Alexandria, VA (June 2, 1998) --Yesterday, we left off looking briefly at First Tennessee's (Nasdaq: FTEN) merchant transaction processing unit, which processes credit card transactions. There are numerous reasons why this unit is highly important, in my estimation, to the investment opportunity that we see here. One of these is that banks are generating a ton of excess capital right now. To benefit over the longer-term from a bank that is in that position, you need to find a company that knows what to do with that excess capital. Simply pouring those resources into more and more loans can sometimes look good in the short term, but in the longer term that can lead to large loan losses. The best example of this is the experience of the money center banks in the 1970s and 1980s, when Latin American loans went south on them.
The intelligent bank looks at a number of different opportunities to increase shareholder value from that capital. That capital can go toward dividends, toward share repurchases, or toward investing in systems and services that will enhance future profitability. First Tennessee's transaction processing subsidiary is one of those sots of investments. In general, the industry generates free cash flow and substantial returns on invested capital (ROIC). Well-run merchant processors can get their ROIC into the 30+ percent range, meaning they generate earnings of $0.30 for every dollar of capital invested in these businesses. When you leverage that with debt rather than equity, returns on equity can get well over the 50% mark.
Looking at the merchant transaction processing industry, valuations are very attractive:
Paymentech Inc. (NYSE: PTI), 25 times projected earnings for fiscal year 1999 ending June '99
BA Merchant Services (NYSE: BPI), 17 times projected earnings for fiscal year 1999 ending Dec. '99.
NOVA Corp. (NYSE: NIS), 27 times projected earnings for fiscal year 1999 ending Dec. '99.
Total Systems Services (NYSE: TSS), 55 times projected earnings for fiscal year 1999 ending Dec. '99.
Total Systems is a special case. It may be overvalued, but I have no idea about that. I do know that its parent, bank holding company Synovus Financial (NYSE: SNV), has benefited greatly from Total Systems' valuation. Synovus is currently valued at 28 times projected earnings for fiscal year 1999 ending Dec. '99. That's well in excess of other banks' valuations:
First Tennessee, 16.9 times projected earnings for fiscal year 1999 ending Dec. '99.
Regions Financial (Nasdaq: RGBK), 15.6 times projected earnings for fiscal year 1999 ending Dec. '99.
Zions Bancorporation (Nasdaq: ZION), 18.9 times projected earnings for fiscal year 1999 ending Dec. '99.
City National Corp. (NYSE: CYN), 16.5 times projected earnings for fiscal year 1999 ending Dec. '99.
Now, let's look at Fifth/Third's valuation on 1999 estimates:
Fifth/Third Bancorp (Nasdaq: FITB), 21.8 times projected earnings for fiscal year 1999 ending Dec. '99
Throwing out Zions, which is in the middle of a fairly large transaction with Sumitomo Bank of California (Nasdaq: SUMI), Fifth/Third trades at a 33% premium to the rest of similarly sized banks. Part of that premium is due to execution and growth issues that have nothing to do with Fifth/Third's transaction processing unit, but part of it does. It also indicates to investors a management mindset on strategic investments and enhancement of shareholder value.
In summary, the market at large has awarded and continues to award merchant transaction processors with very nice valuations. This is because they are free cash flow positive companies with less credit risk than the garden-variety financial services company or bank and with very attractive return on investment (ROI) characteristics. Those banks that operate such subsidiaries enjoy better business line diversity and a better customer pipeline because of the customer relationships of the transaction processing subsidiary, and thus, they get higher valuations if they execute well. All of these pertain to First Tennessee and add to the attractiveness of the company over the long term.
Tomorrow, we'll wrap up this second look at First Tennessee.