really something that's a 1 quarter thing and you don't expect any impact from next quarter?

And then secondly, do you think that is a little bit of -- is it a one-off?

Is it -- could people construe that this -- well, this is a by-product of doing construction lending outside of your home markets, that you're hiring people from outside, and maybe the degree of oversight maybe a little lacking?

Can you just address that?

Thanks.

I will address the income statement part, and then Ken and Jerry can talk about the general nature of the risk as we go nationwide.

If you look at the fraud loss, it is specifically in other expenses.

So when you look at the income statement, you will see it in other expenses.

If you even look at the other expense detail we give, it is in other-other expenses, because it is a fraud loss, which falls down into other types of losses.

So that's -- it is very down in other-other expenses, but it is in the expense line of the Retail/Commercial Bank.

So when you look at the segments, it would be expenses in Retail/Commercial Bank and that's where you'd find it from that standpoint.

Kevin, this is Ken.

Let me answer part of your question and then if you need more detail, we can go into it in more detail.

But let me address the program.

We have over the last 4 or 5 years annually produced billions of dollars, I think 3 to $4 billion of these loans.

We have never had a loss in these loans.

This was a unique circumstance in this group of loans, where we had found some weaknesses in our procedures.

We've corrected those weaknesses last fall when these were discovered, and this is a by-product of that.

So over this -- if this is the level of losses we take over a 3 or 4 year period, then obviously it is not reflective of a poor program, but a very high quality program.

Our procedures in that program, and even in these loans, give us a lot of protection against these losses to the extent that we have claims on these losses against several parties that were our agents, because there was a breakdown in their process, contractual process with us.

So the fact that this happened is not pleasant to us.

But it is not -- we clearly -- I clearly believe, having investigated this to a great degree, is not reflective of a weakness in the overall program, or a poor program, or a high risk program, but it is due to a breakdown in a short period of time that we discovered very early, and were able to take corrective action to minimize our loss.

Okay.

Great.

Thank you very much.

Kevin Reynolds, Stanford Group.

Question, I guess to Marty on the tax rate, just to get back to what you were saying.

I heard you say there was a tax benefit this quarter, I believe of $4 million, $6 million pretax?

Right, I'm just putting it on a pre-tax equivalent basis.

Okay.

What is, in your best estimate, what is the going-forward tax rate, sort of 30.5, 31?

Yes, that's going to be the average that we've been experiencing over the last several quarters.

Okay.

That's my only question.

Thanks.

Felice Gelman, Sunova Capital.

[inaudible]

Ms. Gelman?

I think she is in another conversation, so we probably -- .

Operator, we need to -- .

Heather Wolf, Merrill Lynch.

Just a couple questions for you.

Can you give us a little bit more color on why there was such a big increase in the other revenues in the Capital Markets division?

Yes.

What we talked about is that we had been working on several new products that were coming to play in structured finance, as well as our investment banking activities.

We had made an acquisition last year, and have been building a pipeline which is now very robust, that gives us some investment banking transactions that we have been able to complete, and we'll continue to see those transactions roll into the numbers as we go through the second half of the year.

From the structure in finance we've introduced 2 new products this quarter, which will again continue to reproduce further revenues as we go into the next couple quarters.

And we're also seeing our Trust Preferred business and activity pick up as we would expect.

And again with the refi activity that we should see as we go forward, that would be a benefit as well.

So those other products had several things that kind of kicked in this quarter that reflected the activities that had really been building over the last year, and now we're seeing the fruition of that, and we'll see that as we go forward.

Can you give us any color on what the products were, both in structured finance and investment banking?

Investment banking, we're being able to raise capital for a lot of our different banking customers across the country, both in the sense of debt and equity, so now we have both sides of that equation.

That is with all the bank customers that we have, a very good business for us to be out and being able to do that.

Structured finance, we have some different investment vehicles that we've been able to generate that we can sell to our non-depository customers.

And so those are anything from, like we said, the trust preferred that we've created, which has seen increased activity, as well as some special purpose type of investment vehicles that we can then create and be able to sell to those non-depository customers.

Can you tell us how many Trust Preferred deals you did in the quarter, relative to last quarter?

We do a Trust Preferred deal every quarter.

So we just do 1.

We pull it altogether, and we've been able to put the -- we used to do 2, which we had the insurance separate from the banks.

And now we're doing -- we can put the insurance together with the bank.

So we just have conglomerated it all into 1 issuance every quarter.

And what was the size of the issuance versus last quarter?

The size of issuance would have been larger.

I am not sure by how much, but I think it was probably about -- well, I will get you those numbers, Heather, for sure.

But the deal size was larger this quarter, and we would expect that to remain at a higher level as we go forward.

Okay.

And then a couple more questions.

The hedging losses on the MSR, that's obviously a big shift from the position you had been in for most of 2005.

Can you talk about what happened there, and maybe what we can expect going forward?

Yes.

We had a positive last year, and now we have a small negative.

So it has gone from an $18 million positive to a 3 or $4 million negative.

Some of the positive -- and what's happened really is 2 things. 1 is the flattening of the yield curve does negatively impact our hedging performance, and you're seeing that come through the numbers as that yield curve is now actually even inverted.

When you look at the other pieces, this basis spread between treasuries and mortgages has been somewhat volatile over the last 2 quarters, and that has created an incremental negative.

Typically where we would see it at this point is that that should be relatively neutral, and that we shouldn't see a gain or loss at this point in any given quarter, excluding any disruption that you might see within the marketplace.

Okay.

And 1 more question.

The trading gain and loss in the delivery margin in the mortgage bank really popped up this quarter.

Can you talk a little bit again about what drove that, what might be sustainable going forward?

Yes.

We have, and one of the things we were talking about is executed a little bit different strategy than what you're seeing out in the marketplace.

We have been very judicious about our pricing and our discipline in our pricing.

We've been actually widening out our spreads by being able to maximize the profit that we can get off of the originations that are being generated.

We're giving up a little incremental volume to do that, but we think we're holding, and the reflection of that is the 12% increase in origination fee income, versus a 14% drop in the Mortgage Banking overall origination volume.

So what we would see is, as we were able to move that forward, we've seen some improvements in the third and fourth quarters up to about 100 basis points.

We pushed that on up. 122 is probably a little higher than what we would expect, but between 100 and 122, we would probably keep about half of that as we move forward.

Okay.

Great.

Thank you.

[OPERATOR INSTRUCTIONS]

Any other questions?

Yes, sir.

One moment.

Jon Balkind, Fox-Pitt Kelton.

It is actually Todd Hagerman.

Just a quick question, Marty.

Just a follow-up on the construction loans.

Just to clarify, in terms of the trend in the NPAs, was the pool of loans identified previously in '05, in terms of when we saw the increase in terms of potential problem loans, is that all the same?

Or is this something new and incremental that we're seeing now in terms of the non-accrual?

That is exactly -- when we said identified late last year, these are the same loans that we identified and put in potential problem assets last year.

And what we were referring to is that as we changed our processes back then, we haven't seen any incremental originations that would fit into this pool of loans.

The situation, in the sense of the misrepresentation or the fraudulent activity we have been able to identify and be able to close that loop.

So it has been the work out of those loans we're going through, which until now, we had had no losses with those loans that where we put in potential problem assets.

There was a very small piece of those that recently saw a deterioration in circumstances, and we reacted to that.

Okay.

And just again to clarify, you mentioned you had run the fraud loss through the expense line.

Right.

Were these -- again, if they were nonaccrual, how come that didn't go through, say the reserve, for example?

Right.

Because of the nature of the fraud, and it being related to, as Ken said, our ability also to be able to go back and recoup some of this, there are beyond just the borrowers involved.

So, part of what we were highlighting is a sense that our processes were somewhat sideswiped because of what was going on between developers and appraisers and underwriters.

So you get to several different entities and parties that are involved, or potentially involved in the situation, and that's why it would go through the fraud losses and not through the loan losses.

This is Ken.

There is very clear accounting guidelines that losses because of fraud go through fraud directly to your P&L, and not through your loan loss provisions.

So all of our fraud losses go through that line item, as opposed to the provision for loan losses.

That's helpful.

I just wanted to clarify that point.

Thank you.

Bob Patten, Morgan Keegan.

I just want to follow-up, Ken, when you were talking about the use of proceeds, how it is contributing to revenue growth.

So I would like maybe a little color on that.

And also if you could just bring us up to date with the sort of view expressed when you sold the Processing business that it would be accretive to earnings.

Where do you stand on that now?

Did the margin act the way you thought it would, in light of the current interest rate environment, post-restructure?

Thank you.

Very good question.

When we sold the Merchant business, Processing business, we took the gain and 2 major things took place, or we utilized those gains with 2 major activities.

First, we bought back about -- a little over 3% of our outstanding shares, which basically took and offset the EPS impact at the current year and going forward that we would have expected from the loss of that revenue stream.

So that would have held us whole on the stock buyback.

We took the additional gains, and the largest utilization of that -- those additional gains above what we used to buy back shares, the proceeds, was we took an 80 -- I think right at an $80 million loss in our investment portfolio, and reinvested that proceed, the proceeds from those, to get the 533 yield that Marty indicated over 100 basis points, which was very much in line with our expectations.

Then there were other minor things that we did with the smaller amount of the gain to create additional reduced expense.

We restructured, we took some early retirement costs if you recall, of about -- I think that was 4 to $4.5 million, things in that size that reduced our expenses going forward.

And that has performed very much as we would expected it to contribute to the second quarter, and will do so for the rest of this year and going forward.

Thank you.

This concludes the question-and-answer session today.

At this time I would like to turn it back over to management for any additional or closing remarks.

We again want to thank everyone for their participation and interest in First Horizon, and wish you a good day.

Once again, ladies and gentlemen, this will conclude today's conference.

We thank you for your participation.

You may now disconnect.