First Merchants Corporation

Moat: 1/5

Understandability: 2/5

Balance Sheet Health: 3/5

First Merchants Corporation is a regional bank holding company that provides a range of financial services, primarily in the Midwestern US. Its offerings include traditional banking, commercial lending, and wealth management.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

First Merchants operates in a very competitive and fragmented banking market. While its services are important to its local communities, it does not hold unique advantages, and has very similar banking product offerings compared to many of its competitors.

Business Overview

First Merchants Corporation (FRME) is a regional bank holding company headquartered in Muncie, Indiana. The company’s business operations are concentrated in the Midwest United States, with a significant footprint in Indiana, Ohio, Illinois, and Michigan. The bank operates through numerous branches, providing a range of financial products and services to individuals, businesses, and institutions.

Revenue Streams

  • Net Interest Income: This forms a significant portion of FRME’s revenue. It is the difference between the interest the bank earns on loans and the interest it pays on deposits and other funding sources. Changes in the interest rate environment directly impact this revenue stream.
  • Fee Income: FRME generates revenue through various fees, including fees from service charges, wealth management, brokerage services, and trust activities. These fees are typically less cyclical than interest income, but are often dependent on market conditions.
  • Other Income: This includes gains from sales of securities and other non-interest income.

Industry Trends

The banking industry is undergoing significant changes, including:

  • Increased Competition: The sector is fragmented, with many players and few significant barriers to entry.
  • Technological Disruption: Fintech companies and other tech-driven financial service providers are forcing the industry to adapt to the rapid pace of technological change, forcing investment in digital tools and platforms.
  • Regulatory Changes: The regulatory landscape for banks is continuously evolving, resulting in increased complexity and compliance costs.
  • Interest Rate Sensitivity: Bank profits are highly sensitive to changes in interest rates, which can lead to market volatility.
  • Consolidation: Mergers and acquisitions are very common. They are frequently used to improve a bank’s scale, geographic presence, or technology.
  • Economic Uncertainty: Economic conditions (inflation, recession, etc.) can significantly affect the bank’s loan portfolio and interest income.

Competitive Landscape

FRME faces intense competition from various financial institutions:

  • Regional Banks: Numerous regional banks compete directly with FRME. These banks often operate with similar business models and product offerings.
  • National Banks: Large national banks like JP Morgan and Bank of America have significantly larger scale and resources, but are increasingly competing for regional customers.
  • Credit Unions: Credit unions provide similar services with lower fees, are tax-exempt, and have been gaining traction.
  • Fintech Companies: Digital payment platforms and online lenders are disrupting traditional banking relationships. They are more agile and focused on new technologies.

What Makes FRME Different

While FRME operates as a regional bank with a commitment to its local communities, it offers little in terms of truly differentiated services or advantages. It primarily competes on service and localized knowledge. These factors are not enough to establish a meaningful, lasting advantage as most other regional banks also focus on these areas.

Financials

  • FRME’s profitability and value creation potential remain highly dependent on interest rate conditions, market volatility and credit risk exposure.

Latest Financial Performance

Analyzing FRME’s Q1 2024 results and some trends in the industry, the following can be noted:

  • Earnings: In Q1 2024, EPS dropped significantly YoY from $0.93 to $0.65. Part of the drop was attributed to nonrecurring items in 2023.
  • Net Interest Income: While this represents a large portion of their revenues, it saw significant drops across multiple quarters.
  • Net Interest Margin (NIM): The net interest margin, a key profitability driver for banks, also decreased significantly, from 3.88% in the last quarter of 2023, to 3.43% in Q1 2024.
  • Loan Growth: The bank has modest loan growth, while they are experiencing some deterioration in loan quality, which can lead to higher losses in the future.
  • Noninterest Income: This has been showing some positive results for FRME over the last few quarters.
  • Economic Outlook: The bank is also cautious of the current economic environment, including the possibility of lower interest rates in the future, which would hurt the profitability of their lending operations.

Historical Performance

  • Profitability: The bank has generally achieved stable profits, but ROE has fluctuated significantly depending on the economic environment and rates.
  • Growth: Revenue growth has been inconsistent and heavily dependent on the interest rate environment.
  • Credit Quality: The bank has historically maintained good credit quality, but could suffer from increased credit losses in downturns.

Debt

  • FRME had about 781 million in long term debt as per 10Q.
  • Financial companies typically use debt as a lever for their business. This can be dangerous as we see with some of the cases mentioned below in “Risks”.
  • FRME has also had to take a large amount of short term borrowing in 2023 and beginning of 2024, with amounts greater than 1 billion at some points.
  • FRME has used a lot of debt to increase profitability during times of lower interest rates. However, during times of higher interest rates, the leverage can cause the company harm, reducing their profitability or by forcing their cost of capital to go up.

Moat Assessment

Moat Rating: 1/5

Justification:

FRME has a very weak moat, if any. The bank lacks significant competitive advantages:

  • Lack of Differentiation: FRME primarily offers standard banking products and services which are easily replicated by competitors.
  • Low Customer Switching Costs: Customers can relatively easily switch to other banks or financial service providers.
  • No Intangible Assets: FRME does not have strong proprietary brands, patents, or regulatory licenses that offer a durable advantage.
  • No Network Effects: A bank’s value does not usually increase with its number of customers.
  • No Cost Advantages: FRME does not have demonstrably lower costs compared to its peers and has to compete in a crowded space.
  • No Economies of Scale: While larger banks may have some economies of scale, these do not typically benefit FRME.

Given these structural characteristics, First Merchants Corporation lacks a sustainable competitive advantage and is unable to create the ability to generate above-average profits for extended periods.

Risks to Moat and Business Resilience

  • Recent financial issues and negative economic indicators are increasing risks for the banking industry as a whole and FRME. The main risk comes from the increase in interest rates which will make cost of credit go up and make loan defaults more likely.
  • The market perception of FRME is extremely negative right now, which is also a risk.

Moat Erosion Risks:

  • Technological Disruption: New entrants with innovative digital offerings can rapidly capture market share, potentially eroding the bank’s relevance.
  • Increased Competition: Existing competitors or new market entrants can apply similar strategies, making it hard for FRME to remain competitive.
  • Interest Rate Volatility: As stated previously, banks are susceptible to changes in interest rates, which can impact profitability.
  • Regulatory and Compliance: A constantly changing regulatory environment may cause unexpected costs for the company.

Business Resilience:

  • Limited Pricing Power: The company’s pricing power is limited. The company is a “price-taker” and must operate at existing market rates, and any inability to do so is likely to cause losses.
  • Lack of Product Differentiation: The lack of any unique product makes the company more vulnerable to competition from companies that have more robust product lines.
  • Economic Cyclicality: As a regional bank, FRME’s performance is closely tied to the local economy and can become distressed during economic downturns.
  • Management Turnovers: Since 2021, the bank has replaced its CEO and CFO. These are very important positions for the company and it could take time for new management to fully integrate the company. In addition, this shows a possible leadership instability.

Understandability Rating

Understandability: 2/5

Justification:

FRME’s business model is somewhat easy to understand because it is a traditional bank. However, the complexities lie in navigating the many financial statements and understanding the interactions between interest rates, loan performance, and economic trends. The bank also operates in a complex and changing regulatory landscape, which can be difficult for the average investor to fully understand.

Balance Sheet Health Rating

Balance Sheet Health: 3/5

Justification:

While the overall health is relatively stable, there is a noticeable increase in total assets, loans and leases, and borrowings. The company had a low capital-to-assets ratio. A high loan-to-deposit ratio and high dependence on short term borrowing could put the bank at risk in times of financial distress.

  • Capitalization: The company has a moderate capital base, which may need to be increased to adapt to the current regulatory environment and potential future downturns.
  • Leverage: The bank uses a reasonable amount of leverage. However, a higher-than-average leverage makes FRME more susceptible to potential defaults on debts, when compared to a less leveraged company.
  • Asset Quality: The company has a higher amount of nonperforming assets (past-due payments), and an increasing provision for loan losses. These trends are concerning as it can signal worsening credit quality.
  • Liquidity: While the bank maintains enough liquidity to meet the usual operational requirements, it has been increasing reliance on short-term borrowings, which can be more sensitive to rate changes.

In short, First Merchant’s has a very difficult time maintaining a moat in a complex and highly competitive market with a changing regulatory environment. Furthermore, it is also facing increasing headwinds due to interest rate changes, and other macroeconomic pressures which have also affected their profitability and market value. They do not have strong proprietary advantages and face heavy pressure from multiple competitors.