CBSH - Commerce Bancshares: High Risk Limited Upside Make Stock Unattractive

2023-04-13 20:45:41 ET

Summary

• Economic factors will keep loan growth from dipping below the historical average.
• I’ve reduced my earnings estimate mostly because I’ve revised upwards my operating expense estimate.
• The risk level is high because of the large balance of unrealized mark-to-market losses on the AFS securities portfolio.
• The year-end target price suggests a small upside from the current market price. Further, CBSH is offering an unattractive dividend yield.

Earnings of Commerce Bancshares, Inc. ( CBSH ) will most probably increase this year on the back of normal loan growth. On the other hand, inflation-driven growth in operating expenses will drag earnings. Meanwhile, I’m expecting the net interest margin to be mostly stable this year. Overall, I’m expecting Commerce Bancshares to report earnings of $4.03 per share for 2023, up 5% year-over-year. The year-end target price suggests a limited upside from the current market price. Further, the company’s risk level is high due to large unrealized losses. Considering these factors, I’m maintaining a hold rating on CBSH stock.

Commercial Loan Segment to Drive the Loan Book

Loan growth continued to remain extraordinarily high in the fourth quarter of 2022. As a result, the loan portfolio grew by 7.5% for 2022, which is much higher than the last five-year CAGR of 3.1%. I’m expecting growth to revert to the historical average this year, mostly because of the high interest-rate environment. Residential real estate loans and revolving home equity, which are most vulnerable to borrowing costs among all loan classes, made up 19.7% of total loans at the end of 2022.

Fortunately, the outlook for commercial loans is a bit better. Even though the unemployment rate is set to rise this year, it’ll still be low compared to the last decade (see chart below). Commerce Bancshares operates in the states of Missouri, Kansas, Illinois, Oklahoma, and Colorado. While these states are geographically clustered together, their economies are quite different. Therefore, I believe it’s best to take national averages when trying to gauge credit demand.

The purchasing managers index is another appropriate gauge of credit demand. The manufacturing PMI index gives a negative outlook for commercial loan growth; however, the services PMI index is still in expansionary territory (above 50).

Considering these factors, I’m expecting the loan portfolio to grow by 3% in 2023, which is the same as the CAGR for the last five years. Further, I’m expecting other balance sheet items to grow in tandem with loans. The following table shows my balance sheet estimates.

The Risk Level is High Due to Huge Unrealized Losses

Commerce Bancshares has a very large available-for-sale (“AFS”) securities portfolio which is concentrated in mortgage-backed and asset-backed securities and state and municipal obligations. Due to the fixed-rate nature of these securities, their market value fell as interest rates rose last year, leading to huge unrealized losses. As of the end of December 2022, these unrealized losses had grown to $1,501 million, which is a massive 61% of the total equity balance. Further, $1,501 million is more than three times the earnings for 2022. These losses will most probably begin to reverse next year when interest rates start to fall; however, there is a very slim chance that Commerce Bancshares may feel compelled to sell its securities and realize the as-yet-unrealized loss.

Further, a large part of Commerce Bancshares’ deposit book is uninsured. As of the end of last year, these uninsured deposits made up a whopping 43% of total deposits.

On the plus side, Commerce Bancshares does not have exposure to risky assets like crypto-currencies and venture capital investments. The only high-risk segment in its portfolio is the credit card business, which made up just 3.6% of total loans at the end of 2022.

Single-Digit Total Expected Return Calls for a Hold Rating

Commerce Bancshares is offering a dividend yield of 1.9% at the current quarterly dividend rate of $0.27 per share. The earnings and dividend estimates suggest a payout ratio of 27% for 2023, which is in line with the five-year average of 29%. The company also usually gives a 5% stock dividend in the fourth quarter of the year.

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 2.58x in the past, as shown below.

The stock has traded at an average P/E ratio of around 16.7x in the past, as shown below.

Equally weighting the target prices from the two valuation methods gives a combined target price of $59.1 , which implies a 5.5% upside from the current market price. Adding the forward dividend yield gives a total expected return of 7.4%. Based on the low total expected return and the high level of risk, I’m maintaining a hold rating on Commerce Bancshares.

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