After Breaking Out Cambridge Bancorp Shares Have Less To Offer

Summary

• Despite limited asset and loan growth, CATC continues to deliver double-digit returns on equity.
• Asset quality is high and the bank's growing wealth management division supports a diverse income profile with above-average levels of noninterest income.
• CATC has what long-term investors are looking for but after the quick run-up, the shares have less immediate upside potential.

Cambridge Bancorp (NASDAQ:CATC) is the parent company of Cambridge Trust Company, a profitable 127-year-old commercial bank that is based in Cambridge, Massachusetts. CATC operates 11 traditional branches in Massachusetts, along with 4 wealth management offices – 1 that’s in Boston and 3 others across the border in New Hampshire. Over the years, these two office types have slowly moved in opposite directions, with the traditional branch count consolidating to drive better efficiencies and with the wealth management team adding to support a fast-growing balance of assets under management.

These strategies in combination with a customer base cultivated over several generations have shares near their all-time high – and one could say that due to a steady advance, shares have actually been trading at new all-time highs since I first covered the name in 2014.

CATC data by YCharts

A toppy market does pose a threat to the bank's current valuation, but this is a name that holds up better than most. Volatility is picking up and although the overwhelming trend has been positive a temporary reversal could be a gift to cash ready buyers looking for a better entry into this long-term name.

Loan Portfolio Safe But With Growth On Hold While Duration Is Lowered

Cambridge Bancorp has a focused portfolio, with most of the assets financing commercial and residential mortgages. At year-end, approximately 51% of CATC's real estate portfolio was comprised of commercial real estate loans, with the remainder in residential (43%) and home equity (6%). In the 2015 annual report, the bank announced that it was starting to sell long-term mortgages in the secondary market to lessen interest rate risk.

This has depressed top line portfolio growth (residential loans were around 50% of total loans in between 2009-2015), but CRE-nonowner assets and multifamily are adding, providing support, and sure to eventually yield a larger loan portfolio.

I don't know that there's been a perfect moment to de-risk, but with rates inching up the bank appears to have great timing. Adjustable rate mortgages bottomed at 7% of the portfolio in 2016 and finished 2017 at ~17%. At the end of 2013, loans maturing in less than 3-months were at 7% of the portfolio and are they up to 22% today. And, most importantly, +5-year duration loans have fallen from ~73% of all loans at the end of 2013 to 56% at year-end (most long-dated loans mature between 5-15 years, 40% of total loans).

Housing prices could continue to advance, increasing the opportunity cost of getting out of these assets, but interest rate risk is already hurting sales. CATC is finding some buyers willing to purchase mortgages, but doing so in front of rising rates caused gains from loan sales to fall to $355 thousand in 2017 from $916 thousand in 2016. There is still a large number of mortgages to offload, but I'm doubtful of large gains in 2018 unless sales volumes increase significantly.

Focusing on high-quality assets means investing in some of the lowest yielding loans available. However, the bank's low-yielding loans have provided stable earnings and, with nowhere to go but up, they are the first inline to adjust to higher rates. These numbers are not in a highlight reel, but when other companies are still showing lower portfolio yields CATC’s 4th quarter rate improved by 12 basis points (to 3.89%) compared to the same quarter last year. This alone isn’t a large earnings driver but it’s a move in the right direction and a positive data point to uncover when we know mortgage sales are putting pressure on total loans outstanding.

In the past 6-years, net charge-offs total just $258 thousand. At the end of 2017, the allowance account covered 1.13% of total loans and nonperforming loans 11.8Xs.

Profitable Core-Deposit Base Driving Assets Higher

CATC has an extremely low-cost deposit base (cost of funds for the year was flat at 0.2%) that is responsible for most of the last year’s asset growth (5.46%). Noninterest-bearing accounts are high at 27.7%, and more expensive CD’s in 2017 fell to 8.95% of total deposits from 10.14% in 2016.

The deposit mix is attractive, but it’s hard to expect much more than 5-6% growth in 2018. The bank has slowly trimmed the traditional branch count and the pursuit of high-quality deposits has lost some market share. In Cambridge, Massachusetts, for example, CATC’s 5 branches fell to 14.5% of total deposits in 2017 from 15.4% in 2016.

With that said, there isn’t a pressing need to add to deposits when rates are increasing and when the gross loans to deposits ratio is low at 76%. With its deposits-driven growth strategy, the deposit to loan ratio provides for a good indicator of capacity but I doubt we ever see CATC increase the loan to equity ratio to more than 10X. At 9.85X, the bank got close in 2016, but at the end of 2017 gross loans to equity were back down to a more comfortable 9.18X. Based on the asset quality I think the bank could do fine above 10X, but this is a natural limit that is unlikely going to be broken by this conservative bank.

Earnings And Potential

While it’s clear that maintaining high-quality loans and deposits has pressured growth rates, a lot of small moves in all of the right directions helped lift core earnings in 2017. Like a lot of other banks, reported earnings were down 13% (to $3.61) due to a one-time non-cash write-down on the net deferred tax asset, but without this charge earnings per share would have been $4.55, 9.6% more than 2016.

Based on adjusted earnings of $18.68 million, the company’s adjusted ROA was 0.98% and the adjusted ROE was 13.2%. This above average growth sets the bank up nicely for 2018, despite the small concerns and limits discussed in the loan and deposit sections.

Without requiring a big change or outsized growth from any account, net interest income increased by 7.3% or $3.93 million - which is equivalent to 13.95% of pre-tax income. This is an easy to repeat set-up that is in a good position to continue to benefit from higher rates, as well as the bank's fast-growing wealth management division.

Assets under management increased by 15.5% to $3 billion at year-end, helping to grow noninterest income to $7.6 million in the 4th quarter (full year-noninterest income was $30.2 million, up 5.4% YOY). Wealth management revenues increased 12.7% to $23 million in 2017, which is up to approximately 26% of net interest revenues (net interest income plus noninterest income; wealth management was 76% of noninterest income).

Assets under management have benefited from new accounts and higher valuations that could be challenged in 2018, but overall, I see this division as a long-term bet that is already bearing fruit. It is requiring right now a lot of new hires that are pushing up salaries and noninterest expenses, but at a certain point, this will start to scale and contribute even more to net income.

This is a competitive business but CATC has slanted the odds into its favor by positioning these offices in larger markets (Boston) where small amounts of assets won from the competition can be used to generate meaningful returns, as well as a more diversified earnings composition that you don’t typically get with banks of this size.

Valuation And Bottom Line

Cambridge Bancorp is a great long-term holding that I sold in the middle of 2017. My sale was early based on the uptick that followed after the stock was listed on the NASDAQ exchange, but by then the bank had already reached my target and I was itching to lock-in long-term gains. This time, my short-term approach (6 months to 3 years) worked out, but I will admit that this was a hard one to let go because of how difficult it is to find quality with above average earnings growth potential.

The bank continues to deliver but valuation multiples have outpaced fundamentals, and, looking ‘toppy’, future upside could be limited by adjustments to how the market values financials once rates rise. If my math is correct, higher rates mean negative adjustments to discounted cash flow valuations as well as to some of the asset prices that support the bank’s balance sheet. This is a strong team so I do trust them more than most, but we’re now talking about headwinds for investing customers looking to CATC for financing.

The bank, with its low-cost deposit base, is positioned to continue to benefit from higher rates, but uncertainty is also rising and there is a reason to believe the stock has approached upper bounds (2.35X BV and 18.57X trailing adjusted earnings).

Like the more profitable and wise Phillip A. Fisher, I enjoy investments that might benefit from improved multiples. CATC is good for above-average growth in earnings (high-single digits base on my estimates) and a consistent dividend (2.29%), but at the current price, I remain on the sideline thinking there is less potential for ‘new’ investors like myself to look forward to.

Here is a look at the bank's impressive valuation trends:

CATC PE Ratio (TTM) data by YCharts

Thank you for reading this Seeking Alpha PRO article. PRO members received early access to this article and get exclusive access to Seeking Alpha's best ideas. Sign up or learn more about PRO here.

Analyst’s Disclosure: I/we 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.