CAPScall of the Week: First Merchants

For years, satirical late-night TV host Stephen Colbert has been running a series on his show called "Better Know a District," which highlights one of the 435 U.S. congressional districts and its representative. While I am no Stephen Colbert, I am brutally inquisitive when it comes to the 5,000-plus listed companies on the U.S. stock exchanges.

That's why I've made it a weekly tradition to examine one seldom-followed company within the Motley Fool CAPS database and make a CAPScall of outperform or underperform on that company.

For this week's round of "Better Know a Stock," I'm going to take a closer look at First Merchants (NASDAQ: FRME  ) .

What First Merchants does
First Merchants is a financial holding company that provides community and commercial banking services primarily throughout Indiana, but also in Ohio. As of the first-quarter, First Merchants had $4.3 billion in total assets with total loans outstanding equaling $2.9 billion.

Source: Daniel X. O'Neil, Flickr.

In its first-quarter results, First Merchants reported EPS of $0.38, down from $0.46 in the previous year in spite of an 8.1% increase in commercial real estate loans and a 9.2% increase in total non-maturity deposits. The drop in income can be explained by a one-time $9.1 million benefit last year from its acquisition of the failed bank, SCB of Shelbyville, from the FDIC. Net interest margin for the quarter dipped six basis points to 3.9% and return on average assets fell to 1.04% from 1.26% in the year-ago quarter. 

Who it competes against
Now here's the sad news for any bank: It competes against far, far too many foes. The smartest move for regional banks like First Merchants is to merge or expand outside the box, otherwise regional downturns or low interest rates have the potential to sap earnings potential.

First Merchants' biggest competitor is Old National Bancorp (NASDAQ: ONB  ) , the largest bank by assets in Indiana ($9.4 billion in assets). Old National has been exercising its regional flexibility of late by closing more than a dozen Indiana-based branches and purchasing some 20 offices from Bank of America in Michigan.

The thought process here might be twofold for Old National. First, Indiana has seen much of its recovery, so trying to pry customers and enterprises away from their current financial institution could be difficult. Second, and on the flipside, Michigan really hasn't seen much of an economic recovery and could represent a unique stepping stone for Old National to expand its presence. Regional banks like this really do have the upper hand over money center banks like Bank of America when it comes to creating customer loyalty, so the more expansive they can become, the better chance they have of diversifying their asset portfolio. 

Historically low lending rates are another point of contention for First Merchants and really any other bank operating in the area -- including large money center banks. Take national bank Wells Fargo (NYSE: WFC  ) , for example, which has branches set up throughout Indiana. Even though it has traditionally been the safest of all large banks, it's struggled to generate income because of low lending rates that act as a deterrent to deposit growth and profitability from loans. In its second-quarter results, released just two weeks ago, Wells Fargo delivered a 45 basis point contraction in net interest margin to 3.46% from the year-ago period.

The call
After carefully reviewing the prospects for First Merchant, I've decided to make a CAPScall of outperform on the company.

All states were hit particularly hard during the recession, but those banks that stuck to traditional banking practices like loans and deposits, and that maintained conservatively liquid positions, are now being rewarded. First Merchant is one such bank that did a really good job of seizing the opportunities presented to it. It nabbed SCB for a bargain basement price after the bank failed, then, earlier this year, agreed to merge with CFS Bancorp for the sum of 0.65 First Merchant shares for each CFS share. The combined bank will offer the second-highest asset total in Indiana at $5.4 billion and will have close to 100 branches. 

On a comparative basis, First Merchant is also much more attractive than many of banking's major players from a valuation perspective. To begin with, First Merchant's net interest margin of 3.9%, while a bit lower than the previous year, is still much higher than many of its larger foes -- including Wells Fargo. Even its return on average assets has hovered a clean 10-20 basis points consistently above the average for national banks. As icing on the cake, net charge-offs as a percentage of loans was nearly halved to 0.40% from 0.78% in the previous year, marking a significant improvement in credit quality.

All of these figure help to make my case for a bank trading at just 15% more than its book value and close to 13 times forward earnings. I see considerable upside here over the long run if First Merchant stays the course and sticks to conservative banking practices and small but earnings-accretive acquisitions.

With so much of the financial industry still getting bad press years after the financial meltdown, it may be a "greedy when others are fearful" moment. Not surprisingly, some of Warren Buffett's biggest investments are in the space. In the Motley Fool's free report, "The Stocks Only the Smartest Investors Are Buying," you can learn about a small, under-the-radar bank that's too tiny for Buffett's billions. Too bad, because it has better operating metrics than his favorites. Just click here to keep reading.


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