Rising interest rates in recent months and a softening housing sector have taken some wind out of the sails of Beverly Hills-based City National Corp., the largest independent bank company in the L.A. area.

Indeed, City National in June revised its earnings outlook for 2006 to between $4.65 to $4.78 per share, down from earlier outlooks in the low-$5 range.

The company, which owns City National Bank, cited rising short-term interest rates, which both raised borrowing costs and prompted business customers to shift funds from core non-interest bearing deposits to higher-yield accounts and instruments, some of which are not managed by City National.

That announcement prompted City National's stock price to plummet 11 percent to $64 per share. In April, the stock similarly dropped after another earnings warning. Since June, earnings have been in line with the company's revised guidelines, while the stock has hovered in the mid-$60 range.

In a recent earnings conference call, City National President and Chief Executive Russell Goldsmith characterized these developments as a short-term cyclical dip, saying his focus was on long-term sustainability.

"At City National, we are very aware that we are not growing net income as strongly as we would like, but we are not running this company for just a quarter or two. City National is in this for the long-term," Goldsmith said. "We are aggressively marketing our deposit products, hiring some new sales people and adding clients."

This is part of a strategy to expand City National beyond its base clientele of small and mid-sized local companies and of entertainment industry players, such as talent agencies, law firms and deep-pocketed individuals. (City National is still known as the "bank of the stars.")

But some Wall Street analysts still see more bumps in the road before City National can move out of the current doldrums. Last month, City National reported third quarter net income of $59 million, down from $59.9 million for the same period a year ago. However, on a per share basis net income grew 3 cents to $1.23 due to some recent share buybacks. Revenues were up 2 percent to $214 million.

One week later, Houston-based equity research firm Friedman Billings Ramsey downgraded City National to "underperform," recommending that investors sell some of their holdings.

In issuing the "sell" recommendation, analyst Gary Townsend said he expects more deterioration in City National's core non-interest-bearing deposits, which comprise nearly half of the bank's total deposits.

"This adverse mix shift is unlikely to abate soon and will continue to pressure margins. We expect City National's earnings performance to disappoint over the next few quarters," Townsend said.

City National's Chief Financial Officer Christopher Carey said that now that the Federal Reserve Board has "apparently decided to take a breather" with regard to interest rate hikes, deposit growth might tick up slightly in the fourth quarter, though at much more moderate levels than in previous fourth quarters.

Adding to the potential downside is City National's relatively heavy exposure to real estate. According to Goldsmith, residential lending now accounts for one-third of total loans, while commercial real estate accounts comprise about 28 percent. Most of the rest are business loans.

While Goldsmith said the commercial real estate side remains strong thanks to significant levels of new construction, he did acknowledge that the housing sector is soft.

And that poses some risk, according to Jacqueline Reeves, research analyst with Florham Park, N.J.-based Ryan Beck & Co. In her Oct. 19 report on City National, Reeves said that a continued decline in real estate transaction volumes in California may impact the company's specialty deposit business.

Fee income

Goldsmith said City National is looking to counter these trends by focusing more on its fee income business from private banking and wealth management services. Trust and fee income revenue in the third quarter was up 46 percent from the same period last year, boosted by the recent acquisition of wealth management firm Independence Investments, which increased assets under management to $27 billion.

In addition, City National has expanded its international business, setting up a working capital guarantee program to help export clients access capital while trying to fill overseas orders and offering medium- and long-term loans to U.S. exporters.

Going after import-export clients represents a significant new direction for City National as it attempts to capitalize on the ever-increasing money and trade flows between California and Asia. Goldsmith noted that City National's income tied to foreign exchange and letters of credit has grown at double-digit year-over-year rates for the past six quarters.

But both analysts and Goldsmith agree that the biggest challenge, especially in the long term, is fending off competitors eager to encroach on City National's turf in the private banking and commercial markets in California and New York. In the last 18 months, several business banks and private banks have launched in the L.A. area, including California Business Bank and the Private Bank of California.

"The economies and concentrations of wealth in both markets have attracted both regional and national institutions, some of which have greater resources and hold key relationships within the communities," said Reeves of Ryan Beck.

Goldsmith addressed this concern in his conference call, saying that "while more people are knocking on doors everywhere and trying to take business away from other people," competitors aren't undercutting City National's position with lower prices and fees for their products. "The pricing seems to have stabilized there, and I think that's good," he said.

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