Commerce Bancorp CBH
July 19, 2006 - 3:30am EST by
met99
2006 2007
Price: 31.64 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 5,876 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Value exists when a temporary constraint on the earning power of assets is inevitably going to ease. One can project a substantial increase on earnings by those assets.  When that asset base is growing significantly at the same time, these combined forces result in extraordinary earnings growth in a fairly short period of time.  Such is the case with Commerce Bancorp (CBH).
 
Commerce is a regional bank with a sustainable high rate of deposit growth that is unmatched in the industry.  Presently based in Metro Philadelphia and Metro New York City, CBH is opening two new markets, Metro Washington DC, and SE Florida.  The latter is a wintering ground for NE residents, providing familiarity to seasonal market residents. ‘Stores’ or branches can grow from 389 now, to 625-700 by the end of 2009.
 
Investment Thesis:
 
1) Commerce will continue to grow its deposit base substantially.
2) The present compressed net interest margin (NIM) due to the flat yield curve will eventually unwind to more typical historical spreads.
3) On a greater asset base, Commerce EPS rapidly grow during 2007-2009. 
 
Risks:
 
1)  Deposit growth rate slows substantially.  I respect this concern by modeling outright deposit increases rather than sustained percentage increases on a growing base.
2)  CBH is unable to widen spreads.  I would argue however that current spreads are an aberration, in an unusual yield curve environment.  While the duration of that environment is not knowable, a more typical yield curve, and resulting spreads should eventually return.  Spreads are independent of high or low rates.
 
In the discussion that follows, all figures are in MMs except per share data and multiples.  I utilize period end shares outstanding for all per share data.  In projecting forward, I model DRIP shares and option exercises to ‘dilute’ the future share count and results.  The same effects can be achieved looking at fully diluted shares (including options granted), with net option grant projections going forward.  The absolute ratios and per share amounts differ in the two analyses, but the relative trends are identical.
 
Historical:
 
Commerce has a sustained history of gathering deposits and earning a good NIM on that deposit base.  Here are the historical figures:
 
2002     2003     2004     2005     TTM
830       1088     1393     1596     1711     Total Revenue
218       293       415       431       430       Operating Income
69.7%   70.4%   67.6%   71.2%   71.7%   Efficiency Ratio
4.69%   4.36%   4.28%   3.77%   3.53%   Net Interest Margin
145       194       273       283       283       Net Income
$1.07    $1.27    $1.71    $1.58    $1.52    EPS (basic)
13834   19779   26657   33870   36784   Core deposits
46%      43%      35%      27%      24%      Core deposit growth
18.5%   18.8%   18.8%   14.9%   12.8%   ROE
 
A first look would suggest a steadily slowing trend for CBH.  But it actually shows some strength of the business model.  CBH cannot control the Fed’s movement on short term rates or the yield curve.  As in any business, it must operate in the external environment.  But note that from 2004 to the present, while NIM fell by 75bps (or 17.5%), net income held up quite well.  Deposit growth is responsible for that result despite the strong NIM headwind.  EPS fell for two reasons:  long term debt was eliminated with the conversion of a preferred to common in September ’05, resulting in a 4.8% increase in common shares.  Additionally, DRIP shares and option exercises added 7%.  Combined, they create the notable EPS decline from 2004 to 2005.  Going forward, DRIP investments have been restricted, and option exercises should be a smaller percentage of the share base.  The RATE of core deposit growth is slowing as well, but the percentage figures are run against a rapidly escalating base number.  Core deposit growth was 4,338 in 2002; in 2005 it was 7,213 or increased by 66%.
 
Projected Results:
 
If the NIM were permanently reduced to present levels, then only deposit growth could lift EPS.  But it is inevitable that a more normal sloping curve will be established.  If a wider NIM was applied to a slow or no growth deposit base, that story might be interesting, but hardly compelling.  But in the case of CBH, the business model is fundamentally about attracting substantial new deposits.  This is accomplished by an explicit emphasis on customer service, and a well thought out (and historically well executed) strategy for creating new branches.  These two forces will combine to produce substantial EPS growth to 2009.  Here are the projected figures:
 
2006     2007     2008     2009
1867     2377     2901     3518     Total Revenue
480       659       869       1061     Operating Income
72.7%   71.0%   69.0%   69.0%   Efficiency Ratio
3.40%   3.75%   4.00%   4.30%   Net Interest Margin
312       429       565       689       Net Income
$1.66    $2.20    $2.81    $3.32    EPS (basic)
41070   48570   56370   64570   Core Deposits
21%      18%      16%      15%      Core deposit growth
12.2%   14.0%   15.4%   15.6%   ROE
 
This table reflects some of the model assumptions.  CBH has a relatively high efficiency ratio.  This is explained by the costs of developing and initially operating large numbers of new branches.  While one can hypothesize that as a larger percentage of branches are at peak profitability levels (and thus lower efficiency ratios) the overall ratio could come down, I have maintained an efficiency ratio in the middle of historical norms. 
 
I only slowly bring the NIM back to historical norms.  It’s fallen in 18 months.  I take 2.5 years to get it back to ‘normal’.
 
EPS is run against an expanding share base each year.  From the present 185.7 shares, I use 207.7 shares for 2009 based on DRIP and option exercises.
 
Core deposit growth rates continue to slow.  Again, I emphasize this is a function of an expanding base.  I have increased core deposit growth gradually to 8,200 in 2009.  This is by no means an aggressive assumption.  Branch counts will continue to ramp up, and the deposit gathering machine will be larger.  CBH has just entered both the Washington/Baltimore and SE Florida markets.  As the presence grows in each, growth rates for these markets should advance well.
 
Equity grows significantly over the model time frame, driven by net income and accretive DRIP and option share sales, but reduced by a growing dividend stream.  Even so, the rapid growth of net income drives ROE back above 15%, despite the greater equity base.
 
Forward Valuation (end of 2009):
 
At the end of 2009, CBH will have a trailing EPS growth rate of 18.2%.  Applying a matching PE to the EPS of $3.32 gives a fair value price of $60.42.
 
Another form of valuation is to look at tangible book value and assign a ‘deposit premium’ rate to the core deposit base.  The deposit premium plus tangible book value equals the market cap.  For CBH, the historical deposit premium rate range from 2002 to 2005 has been 15.8% to 11%.  At present it is 9.5%.  I used 11% in projecting a value for CBH in 2009.  Tangible equity is tracked by monitoring net income, share sale proceeds, and dividends.  On this basis, the 2009 share price is projected at $56.74.
 
Finally, CBH treats itself as a ‘money store retailer’.  As such, it seems appropriate
to analyze it with an EV and EBITDA, even if unusual for bank stocks.  Its reporting supports this approach.  One can determine ‘corporate cash’ (and thus net debt for an EV) by starting from total assets, and deducting PP&E, intangibles, other assets, deposits, and other borrowed money.  EBITDA is simply net income plus tax, D&A, and ‘interest on long term debt’.  On this basis, CBH has an EV/EBITDA range of 7.9x on the peak earnings in 2004 to 9.5x on the TTM depressed earnings.  For model valuation, I use 8.0x in ‘peak’ 2009, and cumulatively adjust the 2005 ‘net debt’ by after tax free cash flow, less projected dividends.  On this basis, the per share value is $56.37.
 
The average value from these three approaches is $57.84.  With a modestly increasing dividend rate, total cash received plus stock price is $59.66 at the end of 2009.  This represents an 89% return from the present price.
 
CBH is not a free cash flow story as growth is funded by operating cash flow. However, cap ex and the dividends are fully covered by operating cash flow, with an expanding surplus going forward.  This suggests dividend hikes could be faster than I model.  Subsequent year cash flow increases suggest 3-4 year ‘payback’ on the internal growth investments, depending on the forward year relative net interest margin.
 
Sensitivity:
 
Total Deposit Growth (base case net int. margin):
2006     2007     2008     2009     ‘09 EPS           
7,400    7,400    7,400    7,400    $3.22    low      
7,400    7,700    8,000    8,500    $3.32    base    
7,400    8,000    8,700    9,400    $3.42    high
 
Net Interest Margin (base case deposit growth):
2006     2007     2008     2009     ‘09 EPS
3.4%     3.4%     3.4%     3.4%     $2.77    low
3.4%     3.75%   4.0%     4.3%     $3.32    base
3.2%     4.0%     4.3%     4.6%     $3.50    high
 
In the end, if one believes CBH can continue to grow deposits, and that the yield curve will resume a normal slope, then rapidly escalating EPS are inevitable.  Share pricing will follow.  Buy on weakness.  The author may buy, hold, or sell shares of CBH at any time.

Catalyst

Neither a steepening yield curve, higher NIMs, nor sustained deposit growth are short term catalysts. But all will occur with time, with positive results for the stock.
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