M & I 2Q07 Earnings: Walking Sideways

Implications: Marshall & Ilsley Corporation (MI)
M & I's earnings for 2Q07 were up by 5.5%. A closer look at the details indicates that a one-time gain on sale of MasterCard stock accounted for the increase. Net interest margin compression and a deteriorating real estate loan portfolio suggest that future quarters will limit earnings quality improvements. The upcoming spin off of Metavante will also impact future earnings.

Analysis: M & I is in a tight box with little wiggle room for improving organic earnings. The company will battle a sideways, or flat, earnings picture until the interest rate yield curve returns to a normal curve and the construction lending and residential real estate markets improve. M & I is in a similar quandry with other banks that have construction and residential loan portfolios which puts the squeeze on net interest margins. How M & I uses the capital which will be freed up after the Metavante spin off will buy some time and, most likely, more acquisitions or share re-purchases.

1. Metavante, the data processing subsidiary, is being spun off in 4Q2007, will impact year over year comparisons leading into 2008. Post-Metavante will reconfigure M & I's income statement on fee income and operating expense ratio. Recently, Metavante's modest quarterly earnings increases have been boosted by its acquisitions. Goodwill and its depreciation will disappear from M & I's financial statements, creating a modest positive.

2. The troubled parts of in M & I's income statement are due to the growth in non-performing construction and residential mortgage loans and the continued flat interest rate curve. The interest rate environment is well documented and affects all banks. M & I's loan portfolio deterioration will (a) further crimp its interest income and (b) cause loan loss reserves and charge offs to increase. Both factors will continue the squeeze on net interest income. The loan portfolio troubles, particularly the construction loan portfolio, can take several quarters to cure. The devil is in the details: where are the loans and for what type of development (e.g., sub-division build out, hotels, office space).

3. The flush of capital from the Metavante spin off will fund new acquisitions or share re-purchases. The former gives M & I the chance to expand its earning capacity and the latter is a more tactical use of capital to manage earnings per share calculations. The latest acquisition of First Indiana appears to be part of a dough nut strategy of surrounding Chicagoland, which is a very competitive market. Other markets that have drawn M & I's acquisition interest is Florida, another very competitive market.

How well M & I competes in these new markets will determine its future earning capacity vs. other banks. For M & I to have a meaningful boost from these acquisitions, non-Wisconsin bank earnings need to expand quickly from the current level of about 33% (ex-Metavante). Other regional banks, such as BB&T and Key Bank, have reduced their home state earnings to 20% to 30% through acquisitions followed by organic growth in the acquired markets.