PNFP - Toronto-Dominion Abandons First Horizon Deal Throwing FHN Into A Regional Bank Maelstrom

2023-05-04 12:49:45 ET

Summary

• Toronto-Dominion and First Horizon announced the termination of TD's agreement to buy First Horizon due to TD's inability to secure the needed regulatory approvals in a timely fashion.
• First Horizon has been in "maintenance mode" since the deal announcement and will have to quickly pivot back to an independent growth strategy.
• First Horizon's deposit characteristics are about average, with no over-reliance on large uninsured commercial deposits, but management will likely start competing more aggressively for deposits again.
• Running off excess liquidity helped avoid excessive security balances and unrealized losses, but First Horizon will likely have to meaningfully reinvest in the business to support growth.
• FHN stock looks undervalued below the mid-teens, but bank stocks are overshadowed by tremendous investor fear today.

Maybe there’s no such thing as a good time for bad news, but this was about the worst timing possible for First Horizon ( FHN ) to see its deal with Toronto-Dominion ( TD ) collapse. The two banks announced on May 4 that, in light of no credible visibility on a timeline to regulatory approval of the deal, they had agreed to terminate the transaction. Given the chaos in the regional banking sector and widespread investor panic now, this seriously undermines the share price in the near term, even though First Horizon’s longer-term outlook isn’t that bad.

Relative to things that concern investors most now – liquidity, deposit stability and quality, and large unrealized securities losses – First Horizon isn’t in trouble. That said, First Horizon had sidelined some growth projects and seen some attrition due to the TD deal and recouping that won’t be an instantaneous process. Moreover, even if the deal termination was in fact entirely due to TD’s inability to get timely approval (or a timeline to that approval), some investors will assume that if First Horizon were really worth it, TD wouldn’t have given up. I was clearly wrong in my belief that these two banks would find a way to make the deal happen, and I’ve lost money on the shares I bought after the initial warning in early March that the deal likely wouldn’t close on time. Even so, and even with a larger discount rate to reflect the more challenging operating environment, I believe First Horizon is undervalued below the mid-teens and with upside toward $20 if and when market sentiment normalizes.

A TKO For The TD Deal

Toronto-Dominion and First Horizon announced on May 4 that the two companies mutually agreed to end their merger first announced at the end of February in 2022. Both companies indicated that the termination was not tied to any issue with First Horizon, but rather was due to the lack of any visibility on a possible timeline for the necessary regulatory approvals to close the deal.

As part of the break-up, TD will pay $225M to First Horizon (a $200M cash payment and a $25M fee reimbursement) and will convert its Series G preferred stock into common stock at $25/share. This will result in TD owning a bit less than 4% of First Horizon’s common stock.

I’ve written before about the issues and challenges TD was having in getting regulatory approval for the deal. Certain politicians in the U.S. have been vocal in their opposition to the deal and there was pressure to force TD to agree to a large community benefits plan as well as talk of a consent decree related to certain banking practices on TD’s part in its U.S. operations. Even with what appeared to be TD’s willingness to accept these terms and conditions, it apparently wasn’t enough to get regulators to approve the deal, nor provide any sort of timeline to what further issues needed to be resolved.

I don’t know what the future holds for TD in regard to these issues. It is possible that the remaining obstacles and regulatory delays were tied solely to reluctance on the part of bank regulators to approve additional large deals in the banking space (aside, apparently, from deals for distressed/failed banks). It is also possible, however, that there are unresolved issues tied to TD’s U.S. operations that may yet result in a consent decree and/or requirements from U.S. regulators to change policies, procedures and systems.

If there are outstanding issues between TD and U.S. regulators and if those issues are resolved, it is, I suppose, theoretically possible that TD and First Horizon could revisit the idea of a merger again in the future. I don’t consider that a likely outcome, though, and I believe it’s best to evaluate First Horizon on a standalone basis.

First Horizon Is Challenged, But Not Stressed

With first quarter results in hand, I believe it’s fair to say that First Horizon is seeing the same stresses as most regional banks, but remains in a relatively healthy position.

Revenue (on an FTE basis) declined 3% qoq in the quarter, more or less in line with many comparables, while adjusted pre-provision profits fell about 5%. Credit quality has deteriorated further, with the non-performing loan ratio up 18bp to 0.72%, but is not out of line with the overall sector.

Deposits declined about 3% sequentially, and that was a little worse than average. The issue here does not appear to be one of depositor confidence, but rather management’s operating strategy under the assumption of completing the TD deal. Instead of competing more aggressively on deposits and using excess liquidity to buy securities, management had been allowing excess liquidity to run off.

The good news is that securities are a relatively small part of earning assets (about 14%) and unrealized losses are a manageable percentage of tangible equity. The bad news is that First Horizon has become somewhat less competitive on deposit pricing and will have to make up for lost time, with management already implementing plans to get more aggressive on deposit gathering and retention.

Looking at the makeup of deposits, First Horizon has a pretty healthy mix of retail (46%) and commercial (53%) deposits; banks like Webster ( WBS ) and Commerce ( CBSH ) are among those with noticeably higher retail mixes (57% each), while Western Alliance ( WAL ) and PacWest ( PACW ) are among those with very high commercial mixes (78% for PACW and 86% for WAL). Average deposit size is a little smaller than average (at around $41K), and uninsured deposits make up 45% of the mix – a bit below the 51% average.

I don’t believe that First Horizon is at high risk of a ruinous run on deposits that would push the bank into receivership. That said, the company has been underinvesting in its systems in anticipation of the TD deal (it made little sense to spend on upgrades when TD would want to convert to its own systems), and management basically has to go back to the vault and retrieve its old growth plans, including investing in personnel to grow the commercial lending operations.

The Outlook

With the payments made by TD and the conversion of the preferred shares, First Horizon has a relatively comfortable pro forma CET1 ratio of 11.1% and a pro forma tangible book value per share of $11.70.

I do believe there will be some “bumps” in the road in the near term, not just from the unusually challenging operating environment today, but also from the need for the company to pivot back toward an independent growth strategy. First Horizon’s markets have become no less competitive in the last 15 months, and rivals like Pinnacle ( PNFP ) have plucked away some revenue-producers despite retention efforts put in place at the time of the deal announcement (the Series G preferred shares were issued largely to fund a retention program).

On the positive side, though, First Horizon remains competitively-positioned in attractive, growing markets, and the company has not only strong deposit share in many markets, but also a balanced commercial and specialty lending franchise, as well as a fixed income trading operation that has been quite profitable in less-turbulent markets.

I’m reluctant to make big changes to my model in the absence of guidance from management, and the company will be hosting an investor day in the first week of June. This gives management a chance to refresh and renew their operating strategy, and I expect potentially greater modeling changes at that point. In the meantime, though, while I do believe the next couple of years will be pressured by a challenging bank operating environment and the need to reinvest in the business, I still expect long-term core earnings growth in the neighborhood of 5%.

The Bottom Line

Between a more heavily-discounted earnings model and a ROTCE/TBV model that includes higher near-term spending (and the impact of higher credit costs and deposit costs), I believe $15 to $16 is a reasonable near-term fair value estimate. As conditions normalize, though, I believe that fair value can expand back toward $20, and I believe there are opportunities for First Horizon to out-compete many of its rivals in the Southeast, which would drive more upside.

At this point it’s hard to recommend almost any bank that isn’t JPMorgan ( JPM ), as investors are pretty much in full-on panic. Investors who can accept the elevated risks may find value here, but that is true for many regional banks and I encourage investors to shop around.

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