CBU - Community Bank: Upgrading To Buy But Keeping Earnings Estimate Largely Unchanged

2023-09-15 00:25:10 ET

Summary

• Loan growth will drive earnings growth, while margin will likely restrain earnings growth this year.
• The year-end target price suggests a small upside from the current market price. Further, CBU is offering a good dividend yield.
• Unrealized losses are the major source of risk. Overall, the risk level appears manageable.

Earnings of Community Bank System, Inc. ( CBU ) will likely be flattish this year as loan growth will be countered by margin pressure and higher expenses. I'm expecting the company to report adjusted earnings of $3.53 per share, which is close to the estimate given in my last report on the company. The year-end target price suggests a small upside from the current market price. Based on the total expected return, I'm upgrading Community Bank System to a buy rating.

Revising Upwards the Loan Growth Estimate

Loan additions during the first half of the year have already met my expectations for the full year. The portfolio grew by 4.1% during the first half of the year, or 8.2% annualized, while I expected loan growth of 4.1% for full-year 2023. What's most remarkable about this growth is that it was not due to one-offs. The growth was driven by increases in all loan categories due to net organic growth, as mentioned in the earnings release . This gives me confidence that the growth momentum can be sustained for at least another quarter.

Further, strong job markets make me optimistic about commercial loan growth. Community Bank System operates in the northeastern states of New York, Pennsylvania, Vermont, and Massachusetts. This region currently has low unemployment rates compared to previous years.

Overall, I'm expecting the loan book to grow by 1.50% in each of the last two quarters of 2023. Compared to my last report, I've increased my loan growth estimate for the second half of the year following the first half's outperformance. I underestimated the management's capabilities before, and I've now corrected my estimate. For the full year, I'm now expecting a loan growth of 7.3%, higher than my previous estimate of 4.1%. The following table shows my balance sheet estimates.

Compared to my last report on the company, I haven't changed my adjusted earnings estimate much because the changes I've made in different items cancel each other out.

Riskiness is no Longer Key in my Investment Thesis

The major source of risk for Community Bank System is the large balance of fixed-rate securities whose market values have declined as interest rates have risen leading to unrealized losses. Gross unrealized losses on the Available-for-Sale securities portfolio amounted to $436 million at the end of June 2023, which is a sizable 27% of the total equity balance.

Meanwhile, the deposit book is low on risk. Estimated uninsured and uncollateralized deposits represented less than 20% of second quarter ending total deposits, as mentioned in the earnings release. Further, the available sources of immediately available liquidity represented over 200% of the company's estimated uninsured and uncollateralized deposits.

In my last report, I adopted a hold rating on CBU despite double-digit total expected return because the risks were too high. The bank failures were still recent at the time of my last report. However, the banking industry has settled since then and the risks of failure have abated to a large extent. Therefore, I no longer think the risk level should affect my rating on Community Bank System.

Upgrading to a Buy Rating

Community Bank System is offering a dividend yield of 4.1% at the current quarterly dividend rate of $0.45 per share. The earnings and dividend estimates suggest a payout ratio of 66% for 2023 (using unadjusted earnings), which is much higher than the five-year average of 49%. Nevertheless, I'm not worried about a dividend cut because 66% of earnings can easily be paid out. I wouldn't worry about a payout ratio unless it was close to or over 100%.

I'm using the historical price-to-tangible book ("P/TB") and price-to-earnings ("P/E") multiples to value Community Bank System. The stock has traded at an average P/TB ratio of 3.51 and an average P/E ratio of around 19.7x in the past, as shown below.

Multiplying the average P/TB multiple with the forecast tangible book value per share of $12.2 gives a target price of $42.9 for the end of 2023. This price target implies a 3.0% downside from the September 14 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.

Equally weighting the target prices from the two valuation methods gives a combined target price of $47.9 , which implies an 8.1% upside from the current market price. Adding the forward dividend yield gives a total expected return of 12.2%.

In my last report, I adopted a hold rating because of the risk level. Considering my updated total expected return and assessment of risk, I'm now upgrading Community Bank System to a buy rating.

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