Commerce Bancshares Investors Pay For Better Than This

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About: Commerce Bancshares, Inc. (CBSH), Includes: JPM, PNC
by: Stephen Simpson, CFA
Summary

A surprising miss dents the pay-for-stability argument that has historically supported Commerce Bancshares' premium valuation.

Weak card fee trends aren't an entirely new phenomenon, and management may need to address this more aggressively.

Pressure on non-interest bearing deposit balances is leading to higher deposit costs and maybe more pressure/motive for an acquisition.

Shares still look pricey relative to earnings and internal returns, and further misses could hit the shares harder if it starts unwinding the quality premium thesis.

Given that I thought Commerce Bancshares (CBSH) shares were fairly expensive back in January, I’m not all that surprised that the shares underperformed the major regional bank indices since then, particularly as sentiment seemed to be shifting across the market a bit more towards “risk on”. Still, I was surprised to see the first-quarter miss. Seeing as how I believe that Commerce Bancshares’ premium is often justified by analysts and investors on the basis of superior quality and operating stability, I do worry that if this quarter is more than just an aberration, it could mean more significant underperformance for shareholders.

A Fee-Driven Miss

There were a few different parts of Commerce Bancshares’ first-quarter reports that merit comment, but the most significant part, in my view, was the miss on fee income that drove the bulk of the miss versus expectations on a core EPS basis.

Revenue rose 4% from the year-ago level, coming in about 2% shy of expectations. Net interest income rose 5% (a 1% miss) on just under 1% growth in average earning assets and a 15bp improvement in NIM (but a 6bp qoq deterioration) that slightly missed expectations.

Fee income was up just 1% yoy and down 3% qoq, with surprising weakness in cards (down about 5% and 11% yoy and quarterly, respectively). Management thinks poor weather played a role, and given the severe flooding in the Midwest, not to mention a well-earned benefit of the doubt, that makes some sense. Still, these fees have been chopping lower for a while, with Q1’19 fees down 5% from 2018, down 11% from 2016, and down 5% from 2014.

Opex was more or less as expected, but the damage was done and pre-provision profits were up just 2% year over year (and down 10% sequentially), putting my former notion that Commerce Bancshares would be one of the relatively few banks to post a solid PPOP growth rate in 2019 at risk. Tangible book value per share jumped nicely, though, up 14% year over year.

Loan Growth Pretty “Meh”, And Deposit Costs Are Rising

Commerce reported a little under 2% yoy growth in end-of-period loans and a slight contraction on a sequential basis, while average balances rose 1% and 0.5%, respectively. Both figures (on a qoq basis) were weaker than what the Fed reported for “small banks” in the first quarter (although Commerce Bancshares is not all that small, it doesn’t make the large bank cut for this report).

Within that modest underperformance, the bank’s lending trends broadly fit the Fed data, namely in the sense that commercial (C&I) and commercial real estate (or CRE) lending was healthy and consumer lending was weak - C&I lending grew more than 4% yoy and more than 1% qoq, while CRE lending rose 5% yoy but fell about 0.6% sequentially. Mortgage lending was up 2.7% yoy and down 0.1% qoq, while consumer lending fell 8.5% yoy and 3.2% qoq. Yields continue to improve (up 52bp yoy and 13bp qoq), and management noted strength in leasing, ag, and CRE lending, with the latter being driven in part by its competitive market entries (Cincinnati, Nashville, et al).

Deposits fell about 3% yoy and 2% qoq, with average balances down about 1.5% and 1%, respectively. More problematic was the large drop in non-interest-bearing deposits. This is a growing challenge for the sector (JPMorgan (JPM) saw some pressure here too), but Commerce Bancshares saw a 9% yoy decline and a 10% qoq decline. The bank is offsetting this in part with higher-priced brokered deposits, which led to a 10bp qoq increase in interest-bearing deposits and a 16% sequential jump in the interest-bearing deposit beta from 24% to 40%.

Not Bad, But There’s A Higher Bar

I don’t want to leave readers with the impression that the bank is in trouble. Card fees can be volatile from quarter to quarter, and although lending growth was lower than expected, I think the bank is still doing no worse than “alright”, particularly with C&I and CRE lending. Rising deposit costs and shrinking non-interest bearing deposits are a concern, but that’s true for many (if not most) banks now. I believe Commerce Bancshares is pretty well-placed as an “all-weather bank”, but there is some risk here if the economy slows further and/or faster than I expect.

As far as drivers for better performance, I expect management to continue its policy of selective market expansion/growth with its commercial lending - following a plan similar to PNC Financial (PNC), Comerica (CMA), and many other banks. I also think management could be getting a little more interested in whole bank M&A, particularly for small banks with strong core deposit franchises but relatively more limited prospects for growing loan balances.

The Outlook

I see no reason to hack and slash long-term estimates on the basis of one disappointing quarter, but I do think investors may want to reconsider whether they want to pay such a premium for the notion of stability, consistency, and/or earnings predictability. I’ve never been a big fan of that myself, but I also know better than to argue with the market.

I still think a long-term core earnings (not EPS) growth rate of 5% is valid and viable, but that doesn’t support a particularly exciting fair value - a situation that is quite normal for this bank. Likewise with ROTE-P/TBV and P/E methodologies, I don’t see a methodology by which Commerce Bancshares is “cheap” unless you explicitly factor in some buffer or reward for quality.

The Bottom Line

With increasing competition in key markets like Kansas City (PNC) and St. Louis (JPMorgan), Commerce Bancshares has to stay nimble to keep what it has, let alone continue to grow the business. Management is doing just that with its growing, niche-based commercial lending platform, and I would expect a renewed focus soon on the important fee-generating card business. Valuation remains my sticking point, as I’m not fond of paying up in general, and I do worry that another disappointment or two could have a disproportionate impact on the share price.

Disclosure: I am/we are long JPM. 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.