CIBC: Does The Value Outweigh The Acquisition Risk?

Summary

• The housing market has weighed on the Canadian banks recently.
• Acquisition risk is an important factor to consider for CM going forward.
• If investors can look past the acquisition, CM is trading at a P/E of only 10, with a yield close to 5%

The Canadian Imperial Bank of Commerce (NYSE:NYSE:CM) is the smallest of the big 5 banks in Canada. It has consistently driven the strongest returns on equity, but its lack of international growth prospects and fears over the Canadian housing market have weighed on the valuation. Management hopes to fix its growth prospects through the Private Bancorp (NYSE:PVTB) acquisition, but the bank is likely overpaying, which may be dilutive to shareholders. Housing fears are likely overblown, offering long-term dividend growth investors a good spot to initiate a position in the Canadian banks, with Toronto-Dominion Bank (NYSE:TD), Bank of Nova Scotia (NYSE:BNS), and Bank of Montreal (NYSE:BMO) all trading well off of their highs. However, CM may not be the best choice at this juncture, despite the highest yield and lowest valuation.

The bank's recent earnings report looked solid, with adjusted earnings rising 10% YOY, a return on equity of 18% and a CET1 ratio of 12.2%. The CET1 ratio is a mandated stress test by the Basel III accords, with a minimum of 6%. CM has maintained its ratio very high over time, and the upcoming acquisition will be dilutive but likely won't drop it below 10%.

CM continues to shift its retail banking in order to drive strong customer growth. The bank transformed 30 of its banking centers, with the goal of shifting away from tellers and routine transactions. This shift in focus is based on customers using the mobile app and website to open accounts and shift money, leaving the banking footprint for investment and loan advice. The bank's mobile banking functionality received the highest score of the big 5 for the fourth year in a row from Forrester Research, which should continue to drive growth for the company's retail segment, as well. Residential mortgages grew 12%, and personal deposits grew 7% YOY. Business deposits were up 11%, as well. This level of growth in retail banking is solid, and shows that the bank's investments are paying off.

In Wealth Management, earnings were up 34%, and revenues grew by 13% on strong asset growth. Asset management grew revenues by 16%, as well. The company's Atlantic Trust division will be rolled in with PVTB's US$9.6B in assets under administration for reporting purposes going forward, and this will grow the bank's Wealth Management division. Atlantic Trust received 2 awards in the quarter for 'industry-leading performance', and will likely continue to perform well with CM's high net worth American clients.

Acquiring Into America

The bank's upcoming PVTB acquisition is going to play a large role in CM's growth going forward. It is CM's attempt to acquire its way into American growth, which has held back the bank's valuation in the past when compared to its peers. However, the deal price, recently approved by a PVTB shareholder meeting, is 20% higher than the original offer. The original offer price was going to be difficult for some CM shareholders to swallow, to be honest, and the hike makes it even harder to justify.

The deal price based on the .4176 shares of CM combined with $24.20 values PVTB at $56.81 today. This has come down somewhat with CM around 15% off of recent highs. This values PVTB at close to 2.3X book value, and a P/E ratio of close to 22X. CM currently trades for a P/E of 10X, with a price/book of around 1.8X. This could theoretically be justified by the bank's strong growth rate, however. Since reporting a loss in 2010, PVTB has grown earnings at a 40% clip over the last 5 years. This kind of growth will be welcome to CM shareholders, especially in the American market.

Source: Acquisition Presentation

Additionally, PVTB currently holds ~96% of its loan portfolio in variable rate loans, which will benefit strongly from rising interest rates. The bank is based in Chicago, which is the third strongest city in America for deposits and is a key logistics hub and home to many major corporations. Deposit growth for the bank recently came in at 15% YOY, and loan growth was 16%.

Source: Acquisition Presentation

However, PVTB will be dilutive to CM's returns on equity and CET1 ratio. One of the benefits of being based almost solely in Canada has been CM's best-in-class return on equity. This ratio is going to take a hit as PVTB's most recent reported ROE was 11.4%. CM management expects the transaction to be accretive to earnings by the third year. Based on the rich valuation, write-downs could conceivably eat into the expected returns off of this acquisition, and this needs to be something to consider for investors going forward.

The Canadian Housing Market

Moody's recently cut the credit ratings on all of the major Canadian banks over fears related to private sector debt and housing prices. It's good to see that the credit agency is trying to be proactive on the housing market this time around, but I think it may be an overreaction.

Source: Company Presentation

It's well known that the skyrocketing prices are highly localized within two of Canada's largest cities, Vancouver and Toronto. To break it down further, Vancouver's housing market has been cooling, so the real issue here is just in Toronto. With that, uninsured loan originations in the quarter across Canada had a loan-to-value ratio of just 64%, which is actually higher than that in the Toronto area. Looking at it another way, housing prices would have to drop over 30% for the average uninsured loan to be upside down.

Source: Company Presentation

On the full uninsured mortgage portfolio, LTV ratios are even more solid. Toronto is better than the average here, as well, and 55% shows that Canadians have a healthy amount of equity in their homes. Any time the LTV ratio is over 80%, mortgage insurance is required. Additionally, mortgage interest is typically not tax deductible in Canada, which encourages smaller debt loads and more money down.

It's difficult to predict the exact direction and magnitude of changes in the housing market. Therefore, stating that the Canadian housing market is in a bubble or that it is due to crash at any time is on par with market timing. The Canadian housing market, on the whole, is more conservative than its American counterpart. Additionally, the low LTV ratios and mortgage insurance requirements provide a buffer to the banks in the event of a large downturn in prices. That being said, if prices do start dropping, it will definitely impact the big 5, specifically in lower loan originations. However, for a bank like CM which has paid 146 consecutive years of dividends including through the financial crisis, it won't likely materially affect profitability.

CM is trading around its average P/E ratio over the last 8 years. This is lower than its peers, which some could argue is too low based on its strong profitability ratios. If the PVTB acquisition ends up being a good purchase, I would expect strong multiple expansion. However, if it ends up being too richly valued, it could weigh down the bank's valuation over the medium term.

I have presented the bull case returns for the bank going forward, with multiple expansion to 12X earnings. This rate is based on analyst estimates of growth, and it would result in close to 12% annualized total returns for investors from this level. However, like I said, that is the bull case, with plenty of downside risk due to the upcoming acquisition. I am going to hold on to my shares, but I am not adding today. I see buying opportunities in the other Canadian banks that don't have the acquisition risk.

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Financial statistics were sourced from Morningstar, with the charts and tables created by the author, unless otherwise stated. This article is for informational purposes only and represents the author's own opinions. It is not a formal recommendation to buy or sell any stock, as the author is not a registered investment advisor. Please do your own due diligence and/or consult a financial professional prior to making investment decisions. All investments carry risk, including loss of principal

Disclosure: I am/we are long CM, TD, BNS. 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.