With a Market Cap of $3.2B and a book value of $5B, you might wonder why I am bearish on Comerica (NYSE:CMA).
Increase in Non-Performing Loans
Like all banks, Comerica has seen an increase in non-performing loans (NPL), from 1.03% ($560m) of total loans in Q108 to 2.02% ($1,073m) of total loans in Q109. The increase in NPL is exacerbated by several factors.
First, Comerica is charging off more NPL every quarter, from $108m in Q108 to $153m in Q109. You can see a steady increase in chargeoffs in the quarterly report. This is alarming because despite increasing chargeoffs, the NPL are still increasing. That means more loans are being transferred to non-accrual status than being charged off.
Second, there is no sign of abatement in the trend for increasing NPL. Loans past due 90 days that are still accruing (this is a decision by management not to transfer the loan to NPL status) have increased from $80m in Q108 to $207m in Q109. This tells me that management is trying to paint a better picture than reality and I expect this trend to continue.
Although the primary impact of increasing NPL is more writeoffs, which impair earnings and shareholder equity, there is also a negative impact on net interest income. As loans are transferred to NPL, they no longer contribute to interest income. Looking at Comerica's Q109 report, you can see there has been stress on interest income.
- Q1 2008 Net Interest Income - $476m (Net interest margin 3.22%)
- Q4 2008 Net Interest Income - $431m (Net interest margin 2.82%)
- Q1 2009 Net Interest Income - $384m (Net interest margin 2.53%)
The likely scenario is that higher interest loans are defaulting first due correspondingly higher risk profiles and negatively impacting net interest margins.
Decrease in Total Deposits
Analysts often cite "normalized earnings" as justification for lofty price targets. These represent earnings expectations based on a growing economy with no further deterioration in loan portfolios. The problem with Comerica, however, is that it is also seeing decreases in deposits, a key ingredient for sustainable earnings growth from new loan origination.
- Q1 2008 Total Deposits - $46.82b
- Q4 2008 Total Deposits - $41.96b
- Q1 2009 Total Deposits - $41.89b
With shrinking core deposits, Comerica will be stuck with a stagnant and deteriorating loan portfolio, unable to write profitable new loans. Comerica has already issued $894m in common shares, $2.13b in preferred securities to the US Government, and roughly $4b in medium to long-term debt to make up for funding shortfalls. Deposits will continue to shrink as the bank reports worsening earnings and seeks further government assistance. As it fights just to maintain funding, the prospect of "normalized earnings" won't be visible anytime soon, if ever.
What $5b in Shareholders' Equity?
Approximately $7.5b in loans were made between 2005 and 2008 (I calculated this by subtracting $43.2b in loans recorded in the 2005 balance sheet from $50.7b in loans in 2007), a time when asset prices and business plans were inflated by overly optimistic assumptions. It's anyone's guess what percent of these bubble loans will become NPL and eventually written off, but I wouldn't be surprised to see 20% ($1.5b) gone. That's not counting any defaults from the rest of the loan portfolio, which will probably see a rise in default rate to at least 4% ($1.7b).
If you look at the potential writeoffs and their downward impact on net interest income, combined with $4.9b in fuzzy assets (compare to $3.8b in Q108, under "Accrued income and other assets") that are 'difficult to value', you should easily be able to imagine how $5b in shareholder equity can quickly evaporate.
"Normalized Earnings" - Future Earnings Potential
Comerica is transferring $250m to NPL every quarter, which reduces net interest income by $12.5m quarterly, assuming 5% yield (higher yield loans are more likely to defualt). This is not being offset by new loans because the company lacks the funding to lend.
Comerica will be too busy reducing risks from its loan portfolio that net interest margins will continue to be squeezed due to increasing NPL and eventually chargeoffs. It will be unable to write new loans to offset this due to funding pressures and moreover, the yields it is achieving on new loans now are not high enough to justify its risks and may lead to perpetual writeoffs in the future.
Below gives you an idea of Comerica's "Normalized Earnings", after it has written off most of its bad debt:
Net Interest Income - $371m - $150m ($3b writedowns * 5% avg yield) = $221m
Non Interest Income - $173m
Non Interest Expense - ($400m)
US Gov't Pref Stock Div'd - ($33m)
Net Income - ($39m) or ($0.26/share)
In summary, even if Comerica issues more shares or debt to offset asset writedowns, its "normalized earnings" will never be severely impacted nevertheless. Since they lack the global footprint and "too big to fail" title, they are unlikely to receive more bailouts from the US Government.
I recommend establishing a bearish position on CMA until the company shuts down from insolvency or offers a different strategy to justify a higher valuation.
Disclaimer: Short CMA