CBSH - Commerce Bancshares: In Tougher Times The 'Platinum Tortoise' Outperforms

Summary

• Commerce Bancshares did well in the third quarter on a core basis, with double-digit year-over-year core pre-provision profit growth driven by strong spread income.
• Credit quality remains strong despite higher provisioning, but loan growth was more "okay" than good, and weaker earning asset growth is a modest concern.
• Commerce's strong core deposit franchise and proven conservative management are positives in tough times, but the premium is a concern when bank stocks rally again.

I've criticized the premium multiple of Commerce Bancshares ( CBSH ) in the past, but in tougher times like these, the Street certainly seems to appreciate the quality core deposits and demonstrated underwriting competence of this conservatively-run Midwestern bank. To that end, the shares are almost flat since my last update , a period during which the average regional bank stock lost around 10% of its value.

I'm not excited about paying over 16.5x my forward EPS estimate for CBSH, and likewise, a long-term discounted core earnings model doesn't suggest a great bargain today. That's par for the course with these shares, though, and I suspect long-term holders of these shares won't be bothered by it. I do think banks, as a sector, are undervalued now and as sentiment turns, I don't expect Commerce to continue to outperform given the more moderate growth outlook and the already-robust valuation.

Mixed Trends For The Third Quarter

"Mixed" is a word that could be used for many, if not most, bank earnings reports this quarter, and Commerce Bancshares is no exception. The bank did well on core spread income, but fee income was a little soft, expense leverage was more mixed, provision expense was a little high, and loan growth was mixed.

Core revenue rose 9% year over year and 3% quarter over quarter, which was a bit better than expected by the sell side. Net interest income drove the growth, with a 15% yoy and 6% qoq improvement driven by a significant jump in net interest margin (up 43bp yoy and 22bp qoq to 3.01%). Fee income was more or less flat on an annual and sequential basis, with good growth in card fees (up about 7% yoy and 4% qoq) offset by a decrease in trust fees; importantly, Commerce has never had an especially large mortgage banking business, so the sharp decline in this business line didn't have an outsized impact.

Core expenses rose 5% yoy and declined 1% qoq, with Commerce showing some decent operating leverage after a few underwhelming quarters. Still, relative to expectations, Commerce came up a bit light here. Pre-provision profit was still up 16% yoy, though, and up about 8% qoq, beating expectations.

The miss relative to sell-side expectations (from $0.01 to $0.03 per share, depending on the source you use) was driven largely by higher-than-expected provisions. Reported tangible book value per share declined sharply (down 36% yoy and 12%) due to changes in the carrying value of securities, but ex-AOCI tangible book value was up slightly (around 2%) on a year-over-year basis.

Modest Loan Growth, But Noticeably Lower Deposit Betas

Commerce didn't stand out with respect to loan growth. Whereas the bank sector generated better than 2% qoq loan growth this quarter, Commerce came in at about half that level. That said, adjusted business (C&I) loan performance was more in line, with adjusted growth of 11% yoy and 2% qoq that was more in line with the broader comp growth.

Management did point to a healthy pipeline, though, and the company's funding position remains excellent. As other banks start to feel a bit more of a pinch on funding, Commerce should be able to leverage better yields and better selectivity on the loans they underwrite. That said, the lending environment is still pretty competitive and there is the risk of weaker loan demand in 2023 as business confidence erodes in the face of higher rates.

Deposits were weaker than I'd expected, with end-of-period deposits down about 3% and non-interest-bearing deposits down closer to 6%. I expected that banks with strong core deposit franchises (including Commerce) would be willing to let higher-cost deposits roll off as rates increased, but I was surprised to see the magnitude of decline in NIB deposits. Even so, though, deposit costs rose only 8bp qoq (to a very low 12bp), and a deposit beta of around 5% should compare very favorably to almost all other banks. I'd also note that NIB deposits are still close to 39% of total deposits - higher not only than peers but still above the pre-COVID level of around 33%.

The Outlook

I do have some concerns with respect to Commerce's earnings momentum going into 2023. While strong 2022 results and a weakening outlook for 2023 is "pulling forward" growth for many banks, I'm concerned that the healthy spread leverage here will be offset by weak earning asset growth. Likewise, I'm concerned about relatively limited scope for meaningful expense cuts; I think Commerce is an efficiently-run bank, but I think leverage is a little more dependent on revenue growth now.

As far as positives go, I still like Commerce's opportunities to grow its card and payments business, and I'm curious to see what the bank can do with its middle-market private equity group at a time when many private equity groups are pulling back. I also still see worthwhile opportunities in specialty commercial lending, but again I would note that many of the markets that Commerce has targeted for growth (Nashville, Dallas, Houston, especially) are high-priority targets for many other lenders as well.

My 2022 and 2023 core earnings estimates are certainly higher now (by close to 14% and 6%, respectively) on better-than-expected spread leverage, but I'm not looking for much year-over-year growth in 2023, and my long-term core earnings assumptions haven't changed too much - I still expect mid-teens core ROE and a 6% to 7% core earnings growth rate.

The Bottom Line

Commerce doesn't really look cheap by any of the metrics/approaches I use, including discounted long-term core earnings, ROTCE-driven P/TBV, and P/E, though I can at least get into the low $70s on an adjusted P/TBV basis. By the same token, Commerce almost never looks cheap, and the shares have still outperformed the peer group over the last 10 years.

I can't recommend the shares just because they've done well in the past, but I do believe this bank is led by a proven management team and I can understand its appeal in more challenging times. Still, as my outlook for banks in 2023 is more bullish, I think there are better ideas out there for investors who want greater appreciation potential over the next 12-24 months.

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