2023-04-22 07:13:30 ET
Summary
- The recent sale of treasuries and subsequent paydown of wholesale borrowing will lift the margin.
- The outlook for commercial loan growth is better than the outlook for the residential mortgage segment.
- The year-end target price suggests a high upside from the current market price. Further, CBU is offering a decent dividend yield.
- The risk level is moderately high mostly because of the large balance of unrealized losses.
Earnings of Community Bank System, Inc. (CBU) will most probably increase this year thanks to subdued loan growth. Further, the margin will receive a boost from the recent sale of treasuries and the paydown of expensive borrowing. Overall, I'm expecting Community Bank System to report earnings of $3.63 per share for 2023, up 5% year-over-year. The year-end target price suggests a high upside from the current market price. Based on the total expected return and the moderately-high risk level, I'm maintaining a hold rating on Community Bank System.
Recent Payoff of Wholesale Borrowing to Give One-Time Boost to the Margin
Community Bank's margin remained almost unchanged in the last quarter of 2022 from the third quarter of the year. The margin's movement is likely to have been better in the first quarter of 2023 because Community Bank sold off some of its low-yielding U.S. Treasuries in February and used the proceeds to pay off high-cost wholesale borrowing. The spread between the rates of treasuries and borrowings was 320 basis points, as mentioned in the earnings presentation . As per my calculations, this transaction would've improved the net interest margin by 17 basis points in the first quarter of the year.
After the jump in the first quarter, I'm expecting the margin to remain stable in the remainder of 2023 because the net interest income is barely sensitive to interest rate changes. The results of the management's rate sensitivity simulation given in the 10-K filing show that a 200-basis points hike in rates could reduce the net interest income by 0.4% over twelve months.
2022 10-K Filing
Commercial Segment to Offset Weakness in the Consumer Mortgage Segment
Community Bank System's loan growth slowed down to 3.1% in the fourth quarter, which is still a very high rate considering the company's history of organic growth. Community Bank has historically relied on acquisitions for growth, and the company has performed very poorly when it comes to organic growth. As can be seen in the table below, excluding 2020, Community Bank's organic growth has been lackluster in the past.
CBU's Merger and Acquisition History | ||||
Year | Acquisition Target | Target's Total Assets ($ million) | Change in CBU's Assets for the Year | Difference Attributable to Organic Growth |
2022 | Elmira Savings Bank | 579 | 283 | (296) |
2020 | Steuben Trust Corporation | 608 | 2,521 | 1,913 |
2019 | Kinderhook Bank Corp. | 643 | 803 | 160 |
2017 | Merchants Bancshares, Inc. | 1,999 | 2,080 | 81 |
2015 | Oneida Financial Corp. | 769 | 1,063 | 294 |
Source: 3Q 2022 Presentation, Author's Calculations |
The outlook for consumer mortgages is bleak because of high borrowing costs. This segment makes up around 34% of total loans; therefore, a slowdown in this segment will hurt overall loan growth. The Mortgage Bankers Association has reduced its forecasts for mortgage-purchase volume recently. The latest forecast is 7.9% below the forecast given in the release for November when I wrote my last report on the company. The chart below compares MBA's latest estimates with its previous estimates given in November.
Authors Calculations, Forecasts by Mortgage Bankers Association
The outlook for commercial loans is a bit better because of improving regional job markets. Community Bank System operates in the northeastern states of New York, Pennsylvania, Vermont, and Massachusetts. Although three of these states (i.e. New York, Pennsylvania, and Massachusetts) currently have worse unemployment rates than the national average, their rates are still low compared to their respective histories.
Considering the outlook for consumer mortgage and commercial loans, I'm expecting the total loan portfolio to grow by 4% in 2023. The following table shows my balance sheet estimates.
Financial Position | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net Loans | 6,232 | 6,841 | 7,355 | 7,324 | 8,748 | 9,104 |
Growth of Net Loans | 0.4% | 9.8% | 7.5% | (0.4)% | 19.5% | 4.1% |
Other Earning Assets | 2,982 | 3,088 | 3,597 | 4,979 | 5,315 | 5,531 |
Deposits | 8,322 | 8,995 | 11,225 | 12,911 | 13,012 | 13,541 |
Borrowings and Sub-Debt | 414 | 345 | 371 | 330 | 1,138 | 1,184 |
Common equity | 1,714 | 1,855 | 2,104 | 2,101 | 1,552 | 1,452 |
Book Value Per Share ($) | 33.1 | 35.5 | 39.4 | 38.6 | 28.6 | 26.8 |
Tangible BVPS ($) | 18.9 | 20.7 | 23.6 | 22.7 | 12.0 | 10.1 |
Source: SEC Filings, Author's Estimates(In USD million unless otherwise specified) |
Earnings Likely to Grow by 5%
Earnings of Community Bank System will most probably grow this year on the back of mid-single-digit loan growth and the one-time jump in net interest margin. I'm expecting the company to report earnings of $3.63 per share for 2023, up 5% year-over-year. In my last report, I estimated earnings of $3.83 per share for 2023. I've reduced my earnings estimate because of the loss on the sale of treasury securities in February.
The company is scheduled to announce its first-quarter results on April 25, 2023. I'm expecting Community Bank to report earnings of $0.46 per share for the quarter, including the impact of the loss on the sale of treasury securities. Adjusting for this loss, I'm expecting earnings of $1.04 per share.
The following table shows my annual income statement estimates.
Income Statement | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net interest income | 345 | 359 | 368 | 374 | 421 | 488 |
Provision for loan losses | 11 | 8 | 14 | (9) | 15 | 14 |
Non-interest income | 224 | 231 | 228 | 246 | 259 | 209 |
Non-interest expense | 345 | 372 | 377 | 388 | 424 | 434 |
Net income - Common Sh. | 168 | 169 | 164 | 189 | 188 | 197 |
EPS - Diluted ($) | 3.24 | 3.23 | 3.08 | 3.48 | 3.46 | 3.63 |
Source: SEC Filings, Author's Estimates(In USD million unless otherwise specified) |
Risk Level is Currently High, but Could Reduce by Next Year
As interest rates rose last year, the market value of available-for-sale securities ("AFS") dropped, leading to large unrealized losses. These losses amounted to $524 million at the end of December 2022, as mentioned in the 10-K filing. As mentioned above, the company sold some U.S. Treasuries in February at a realized loss of $39.6 million. Following this transaction, the remaining unrealized losses should be around $484 million. To put this number in perspective, $484 million is 31% of the total equity at the end of last year, and 2.6 times the net income for 2022. Due to the building up of these unrealized losses, the company's risk level has risen. However, I believe these losses will reverse next year when rates start to decline. There are currently no signs of panic that could trigger a deposit run on the bank and force the bank to sell its AFS portfolio at a loss.
Another factor that calls for caution is the moderately-high level of deposits that cannot be insured by FDIC. As of the end of December 2022, these deposits represented 31% of total deposits.
Due to these two factors, I believe Community Bank System's risk level is moderately high.
Maintaining a Hold Rating
Community Bank System has a long-standing tradition of increasing its dividend every year. Given the earnings outlook, I'm expecting the company to increase its dividend by $0.01 per share to $0.45 per share in the third quarter of 2023. The earnings and dividend estimates suggest a payout ratio of 49% for 2023, which is in line with the five-year average of 48%. Based on my dividend estimate, Community Bank is offering a forward dividend yield of 3.7%.
I'm using the historical price-to-tangible book ("P/TB") and price-to-earnings ("P/E") multiples to value Community Bank System. The stock has traded at an average P/TB ratio of 3.52x in the past, as shown below.
FY18 | FY19 | FY20 | FY21 | FY22 | Average | |
T. Book Value per Share ($) | 18.9 | 20.7 | 23.6 | 22.7 | 12.0 | |
Average Market Price ($) | 59.3 | 64.0 | 60.6 | 73.8 | 66.6 | |
Historical P/TB | 3.13x | 3.09x | 2.57x | 3.25x | 5.57x | 3.52x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the average P/TB multiple with the forecast tangible book value per share of $10.1 gives a target price of $35.7 for the end of 2023. This price target implies a 24.6% downside from the April 21 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.
P/TB Multiple | 3.32x | 3.42x | 3.52x | 3.62x | 3.72x |
TBVPS - Dec 2023 ($) | 10.1 | 10.1 | 10.1 | 10.1 | 10.1 |
Target Price ($) | 33.6 | 34.6 | 35.7 | 36.7 | 37.7 |
Market Price ($) | 47.3 | 47.3 | 47.3 | 47.3 | 47.3 |
Upside/(Downside) | (28.9)% | (26.7)% | (24.6)% | (22.5)% | (20.3)% |
Source: Author's Estimates |
The stock has traded at an average P/E ratio of around 19.6x in the past, as shown below.
FY18 | FY19 | FY20 | FY21 | FY22 | Average | |
Earnings per Share ($) | 3.2 | 3.2 | 3.1 | 3.5 | 3.5 | |
Average Market Price ($) | 59.3 | 64.0 | 60.6 | 73.8 | 66.6 | |
Historical P/E | 18.3x | 19.8x | 19.7x | 21.2x | 19.3x | 19.6x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the average P/E multiple with the forecast earnings per share of $3.63 gives a target price of $71.3 for the end of 2023. This price target implies a 50.6% upside from the April 21 closing price. The following table shows the sensitivity of the target price to the P/E ratio.
P/E Multiple | 17.6x | 18.6x | 19.6x | 20.6x | 21.6x |
EPS - 2023 ($) | 3.63 | 3.63 | 3.63 | 3.63 | 3.63 |
Target Price ($) | 64.0 | 67.6 | 71.3 | 74.9 | 78.5 |
Market Price ($) | 47.3 | 47.3 | 47.3 | 47.3 | 47.3 |
Upside/(Downside) | 35.3% | 43.0% | 50.6% | 58.3% | 66.0% |
Source: Author's Estimates |
Equally weighting the target prices from the two valuation methods gives a combined target price of $53.5 , which implies a 13.0% upside from the current market price. Adding the forward dividend yield gives a total expected return of 16.7%.
Although the total expected return is high, I don't want to give the stock a buy rating because of the moderately-high risks. Therefore, I've decided to maintain a hold rating on Community Bank System.
For further details see:
Community Bank: Jump In Margin, Subdued Loan Growth To Help Earnings