Commerce Bancshares: Partial Provisioning Normalization To Drag Earnings

Summary

• Loan growth will eventually lead to a normalization of provisioning for loan losses.
• An improvement in the earning asset mix and an interest rate hike will likely expand the net interest margin.
• The December 2022 target price is below the current market price. Further, CBSH is offering a modest dividend yield.

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Earnings of Commerce Bancshares, Inc. (NASDAQ: NASDAQ:CBSH) will likely decline next year as the provisioning for loan losses will rise towards a more normal level. On the plus side, there is hope that the declining loan trend will reverse soon, leading to a better earning asset mix. The anticipated interest rate hike will also materially boost the net interest income. Overall, I'm expecting Commerce Bancshares to report earnings of around $3.67 per share in 2022, down 20% year-over-year. Next year’s target price suggests a small downside from the current market price. Hence, I'm adopting a neutral rating on Commerce Bancshares.

Earning Assets Optimization Likely to Boost Net Interest Income

Commerce Bancshares’ loan portfolio declined sharply in the last two consecutive quarters, mostly because of the forgiveness of Paycheck Protection Program (“PPP”) loans. As a result, the loan balance at the end of September 2021 was 7.4% below the March-end balance. Due to the loan decline and continued deposit growth, the earning asset mix shifted towards the securities portfolio, which is now almost as large as the loan portfolio. The following table shows the earning assets mix using data from the third quarter’s 10-Q filing.

However, all was not bleak as Commerce Bancshares was able to significantly reduce its excess cash balance in the third quarter and deploy it into higher-yielding securities. The following chart shows the trend of interest-earning deposits with other banks (a cash equivalent).

Despite the mopping-up of excess cash, there is still plenty of room for improvement because of the large securities portfolio. The recent asset mix shift towards securities has a significant impact on the average earning asset yield because the yields on the different asset classes are quite varied. The following table summarizes the different yields, as given in the 10-Q filing.

The management mentioned in the third quarter’s investor presentation that it is prudently deploying excess deposits into higher-yielding assets. In my opinion, an improvement in the earning asset mix is possible in the coming quarters because of a positive loan outlook. The following factors contribute to the loan outlook.

1. Only a small amount of PPP loans remain to be forgiven. After significant PPP loan forgiveness in the last few quarters, only a small number of loans now remain outstanding. As mentioned in the 10-Q filing, PPP loans outstanding totaled $307.9 million at the end of September 2021, down from $1.4 billion at the end of March 2021. PPP loans outstanding made up just 2.0% of total loans at the end of September 2021. Therefore, most of the forgiveness is already behind us.
2. Economic growth bodes well for the business loan portfolio. The recovery from the pandemic will likely drive economic growth in the country, which will, in turn, boost credit demand. Commerce Bancshares operates in several states, namely Missouri, Kansas, Illinois, Oklahoma, and Colorado. As a result, the economic growth for the overall country is a good measure to gauge credit demand. The United States economy grew by 2.0% in the third quarter of 2021, according to official sources.
3. The consumer credit card outlook remains positive. Commerce Bancshares earns a high interest rate of around 11.29% on its consumer credit card portfolio. The card business also contributes heavily to non-interest income. In fact, bank card transaction fees made up 11.7% of total revenues in the third quarter. Consumer credit demand depends on the unemployment rate, which has improved substantially recently, as shown below.

Data by YCharts

Considering the factors mentioned above, I'm expecting loan growth to return to the pre-pandemic normal of mid-single-digit growth. I'm also expecting loans to outpace deposit growth, which will improve the earning asset mix. I'm expecting the loan to deposit ratio to improve to 54.0% by the end of December 2022 from around 53.4% expected at the end of December 2021. The following table shows my balance sheet estimates.

Margin Expansion on the Cards

The anticipated asset mix shift will boost the average earning asset yield in the coming quarters, which will, in turn, support the net interest margin.

Further, an interest rate hike will boost the margin. Around 50% of the total loan portfolio is made up of variable-rate loans, as mentioned in the investor presentation. Due to the significant proportion of variable-rate loans, the anticipated interest rate hike next year will most probably have a material impact on the average portfolio yield. The Federal Reserve projects around a 25 basis point interest rate hike next year.

The liability side will further help the margin in a rising interest-rate scenario. Around 41% of average deposits in the third quarter were non-interest-bearing, as mentioned in the presentation. Therefore, a large part of the deposit portfolio will likely remain unchanged if rates rise. Due to a shift in asset mix, sensitive earning asset yields, and sticky deposit costs, I'm expecting the net interest margin to increase by two basis points in the last quarter of 2021 and then by four basis points in 2022.

Partial Normalization of Provisioning to Undermine Revenue Growth

Commerce Bancshares released a large part of its loan loss reserves in the last four consecutive quarters. Further provision reversals cannot be ruled out because the current allowance level appears somewhat excessive. Allowances were 15.6 times the non-performing loans at the end of September 2021, as mentioned in the presentation. Therefore, I'm expecting a net provision reversal of around $2 million in the last quarter of 2021.

However, the provision expense will likely move higher towards a more normal level next year. This is because of the anticipated loan growth as discussed above. Higher loan growth will naturally lead to higher loan loss provisioning. Nevertheless, I'm expecting the provisioning to remain below normal next year because of the relatively high allowance level. I’m expecting the provision expense to make up 0.20% of total loans in 2021. In comparison, the provision expense made up 0.31% of total loans from 2016 to 2019.

Expecting Earnings to Decline by 20% Next Year

Higher provision expense will likely be the biggest contributor to an earnings decline next year. On the other hand, loan growth and margin expansion will support the bottom line. Overall, I'm expecting Commerce Bancshares to report earnings of $1.06 per share in the last quarter of 2021, taking full-year earnings to $4.60 per share. For 2022, I'm expecting earnings to decline by 20% year-over-year. The following table shows my income statement estimates.

Actual earnings may differ materially from estimates because of the risks and uncertainties related to the COVID-19 pandemic and the timeline of an interest rate hike.

Small Downside Justifies a Neutral Rating

Commerce Bancshares is offering a dividend yield of 1.4%, assuming the company maintains its quarterly dividend at the current level of $0.2625 per share. The earnings and dividend estimates suggest a payout ratio of 29% for 2022, which is close to the 2016-2019 average of 31%. Therefore, I’m not expecting any change in the cash dividend level. Apart from the cash dividend, the company also usually pays a stock dividend of 5% annually.

I’m using the historical price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples to value Commerce Bancshares. The stock has traded at an average P/TB ratio of 2.30 in the past, as shown below.

Multiplying the average P/TB multiple with the forecast tangible book value per share of $32.1 gives a target price of $73.7 for the end of 2022. This price target implies a 0.9% upside from the November 18 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.

The stock has traded at an average P/E ratio of around 17.7x in the past, as shown below.

Multiplying the average P/E multiple with the forecast earnings per share of $3.67 gives a target price of $65.0 for the end of 2022. This price target implies an 11.1% downside from the November 18 closing price. The following table shows the sensitivity of the target price to the P/E ratio.

Equally weighting the target prices from the two valuation methods gives a combined target price of $69.4, which implies a 5.1% downside from the current market price. Adding the forward dividend yield gives a total expected return of negative 3.6%. Hence, I’m adopting a neutral rating on Commerce Bancshares. I wouldn’t consider investing in the stock unless its price dipped by more than 15% from the current level.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.