In Banking, Boring Is Beautiful

06/04/2008 12:00 am EST


Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar Dividend Investor, finds a solid Midwestern bank that's well-managed, pays a good dividend, and keeps its nose clean.

First Midwest (Nasdaq: FMBI) is a commercial-focused bank with deep roots in the Chicago suburbs. [That] and a focus on community lending have given the company a strong deposit base, and its mostly commercial loan portfolio should generate lower credit costs than the competition in this consumer-led downturn. We see limited downside risk, unless the commercial real estate market weakens significantly.

The bank's bread-and-butter business is commercial lending, [which represents] more than 80% of the loan portfolio; commercial real estate is 40%. The proportion of commercial loans has grown over the past few years as the company exited riskier or subscale consumer-lending operations, such as indirect auto and, most recently, residential mortgage. These moves have helped keep loan losses (0.3% of average loans over the past decade) lower than the bank's regional peers.

While the commercial focus should help control losses, risks remain: The bank has about $400 million of residential construction loans (8% of loans), and nonperformers and delinquencies have increased significantly in this portfolio. As such, we expect charge-offs to rise from 0.16% of total loans in 2007 to about 0.50% this year. A big jump, [but] manageable, in our view. The bank should remain profitable enough to gradually build capital even with higher loss rates.

While competition is intense, we think the diverse marketplace and the company's focus should help sustain margins. Its strong mix of non-interest-bearing and core deposits keeps funding costs low. Over time, its growing mix of fee business, mainly trust management and payment card transactions, should help balance revenue, improve efficiency, and increase profitability.

The company's tangible capital ratio (excluding certain items) fell below 6% last year because of asset write-downs, short of management's 6%-6.5% target. We expect capital levels to rebuild internally over the next year. With a payout ratio of 61% against likely 2008 earnings, we find healthy support for the dividend.

We expect 5% asset and revenue growth in the coming years as First Midwest looks to build out its Chicago footprint. With share buybacks likely to continue over the long run, we anticipate average annual dividend growth of 7%, which should lengthen a 16-year streak of [dividend] growth.

At our Buy price of $27.70 (it closed below $26 Tuesday-Editor), First Midwest would offer a 4.5% yield-unusually high by the stock's historical standards-and the prospect of 11%-12% annual total returns on average. Relatively few yields in the 4%-7% range offer a combination of low-risk business practices and a record of consistent and rewarding dividend growth. First Midwest offers both and looks like a worthy holding.

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