Surprises at banks seem to skew to the negative much more often than to the positive, so a relatively dull quarter in not such a bad result for Commerce Bancshares (NASDAQ:CBSH). What's more, this highly-focused Midwestern bank continues to show very good loan growth in an increasingly competitive market. While I like management's recent move to acquire a small bank in Oklahoma, the valuation here seems too rich and I'm not completely sold on the company's strategy of increasingly funding loans with wholesale deposits.
The Numbers For The Second Quarter
To cut to the chase first, Commerce had an OK second quarter. Both revenue and expenses came in a little worse than expected, leading to a roughly two-cent miss on a pre-tax basis. There were a few accounting items that factored into that, though (primarily securities losses), and I'd say the core miss was just a penny.
Operating revenue fell 1% from the year-ago period, but rose 5% on a sequential basis. Net interest margin held up better than I expected (down 34bp yoy to 3.21%), which led net income to decline 3% from last year and rise 6% sequentially. Fee income also continued to grow (up 2% and 3%, respectively), with solid mid single-digit growth in bank card fees.
Expenses continue to rise (up 4% and 1%), leading to a roughly two-point sequential decline in efficiency ratio. All told, operating income fell 8% from last year's level, but rose 10% sequentially.
Continuing To Grow The Loan Book, But At What Cost?
Commerce continues to do quite well with its lending growth - delivering period-loan balances that were 11% and 4% higher. Growth was balanced across commercial, consumer and mortgage lending, but deposits declined 3% from the first quarter and the bank is increasingly turning to borrowed/wholesale funds (Jumbo CDs and Fed Funds) to fill the gap.
I find this is a bit strange for an otherwise conservatively-run bank. It's not that these other sources of funds are particularly expensive today, but Commerce seems to have plenty of capital and turning to these funds sources to underwrite loans in this rate environment is a bit of a puzzler to me.
In any case, Commerce continues to report good credit quality. Non-performing loan balances were down by more than a third from the year-ago period, and the NPA ratio now sits at almost 0.50% - likely to be one of the better results of this reporting season.
A Small Deal In Oklahoma, But A Very Smart One
I was encouraged by Commerce's announcement in May that it will be acquiring Summit Bank in an all-stock deal. M&A is a logical decision for the company given its capital situation (a Tier 1 common ratio of almost 14%), and I had thought expanding into Oklahoma was likely.
Summit is an interesting deal, though. At $41 million, it's a tiny deal and the bank has only two branches, but over $200 million in loans and deposits. Commerce definitely sees quality here, though, as it is paying about 1.7x tangible book (which seems fair given the return on assets from Summit's call report).
The Summit deal in no way makes Commerce an immediate threat to BOK Financial (NASDAQ:BOKF) or BancFirst (NASDAQ:BANF) from a deposit share standpoint, though it will more than double Commerce's share to about 0.5%. What I like about the Summit deal is that brings expertise in another specialty lending niche - lending to companies in the energy sector. Couple that with a loan office in Dallas, Texas, and I think Commerce is establishing another quality lending niche with growth potential.
I don't expect this to be the last deal Commerce considers. Building share in Colorado (particularly in Denver) and/or growing into markets like Tennessee (Nashville) and Texas (Dallas) makes a lot of sense and there's a pretty good selection of potential partners for Commerce to consider.
Competition And Rates Mitigate Near-Term Opportunities
I'm a little surprised to see how strong Commerce shares have been recently given the serious competition in commercial lending. While larger banks like Bank of America (NYSE:BAC) seem more willing to compete on price in Missouri and Kansas, smaller banks are competing more on the basis of lending terms. Likewise it's not like Commerce would see an immediate benefit from higher rates - higher rates would chew into the AFS gains first, and banks like People's United (NASDAQ:PBCT) probably offer more immediate earnings leverage to higher rates.
That said, everybody knows the situation with banks these days and the difficulty the sector will have in producing earnings growth. What Commerce does have is capital, and quite a bit of it. That leaves the company in good shape to raise the dividend and/or buy back shares, and that seems to be one of the more important drivers for bank stock performance right now.
The Bottom Line
I'm not a fan of these shares given the current valuation. A long-term return on equity model suggests a fair value of about $39 on the basis of a 14% long-run ROE. Likewise, using a long-term historical regression analysis of book value multiples and returns on tangible assets suggests a fair value multiple of 1.85 on tangible book, or about $40.
Neither of those targets offer any upside today, and I think these shares look too expensive. Given the company's options for deploying capital I wouldn't short them (too much risk of a value-additive deal), but I wouldn't be in any hurry to buy when there are other banks still trading at meaningful discounts to fair value.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.