Drip
Portfolio Report
Monday, June 1, 1998
by Dale Wettlaufer ([email protected])
Alexandria, VA (June 1, 1998) --I'm back from vacation today. Aspen was interesting -- the late spring skiing was great. Stay away from the Woody Creek Tavern, though. That Hunter S. Thompson is a freak! Boulder was enjoyable, too. I would recommend that golfing fanatics check out Colorado as a vacation destination. There is a growing array of excellent courses and the most expensive one I played charged $50 for greens fees and cart. Anyway, back to business.
Having thrown out the financials on a bunch of banks already, I thought we'd spend some time looking at the specifics of a couple this week with the intent of deciding whether or not these should move on the final list of banks from which we will make a final investment decision.
First Tennessee National Corp. (Nasdaq: FTEN)
The upside to First Tennessee is that its growth, diversity, and asset turnover are all stellar. The downside is that its securitization activities are a significant part of net income, throwing lots of non-cash credits into the income statement and making the financials harder to understand. Notwithstanding the non-elective treatment of financials that is mandated by the Financial Accounting Standards Board, the company is a financial powerhouse among regional banks and is reminiscent of Norwest (NYSE: NOB), another highly successful regional that has grown into a large super-regional institution.
Part of the key to understanding First Tennessee is to look at its mortgage production infrastructure. As of the end of the year, the company operated some 147 mortgage banking offices in 30 states. Through this infrastructure, the company is a low-cost producer of mortgages. That creates an income stream that comes through the bank in a number of ways. First, it earns money on originating the mortgage. Then it earns money on selling the mortgage in a securitization. Then it earns money investors pay the company to service those mortgages. Finally, since the company generates and moves around so many asset-backed securities, its capital markets operation has become huge. Last year, it was the largest underwriter of U.S. government agency securities with maturities longer than one year. This includes Fannie Mae, Freddie Mac, and FHA loans. The company is also a sizable underwriter of municipal securities.
These add up to a very high asset turns sort of business, which is what we like to see in a financial services company. It's less an investor in financial assets and more a services provider with a low-cost financial assets "plant." Consequently, its capital is constantly moving and it is at less risk of cyclical, interest rate, and default pressures.
Other attractive business lines of the company include merchant transaction processing, which is a high-margin business with low capital investment requirements. The company's position as a large commercial bank that has regular contact with customers as well as its position as a credit card lender give it a good "moat" in the states where it does banking business. First Tennessee is currently the 14th largest merchant transaction processor. This again is a business that is much less susceptible to interest rate shocks and counter-party credit risks because the bulk of return on capital is dependant on transaction volume and not the credit quality of customers.
One need only to look north to Fifth/Third Bancorp (Nasdaq: FITB) to see what this sort of diversification into high return business lines has done for that bank's valuation and returns on invested capital. Including its substantial check processing capabilities, First Tennessee is one of the most substantial financial transaction processors in the country, which is a giant credit in favor of the company, in our opinion, because such high return businesses can fuel much more growth than could be achieved in a normal, plain-vanilla banking operation.
More on First Tennessee tomorrow.
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