CBU - Community Bank System Needs Robust Growth To Drive More Appreciation

Summary

• Community Bank System's fourth quarter earnings were mixed, with a top-line miss and sluggish loan yield growth (both rare among banks this quarter) but solid operating leverage.
• This bank has an excellent deposit base driving an exceptionally low deposit beta, and I do see opportunities to gain lending and deposit share in several markets.
• The biggest issue I have with Community is that it seems to me that robust growth expectations are already built into the share price today.

In a market where I’m finding a lot of beaten-down bank stocks where valuations seem to be assuming undemanding long-term core earnings growth, I can’t really say the same for New York’s Community Bank System ( CBU ) (“Community Bank”, or “Community”). While I am quite impressed with this bank’s strong deposit franchise, fee-generating non-banking businesses, and market growth opportunities, I feel like that’s amply reflected in today’s price.

I have to use a mid-teens P/E just to get to today’s price, and likewise the shares already seem well-valued on the basis of long-term discounted core earnings and near-term ROTCE (as it drives P/TBV multiples). This is a name worth putting on a watch list, but it’s tough for me to argue for paying up for it today, even if the bank’s credit quality and low deposit betas are well-suited to the current market.

Mixed Results To End The Year

Community’s fourth quarter results were mixed relative to sell-side expectations and what I’ve seen overall in earnings reports from smaller banks this quarter. Core pre-provision profits looked alright, but not exceptional, and I don’t see outsized pre-provision profit growth next year.

Revenue rose about 10% year over year but was basically flat on a sequential basis, leading to a modest miss relative to sell-side expectations (about 1%, or $0.015/share). Net interest income was up more than 17% yoy and close to 2% qoq, which was a little weaker than I’d expected, as net interest margin rose 28bp yoy and shrank 1bp qoq to 3.02%, while earning assets rose about 2% qoq.

Non-spread income is a meaningful contributor to Community’s earnings, but a lot of the non-bank fee-generating businesses are related to the markets, and weaker equity markets did have an impact that I think obscures underlying strength. Fee-based income fell slightly from the prior year and more than 2% sequentially, with service charges up 4% qoq, employee benefits earnings up 4%, and wealth management and insurance earnings down about 17%.

Adjusted operating expenses were up 6% yoy and down 1.5% qoq, coming in better than I’d expected, though the efficiency ratio of 60.4% is still a little high relative to its peer group. Adjusted pre-provision profits rose 17% yoy and about 3% qoq, good for a small beat relative to my expectations (about $0.01/share), but still rather lackluster compared to many smaller banks. Lower than expected provisioning helped boost overall results.

Top-Notch Deposit Betas, Offset By Modest Loan Growth And Yield Expansion

Community posted about 3% end-of-period loan growth, which while not ahead of what typical smaller banks have done, isn’t far behind. Commercial lending was strong, up more than 4%, while mortgage lending slowed (up about 1%) and consumer indirect lending (autos, mostly) rose more than 5%.

Yields improved a modest 20bp yoy and 17bp qoq to 4.39%, held back in part by the bank’s skew to fixed-rate consumer lending. The bank originated $560M of loans in the quarter, though, and with a richer mix of commercial loans, the yield on these new loans was just under 6%.

On the deposit side, deposits declined 3.5% on an end-of-period basis, with a 3.3% decline in non-interest-bearing deposits. That latter number is better than average, and Community continues to benefit from a sizable core deposit base that’s not especially rate-sensitive. Non-interest-bearing deposits remain at a healthy 31.5% of total deposits, and the loan/deposit ratio of 68% is comfortable for the time being.

Deposit costs remain very attractive, with interest-bearing deposit costs rising just 14bp yoy and 9bp qoq to 0.26%, while overall deposit costs rose 10bp yoy and 6bp to just 0.18% - an incredibly strong result relative to most banks. With this, Community’s cumulative deposit beta remains at an exceptionally low level in the low single-digits at a time when many banks are seeing their deposit beta hit the high-20%’s or worse.

Opportunities To Grow

There are a lot of things I like about Community Bank. While this is a relatively small bank in the grand scheme of things, in 12 of 13 countries where it has $500M or more in deposits it has deposit share of 25% or higher (over 70% in some cases). That provides a good foundation of sticky low-cost deposits in markets that aren’t likely to attract a lot of branch-based competition.

I also think there’s above-average loan growth potential here. Community is willing to remain active in indirect auto lending at a time when many banks have pulled back, and while auto lending has driven outsized losses for some banks in the past, Community’s business is anchored by very strong credit quality (an average FICO of 750).

I also think there are opportunities to grow the commercial lending portfolio. One of Community’s major competitors in many markets is M&T Bank ( MTB ), and while I like this bank , large acquisitions like M&T’s acquisition of People’s tend to drive outsized customer attrition, particularly customers that prefer to work with smaller banks. I think this could be an opportunity for Community to gain some commercial lending share over the next year or two and/or possibly grab some revenue producers who would prefer to work elsewhere.

Last and not least is ongoing growth potential in the fee-based businesses. The markets for employee benefit/retirement plan administration is still fragmented and larger players don’t always do a good job of serving smaller business clients, giving Community an opportunity. Likewise with the insurance operations.

The Outlook

My issue with Community has everything to do with the growth expectations that now seem embedded in the valuation. Management’s guidance for 2023 leads me to think that high-single-digit pre-provision profit growth will be challenging. Likewise, it looks like the share price already anticipates high single-digit long-term core earnings growth. I don’t rule that out as achievable, but there are definitely other banks out there that I believe will achieve similar growth and sport much lower valuations.

I have to use a 15.5x multiple on my ’23 earnings estimate just to get to today’s price, and that doesn’t leave much on the table in terms of rerating. I do think Community’s low deposit beta and organic growth opportunities can drive above-average growth, but again this seems to be in the share price (likewise with a near-term ROTCE-based P/TBV approach).

The Bottom Line

Perhaps I’m missing something here, but I just don’t see today’s valuation as particularly appealing. Community’s business should be better-protected than many other banks that are facing more risk on funding costs and credit quality, but again that seems to be in the price. Likewise, I appreciate the combination of potentially above-average earnings growth and a decent dividend yield. This is a name I’d consider at a lower price, and it’s worth following, but I just can’t connect the dots on the valuation today.

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