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.
Financial Position | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net Loans | 6,232 | 6,841 | 7,355 | 7,324 | 8,748 | 9,383 |
Growth of Net Loans | 0.4% | 9.8% | 7.5% | (0.4)% | 19.5% | 7.3% |
Other Earning Assets | 2,982 | 3,088 | 3,597 | 4,979 | 5,315 | 4,317 |
Deposits | 8,322 | 8,995 | 11,225 | 12,911 | 13,012 | 13,261 |
Borrowings and Sub-Debt | 414 | 345 | 371 | 330 | 1,138 | 494 |
Common equity | 1,714 | 1,855 | 2,104 | 2,101 | 1,552 | 1,559 |
Book Value Per Share ($) | 33.1 | 35.5 | 39.4 | 38.6 | 28.6 | 29.0 |
Tangible BVPS ($) | 18.9 | 20.7 | 23.6 | 22.7 | 12.0 | 12.2 |
Source: SEC Filings, Author's Estimates(In USD million unless otherwise specified) |
Slight Margin Compression Likely in the Second Half
Community Bank's net interest margin jumped up in the first quarter and then remained almost stable in the second quarter of 2023, in line with the expectations presented in my last report on the company. The first quarter's jump was attributable to the sale of securities and subsequent paydown of high-cost wholesale borrowings.
The balance sheet is currently liability-sensitive, which means that liability re-pricing will outweigh asset re-pricing in the event of a rate hike. As per the results of the management's rate-sensitivity analysis given in the 10-Q filing , a 200-basis points hike in rates could decrease the net interest income by 6.1% over twelve months.
2Q 2023 10-Q Filing
I'm expecting a further 25-basis points rate hike in the remainder of 2023. Considering my interest rate outlook and the liability-sensitivity, I'm expecting the margin to dip by five basis points in the second half of 2023. Compared to my last report on the company, I've slightly reduced my margin estimate as the rate upcycle is now likely to last longer than what I previously anticipated.
Expecting Flattish Earnings
Earnings will likely remain flattish this year as loan growth will get countered by margin pressure. Further, inflation-driven growth in operating expenses will counter loan growth. Adjusting for the one-time loss on sale of investment securities reported in the first quarter of 2023, I'm expecting earnings of $3.53 per share. Including the loss on sale, I'm expecting Community Bank System to report earnings of $2.68 per share. The following table shows my income statement estimates.
Income Statement | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net interest income | 345 | 359 | 368 | 374 | 421 | 439 |
Provision for loan losses | 11 | 8 | 14 | (9) | 15 | 11 |
Non-interest income | 224 | 231 | 228 | 246 | 259 | 212 |
Non-interest expense | 345 | 372 | 377 | 388 | 424 | 457 |
Net income - Common Sh. | 168 | 169 | 164 | 189 | 188 | 144 |
EPS - Diluted ($) | 3.24 | 3.23 | 3.08 | 3.48 | 3.46 | 2.68 |
Source: SEC Filings, Author's Estimates(In USD million unless otherwise specified) |
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 $42.9 for the end of 2023. This price target implies a 3.0% downside from the September 14 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.
P/TB Multiple | 3.31x | 3.41x | 3.51x | 3.61x | 3.71x |
TBVPS - Dec 2023 ($) | 12.2 | 12.2 | 12.2 | 12.2 | 12.2 |
Target Price ($) | 40.5 | 41.7 | 42.9 | 44.1 | 45.4 |
Market Price ($) | 44.3 | 44.3 | 44.3 | 44.3 | 44.3 |
Upside/(Downside) | (8.5)% | (5.8)% | (3.0)% | (0.2)% | 2.5% |
Source: Author's Estimates |
Multiplying the average P/E multiple with the forecast earnings per share of $2.68 gives a target price of $52.8 for the end of 2023. This price target implies a 19.3% upside from the September 14 closing price. The following table shows the sensitivity of the target price to the P/E ratio.
P/E Multiple | 17.7x | 18.7x | 19.7x | 20.7x | 21.7x |
EPS - 2023 ($) | 2.68 | 2.68 | 2.68 | 2.68 | 2.68 |
Target Price ($) | 47.4 | 50.1 | 52.8 | 55.5 | 58.2 |
Market Price ($) | 44.3 | 44.3 | 44.3 | 44.3 | 44.3 |
Upside/(Downside) | 7.2% | 13.3% | 19.3% | 25.4% | 31.4% |
Source: Author's Estimates |
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.
For further details see:
Community Bank: Upgrading To Buy But Keeping Earnings Estimate Largely Unchanged