When James S. Chip Mahan 3d talks about Security First Network Bank, the first purely Internet-based bank, he often plays up the modest Kentucky origins of its corporate parent, Cardinal Bancshares. The chief executive has said the $668 million-asset base of Cardinal could amount to a rounding error at one of the nation's biggest banks. He deadpans that Pineville, Ky., the official headquarters of the Security First subsidiary, is so remote that the Greyhound bus company turns around and goes back out the way it came in. Those folksy observations have the effect of highlighting the contrast between a community bank that operates in rural Kentucky and the groundbreaking alternative it pioneered to exist in cyberspace. It's easy to focus on the differences between the two. Cardinal is an unremarkable community bank that was started in 1989 with $16 million of capital by Mr. Mahan and 35 other investors. Security First has captured the attention of the industry and millions of investment dollars from four big banks for having developed the software to enable secure banking transactions over the Internet. That apparent gulf between a community bank's roots and a high-tech institution with a speculative future will be formalized when Security First is spun off in a public offering, which is expected before the end of June. At least one analyst says the offering could produce the kind of stratospheric first-day gains posted by other Internet-related firms, such as Yahoo! Inc. But if that happens, the confidence of investors will be based more on the future promise of Security First than on any financial performance of Cardinal, which lost money in 1994 and barely turned a profit last year. In this way, the saga of the virtual bank may reflect Wall Street's enthusiasm for all things Internet even when the firms lack a solid earnings stream or the imminent prospect of one. Indeed, there is little in Cardinal's history to suggest that the bank would become a pioneer in the burgeoning on-line banking arena. Since its inception, Cardinal has grown steadily from a $40 million-asset bank, largely through acquisitions, including two merger-conversions that dramatically boosted its capital. Profitability grew steadily, if slowly, during the early 1990s. Then in 1994, Mr. Mahan made a push to rapidly expand the bank's consumer finance subsidiary, opening some 20 offices in a little more than a year. That drive, along with a $1.5 million loss on the sale of securities, contributed to $538 million worth of red ink for the year. Performance was also hampered by a check-kiting scheme that forced the bank to write off $452,000. But by 1995, the key components of a new Internet banking strategy a rather complicated web of alliances began to fall into place. Security First would deploy software developed by a data security firm, Secureware Inc., to protect the bank and its customers from computer fraud. The Atlanta-based company, headed by Mr. Mahan's brother-in-law, Michael McChesney, had worked with technology giants like International Business Machines Corp. and Sun Microsystems Inc. before it agreed to sell the core data security technology to Hewlett-Packard in February. Mr. McChesney, in turn, was named chief executive of a new software firm, Five Paces Software Inc., which designs the core Internet banking application. When the spinoff is completed, Five Paces will become part of Security First and continue to license the system to other banks. Along the way, Security First attracted four investors and millions of dollars, including $2 million each from Wachovia Corp. and Huntington Bancshares. Area Bancshares, Owensboro, Ky., put up $1 million. And earlier this year Synovus Financial Group invested $2 million. The banks plan to use the Five Paces software to deliver services via the Internet. Alltel Information Services Inc., a bank outsourcing and software company, also entered the picture earlier this year. The Little Rock-based firm will run a data processing service bureau for Five Paces and market an Internet- based banking solution to its client base. We have 112 people here in Atlanta today, said Mr. Mahan, including the Secureware team, the Five Paces team, the Security First Network team, and the Alltel people that are running it. Security First opened to the public last October. But the software development costs associated with all of this activity, along with continuing losses at the consumer finance unit, Cardinal Credit, created a significant drag on earnings in 1995. Return on assets was 0.14%. With all this going on, Cardinal agreed to sell its consumer finance business to Norwest Corp. in March. But there are no regrets; Mr. Mahan said the $34 million sale price represented a 30% premium. I guess really what happened was somebody made us an offer we couldn't refuse, he said. Mr. Mahan also acknowledged that the need for additional capital to fund Security First played a part in the sale. Make no mistake about it, the fact that came at the same time that we have been spending all this money on this Internet project, which brought our capital ratios down, was very nice, he said. Only time will tell if the new strategic direction will pay off. But clearly, the decision to sell off Cardinal Credit and the holding company's spotty performance have not soured interest on Wall Street. Cardinal's stock has been flying high, with shares trading recently in the high $60s. Investors will get a piece of the new company when it goes public. Elizabeth A. Summers, an analyst with Ryan, Beck & Co., said a capital- intensive endeavor like Security First would be expected to lose money in the short term. As long as we're in a basic bull market . . . I think there is the potential for a lot of excitement by the market for that company, said Kathryn Bissette, a Sterne, Agee & Leach analyst, of the public offering. Just because that's been the case for other Internet-related stocks. But others are skeptical about the prospects for the new business. Warren Heller, director of research at Veribanc Inc., in Wakefield, Mass., noted that Security First signed up just 1,000 on-line customers in its first three months of operation and that the average deposit per account was just $1,500. Mr. Mahan said the customer base has since more than doubled, to about 2,100. And deposits jumped about $3 million between February and April after Security First was able to offer interest-bearing accounts. Once a broader range of products are available to customers on-line, including brokerage accounts next month, he said Security First can attract more customers through advertising and marketing. The pace is quickening, said Mr. Mahan. We're adding 30 to 50 new customers a day in the electronic bank. Mr. Heller said, I'm underwhelmed. He likened the early Internet customers to fluttering butterflies who aren't committed to the bank. He also questioned whether licensing agreements of the Five Paces software with other banks will be the cash cow Mr. Mahan expects. Why would they want to buy? Do you really want to go into competition nationally for 2,000 accounts? he said. I think it's going to be real tough. But Walter Leonard Jr., a Wachovia executive vice president who heads the bank's operations subsidiary, said the bank believes the technology will be successful. We wanted to get the access to the security software, he said. Wachovia also wanted to test the market for Internet-based delivery to gain some knowledge without having to leap headlong into trying to do that ourselves. Mr. Leonard said Wachovia did not look at the financial performance of Cardinal. Our investment was not in, nor is it in, Cardinal. So that was not an issue for us, he said. Further, he said the fact that Mr. Mahan was familiar to many at Wachovia he had worked there for a decade in the 1970s and early 1980s had little influence. The proposal obviously stood on its own, said Mr. Leonard. At any rate, Mr. Mahan said Cardinal's performance will improve the day we spin it off. Freed from spending money on Security First and the consumer finance unit, the profitability in the core banking business goes directly to the bottom line. And analysts agree. I would expect that Cardinal's earnings would return to more normal levels, and more in line with comparable banks, said Ms. Bissette. Meanwhile, Mr. Mahan is spending his time in Atlanta building Security First, and on the road promoting the project. Is that more fun than running a community bank?

It sure is, said Mr. Mahan.

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