October 27, 2006
Research Associate: Moonmoon Todi, M. Fin
Editor: Nachiket Moghe, CFA
Sr. Editor: Ian Madsen, CFA 1-800-767-3771 x417
North Wacker Drive Chicago, IL 60606
AmSouth Bancorporation (ASO - NYSE)$29.84
Note: This report contains substantially new material. Subsequent reports will have changes highlighted.
Reason for Report:3Q06 Earnings Update. Previous Edition:October3, 2006
Overview
AmSouth Bancorporation (ASO), based in Birmingham, Alabama, is a regional bank holding company with $54 billion in assets, more than 700branch banking offices and 1,200 ATMs. ASO operates in Florida, Tennessee, Alabama, Mississippi, Louisiana, and Georgia.Among regional banks in the Southeast, ASO is a leader in several key business segments, including consumer and commercial banking, small business banking, mortgage lending, equipment leasing, annuity and mutual fund sales, and trust and investment management services. ASO also offers a complete line of banking products and services on its website operates on a calendar year basis.
The analysts have identified the following factors for evaluating the investment merits of ASO:
Key Positive Arguments / Key Negative ArgumentsGrowth Opportunities
- ASO’s attractive footprint positions it for solid growth.
- Accelerated return to Florida branch building before mid-06 isexpected to drive stock price performance.
- NII growth will continue to be aided by momentum in the existing franchise.
- Resumption of de novo branch expansion to contribute to earnings in coming years.
- Merger with Regions creates the tenth largest bank in the U.S. It will have leading positions in some of the fastest growing markets in the U.S.
- Flattening of the yield curve, and continued pressure on net interest margin.
- Competitive pricing environment for loans and deposits.
- Credit quality expected to deteriorate given exposure to an aging real estate cycle (largely in Florida), and unsecured consumer lending.
- Incremental expenses fromde novo branching is likely to stifle EPS growth in 06.
- The Regions merger deal seems to favor Regions more than AmSouth in relation to organic growth potential.
Recent Events
On October 20, 2006, Regions Financial and ASO announced that the Federal Reserve Board has approved the application for the two companies to merge. The merger has catapulted ASO-RF to a large cap bank. Some analysts’ reckon that increased size does not guarantee enhanced top line growth growth. ASO’s stock price will be governed by RF’s price in the short term.
On October 19, 2006, U.S antitrust authorities conditionally approved the merger of ASO with Regions Financial. Based on the condition set by Department of Justice Regions Financial and ASO have agreed to sell 52 AmSouth branch offices in Alabama, Mississippi, and Tennessee with about $2.7 billion in deposits to resolve competitive issues raised by the companies' proposed merger.
On October 17, 2006, the company announced its 3Q06 earnings results. Relative to 2Q06, the results reflected significant net interest margin pressure (-20 bps), balance sheet growth driven on the loan side (slight contraction in securities portfolio), a slight decline in core fee income (lower trust and investment services, as well as flat service charges), lower expenses, and fairly stable credit quality metrics.
On October 2, 2006, a regular quarterly dividend of $0.26 per common share was paid to the shareholders as of record on September 20, 2006.
On September 5, 2006, AmSouth launched “Home Free Sweepstakes” under which its customers will have a chance to have their mortgage paid off this fall.
On May 25, 2006, ASO announced that it had entered into an agreement for a merger with Regions Financial.
Revenue
The tables are current as of 10/27/06.
Prior to the 3Q06earnings release, the Digest average was projecting NII growth rate of 6.1% for ’06 and 8.1% for ’07. The growth rate of total non-interest income for ’06 and ’07 were 0.2% and 6.8%, respectively. Following the release, the Digest average for NII growth rate decreased substantially to2.9% for ’06 and 5.2% for ’07. The growth rate for total non-interest income increased to1.4% for 2006and decreased to 3.2% for 2007.
($ in millions) / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 2007E / 2008ENet Interest Income / 409 / 414 / 400 / 405↓ / 1,614↓ / 1699↓ / 1764↓
Provision for Credit Losses / 27 / 24 / 26 / 17↓ / 99↓ / 115↓ / 170↓
Core Non-Interest Income / 219 / 230 / 248↑ / 229↓ / 927↑ / 957↓ / 1050↓
Securities Gains / 1 / 0 / 0 / 0 / 2↑ / 3↓ / 3↓
Total Non-Interest Income / 220 / 230 / 248↑ / 229↓ / 929↑ / 958↓ / 1053↓
Total Revenue / 628 / 644 / 648↓ / 633↓ / 2,543↓ / 2,657↓ / 2818↓
Net Interest Margin / 3.42% / 3.40% / 3.19%↓ / 3.19%↓ / 3.34%↓ / 3.30%↓ / 3.42%
Core fee revenues were up only slightly, which coupled with the lower spread revenues, resulted in a 1.9% sequential decline in operating revenues.
Net interest income in 3Q06 was $388.8 million, an increase of 3.7% compared with 3Q05, as loans grew 11.7% year over year. Despite the solid loan growth, the net interest margin compressed to 3.19% as a result of the continued difficult interest rate environment and a shift in consumer preference toward higher cost time deposits. Although average total deposits increased 5.7% to $37.4 billion compared with 3Q05, low cost deposits declined 1.3% to $23.9 billion on the same basis.The Digest average net interest income in 3Q06 was $400 million.
One brokerage firm (Keefe Bruyette) adds that though continued difficult interest rate environment and customer migration into higher-cost deposits were blamed for the NIM pressure, it believes funding costs continue to outpace yields as deposits have lagged past rate increases.
According to one brokerage firm (B.of America) the drop in NIM of 20 bps quarter on quarter, could negatively impact the future earningstrajectory, while better-than-expected credit trends should help in 2007.
Another brokerage firm (Goldman) believes net interest margin will remain stable in 4Q06 versus the sizable decline in 3Q06 as the run-off in low cost deposits has moderated toward the end of 3Q06.In addition, purchase accounting adjustments in the RF deal on AmSouth’s securities portfolio will aid the net interest margin into 2007.
Analysts feel the ASO and Regions merger has taken place in a challenging revenue environment.
According to one brokerage firm (Sandler), the deal uses cost savings to help EPS growth in a challenging revenue environment.
Management is focused on making minimal impact on revenue momentum through the integration processafter Regions merger. It has quickly announced key managers through the combined company, and is also actively communicating with customers through the integration process.
($ in millions) / 2Q05A / 3Q05A / 4Q05A / 2005A / 1Q06A / 2Q06A / 3Q06ACore non-interest income detail
Service charges on deposit accounts / $91 / $95 / $95 / $367 / $95 / $103 / 103
Trust income / 30 / 29 / 23 / 113 / 24 / 24 / 24
Consumer investment services income / 19 / 19 / 18 / 76 / 22 / 24 / 23
Interchange income / 23 / 23 / 25 / 91 / 25 / 26 / 26
Bank owned life insurance / 11 / 11 / 11 / 43 / 11 / 11 / 12
Bank card income / ---- / ---- / ---- / ---- / -----
Mortgage income / 5 / 6 / 2 / 17 / 3 / 3 / 4
Other Core Non-Interest Income / 42 / 76 / 42 / 202 / 39 / 39 / 45
Total Core Non-Interest Income / 220 / 259 / 216 / 910 / 219 / 231 / 248
Non-interest revenue, which includes earnings from service charges, trust, investment services, interchange, and other sources of fee income, was $248.4 million for the quarter, compared with $259.6 million for the same quarter in 2005, which included a gain of $44.0 million from the sale of the company's mutual fund management business.
According to one brokerage firm (Sun Trust) fee income jumped 29% compared to 2Q06 annualized, mostly due to a sharp increase in other income (all from nonrecurring gains on sale of branches and other items) and higher portfolio income and commercial credit fees.
According to one brokerage firm (Zacks Investment Research) apart from the impact of RF, soft top-line growth continues to be a hindrance to the stock’s performance.Net revenue has been flattish (up 4% or less) for four years now, and the sale of the credit card business and the mutual fund management business have put additional pressure on top-line comparisons for a time. Both had significant fee-income components, so the pressure will be felt most in non-interest income. This also increases ASO‘s reliance on spread income, moving it away from a more balanced model, which could theoretically pressure the P/E multiple. It does magnify the impact of a declining NIM.
Please refer to the separately published ASO spreadsheet for additional details and updated forecasts.
Margins
Prior to the3Q06 earnings release, the Digest average for pre-tax margin was 43.1% for Q406 and 43.8% for ‘06. Following the release, the expectations increased to43.6% for Q406 while itdecreased to 43.2% for ‘06.
1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 2007E / 2008EPre-tax operating income / 43.1% / 43.5% / 44.3%↑ / 43.6%↑ / 43.2%↓ / 42.6%↓ / 43.3%↑
After-tax net operating income / 28.8% / 28.7% / 29%↑ / 28.7%↑ / 28.8%↑ / 28.5%↑ / 28.6%↑
Efficiency ratio / 52.5% / 52.8% / 51.8%↓ / 53.7%↑ / 52.9%↑ / 53.1%↑ / 50.7%↑
Non-interest expenses in the third quarter were $335.7 million, essentially unchanged from 3Q05.
Expenses were well contained; declining 1% sequentially. The efficiency ratio improved to 51.8% from 52.6% in the first half of 2006.
According to one brokerage firm (Sun Trust) expenses fell 5% compared to 2Q06 annualized on lower marketing, professional fees, and other expenses. Those expenses were likely lower due to the pending merger.
Another brokerage firm (Keefe Bruyette) believes that these reductions were likely included in the estimated cost savings of the merger and should not be doublecounted. It adds that though personnelexpenses was flat, occupancy and equipment ticked up 6% compared to 2Q06 .
According to one brokerage firm (Zacks Investment Research) the sizable branch expansion plan is another source of increased costs.
The combined entity of Regions and AmSouth is expected toreap cost savings estimated at 10% of the combined companies’ expense base amounting to $400 million. The first $150 million will be realized in 2007, and the remainder in 2008.
Please refer to the separately published ASO spreadsheet for additional details and updated forecasts.
Earnings per Share
Prior toQ3 earnings release, the Digest average EPS estimates for 4Q06 and ’06 stood at $0.54 and $2.12, respectively. Following the release, the EPS expectations for 4Q06 and ’06 decreased to $0.53 and $2.12,respectively.
1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 2007E / 2008EGAAP EPS / $0.52 / $0.53 / $0.54 / $2.09↓ / $2.15↓
Operating EPS / $0.52 / $0.53 / $0.53 / $0.53↓ / $2.10↓ / $2.23↓ / $2.40↓
Zacks consensus / $0.52 / $0.53 / $0.53 / $0.53↓ / $2.11↓ / $2.26↓
Digest High EPS / $0.52 / $0.54 / $0.54 / $0.56 / $2.15 / $2.40↓ / $2.40↓
Digest Low EPS / $0.52 / $0.51 / $0.49↓ / $0.50↓ / $2.06↓ / $2.15↓ / $2.40↓
Digest Average / $0.52 / $0.53 / $0.53 / $0.53↓ / $2.10↓ / $2.23↓ / $2.40↓
Digest Average YoY Growth / 7.5% / 2.2% / 3.8%↓ / 2.4%↓ / 3.8%↓ / 6.0%↓ / 7.8%↓
ASO reported earnings of $.54 per diluted share in 3Q06, compared to $.51 per diluted share reported for 3Q05. Net income for 3Q06 was $187.7 million and resulted in a return on average equity of 20.3%, a return on average assets of 1.38%, and an efficiency ratio of 51.8%.
The company reported EPS of $0.54 includes a $0.02 gain from the sale of 6 branches in Tennessee, a $0.02 gain from the cancellation of $450 million of long-term repurchase agreements, and a $0.01 gain on the MasterCard IPO,$0.02 was contributed by over-provisioning as its loan loss provision of $25.5 million exceeded net charge-offs by $10 million. Results also included securities gains.
According to one brokerage firm (Sun Trust) sequential earnings growth was driven by higher fee income and lower expenses, offset by lower net interest income and a higher loan loss provision. The firm has lowered itsEPS estimates to account for slower than previously modeled loan growth and more NIM compression.
ASO said its next dividend will be paid by RF which it expects to be due in first quarter of 2007. It also pointed out that the $0.35 quarterly dividend paid by Regions Financial is 7% higher than its own current dividend rate, on an exchange-adjusted basis.
One brokerage firm(Sandler) thinks that the expected EPS accretion from the ASO and Regions merger will be at least partly offset by its expectation for P/E dilution mostly because the combined company will no longer be considered as a viable takeout candidate given its increased size.
Please refer to the separately published ASO spreadsheet for additional details and updated forecasts.
Balance Sheet
($ in millions) / 2Q05A / 3Q05A / 4Q05A / 2005A / 1Q06A / 2Q06A / 3Q06AAverage Loans / $33,362 / $33,766 / $34,994 / $33,837 / $36,345 / $37,013 / $37725
Average Securities / $12,375 / $11,970 / $11,792 / $12,164 / $11,531 / $11,526 / $11463
Average Deposits / $34,858 / $35,415 / $36,116 / $35,280 / $36,746 / $37,067 / $37444
Loans grew 11.7% year over year.Commercial loan growth was particularly strong, increasing 17.5% compared with 3Q05, led by a 33.8% increase in commercial real estate (CRE) lending compared with the prior year. Residential mortgages increased 9.4% compared with 3Q05.Average loans were up 8% annualized linked quarter, compared to 7% annualized growth in 2Q06.
Average total deposits increased 5.7% to $37.4 billion compared with 3Q05 and low cost deposits declined 1.3% to $23.9 billion on the same basis.Although deposits grew 4% sequentially annualized, all of the growth was in higher cost time deposits, with sizable migration from non-interest bearing, low interest bearing, and money market/saving deposits. Total low cost deposits declined 15% sequentially annualized, while time deposits grew a sizable 40% sequentially annualized and average other borrowings increased $349 million. A sequential decline in securities was likely also used to fund loan growth.
Credit quality remained strong, with net charge-offs of $15.9 million or 0.17% of average net loans in the third quarter, a decrease of 2 basis points compared with the third quarter of 2005. The provision for loan losses totaled $25.5 million for the third quarter, while the ratio of loan loss allowance to total loans was 0.97% inSeptember 30, 2006.
Total nonperforming assets inSeptember 30, 2006, were $113.5 million, or 0.30% of loans net of unearned income, foreclosed properties and repossessions, compared to $98.1 million, or 0.29% for the quarter endingon September 30, 2005 and $109.4 million, or 0.29%, in the second quarter of this year.
According to one brokerage firm (Zacks Investment Research)significant further improvement in credit quality is unlikely at this point, but charge-offs and provisions are likely to remain below the long-term average for a time.
According to one brokerage firm (Goldman), net chargeoff ratios might increase slightly in the second half of 2006 as Katrina related losses are estimated to become more fully realized. Approximately, 3% of the company’s loan portfolio is in the areas of Louisiana and Mississippi impacted by Katrina. While there may be a longer-term benefit from increased economic activity, the near-term results are likely to reflect higher loan losses, which may result in a larger charge.
The companies ASO and Regions have agreed to sell $2.7 billion of deposits as suggested by the Department of Justice (DOJ) to resolve the competition issues raised by the companies’ proposed merger. The DOJ has approved the merger of the two companies based on this condition.
Please refer to the separately published ASO spreadsheet for additional details and updated forecasts.
Target Price/Valuation
There had been 1 ratingdowngradeand 2price targetrevisions (upward) following the 3Q earnings release. Also, 2 analysts have dropped their coverage due to ASO’s pending merger with Regions Financial. Of the 14 analysts following the stock, 1 hasgiven a positive rating, 8 have neutral ratings, and4 have negative ratings. One analyst (Goldman) has not provided a rating on the stock. The Digest target price ranges from $25.00(19.36% downsidefrom the current price;Keefe Bruyette) to $33.00↑ (10.58% upside from the current price; Friedman, Billings). The average target price is $29.26 (↑from the previous report;and 0.58% downside from the current price).
Rating Distribution
Positive / 1Neutral / 8↓
Negative / 4↑
Not Rated / 1
Average Target Price / $29.26↑
Digest High / $33.00↑
Digest Low / $25.00
Number of Analysts / 14↓
Risks to achieving the target price include a flatter yield curve and NIM pressure, competitive operating environment, and regulatory issues.
Please refer to the separately published ASO spreadsheet for additional details and updated forecasts.
Potentially Severe Problem
There are none other than those discussed in other sections of this report.
Upcoming Events
Events
/Dates
FOMC meeting / October 24-25FOMC meeting / December 12
4Q06 Earnings Update / Mid January 2007
Capital Structure/Solvency/Cash Flow/Governance/Other
On April 20, 2006, ASO announced that its Board of Directors has authorized stock buybacks of up to 25 million shares. The authorization represents more than 7% of the company's outstanding shares, and would be valued at $711 million based on ASO's April 19, 2006, closing price of $28.46 per share. During the second quarter, AmSouth repurchased 6 million shares making the total share repurchase to 11.1 million in the first half of 2006.
On May 25, 2006, ASO announced its merger with Regions Finance. The new company will retain the Regions name. The all-stock deal exchanges 0.7974 shares of Regions for every share of ASO.J.W. Moore, Chairman, President and CEO of Regions will become the Chairman of the combined entity and C. Dowd Ritter, Chairman, President and CEO of AmSouth, will be the President and CEO of Regions.
The merger with RF is expected to close in November. The companies have completed their systems review, and decided to use Morgan Keegan’s investment system, RF’s mortgage system, and ASO’s core banking systems (loans, deposits, trust). It also decided to use RF’s retail product set, which was more comprehensive than ASO’s.
On October 19, 2006 Department of Justice declared that Regions Financial and ASO have agreed to sell 52 AmSouth branch offices in Alabama, Mississippi, and Tennessee with about $2.7 billion in deposits to resolve competitive issues raised by the companies' proposed merger. The agency said that without the divestitures the merger would adversely affect competition in local markets in the three states for small business lending, resulting in fewer choices for small business customers. The combination of Regions and AmSouth will create the largest bank in Alabama and Mississippi, the second largest bank in Tennessee, and the fifteenth largest bank in the United States.
Federal Reserve Board has also approved the merger of the two companies: Regions and ASO.
Some brokerage firms believe the merger of RF and ASO confirms that a persistent flat yield curve and slowing loan growth will force many banks to strike low-premium, defensive consolidation deals, limiting upside for investors.
Branch Expansion plans–ASO announced that it plans to add 54 additional locations to its current 232 branches in Florida by year end. Management of the combined entity announced that it planned to use ASO’s expertise in de novo branching to build new locations in growth markets across the footprint. At 2Q06 end, the company has already completed 26 of the planned 54 locations.In terms of merger planning, the companies have identified most of the 150 overlapping branches that will be consolidated.
Operational advantages of merger:
- The merger deal creates a sizable entity – a top ten bank with a #1 deposit share in 10 of its top 25 markets.
- Capital allocation will be enhanced by focusing more effort on faster growing areas, while scaling back or exiting the lowest-growth areas.
- Morgan Keegan, which has been quite strong of late, will have significant growth potential in ASO’s markets.
- The slow, methodical approach to integration favored by RF should allow for maximum customer retention.
Valuation Price: Brokerage firms are of the opinion that AmSouth shareholders are not receiving a premium bid, despite the company’s valuable franchise and a sizable presence. ASO shareholders will receive 0.7974 shares for RF stock for each ASO share, which represented a discount of 2% to the market value, which the firms believe to be very modest.Long-term restructuring costs are estimated to be $700 million, some of which will be capitalized. According to most brokerage firms,ASO has better growth in both loans and deposits. ASO also has better credit quality and a significantly better tangible efficiency ratio. With its significant and growing presence in Florida, brokerage firms feel ASO should have been taken out at a premium.