Description

Introduction -

I am recommending a short on Pennsylvania Commerce Bancorp (COBH) which I believe could decline by 30% by the end of this year. This is the most expensive bank I can find in the US on a PEG basis and one of the highest on 2007 P/E. There is almost no chance of a takeout at a premium to the current price. An inverted yield curve will negatively impact EPS, and the largest shareholder will be under pressure to sell.

COBH is an unusual animal as it is a franchise operation of Commerce Bancorp (CBH), a name on which much ink has been spilled over the last few years. To understand COBH, I must first give you a quick couple of paragraphs of background on CBH.

I - CBH:

As many of you may already know, CBH is a very fast growing bank with a franchise that stretches from New York City to D.C. run by a Mr. Vernon Hill who is either a genius or a crook depending upon whose opinion you ask. CBH offers great rates and over-the-top customer service and its deposits grow very quickly (much faster than its loans) and lives off the spread between short and long rates.

After a big run (+600%) from 1996-2003, CBH is only up 8% (in line with the BKX Index) over the last 15 months due to a combination of
- a flattening yield curve which hurts earnings
- imitation by some competitors of CBH’s service levels,
- a balance sheet restructuring which wiped out last year’s EPS growth,
- execution concerns regarding the bank expanding first into DC and now south FL
- a myriad of litigation actions and management conflict of interest issues.
- That CBH stock has held up as well as it has in the last year is likely due to continued buyng by the top three holders of the stock (TCW, Putnam, and Capital) who now own more than 30% of the company)

II - COBH and its recent troubles:

COBH operates in central Pennsylvania under the Commerce Bank brand name and has been expanding quickly. CBH receives a fees from COBH for 1) managing COBH’s back office, 2) handling much of its legal and regulatory load, and 3) sending out statements and doing most of its product and brand development. Most of COBH’s 28 branches are in the ‘bustling’ Harrisburg, Reading and York urban areas. Seven more branches are planned.

Growth was fantastic for COBH (as it was for CBH) in the late 90’s and early ‘00s. BVPS grew from $3.7 in ‘98 to $14.30 at the end of ’04 and annual EPS moved up from $.54 to $1.63 over the same time period. The stock responded in kind and the earnings multiple has expanded. However, things have become much more difficult as of late. BVPS increased at a much slower pace in ’05 and EPS actually fell YoY to $1.48 as a result of a flatter yield curve and a secondary equity offering necessary to finance growth that was dilutive to EPS.

Things aren’t looking up for COBH in ’06 either. EPS is expected to fall again this year to $1.36 and those estimates have been falling over the last 6 months. Sell-side models also do not incorporate a sustained flattening/ inverted yield curve which may lead to additional negative surprises on the back of COBH missing consensus the last couple of quarters. COBH has a very low loan/deposit ratio of around 45% (vs. CBH’s which is around 35%) which leads to the company holding a large security portfolio. And the security book is under pressure due to low rates and a flat curve. A restructuring charge similar to the one CBH took last year might be necessary in 2006.

III - Irrational Valuation:

A quick look at COBH’s P/E shows that its valuation makes little sense:
COBH CBH
2006 P/E 22.9X 18.4X
2007 P/E 20.7X 15.1X
'06 EPS Change -10% 20%
'07 EPS Growth 10% 22%
P/B 2.1X 2.6X
ROE 13% 14%

So what we have here with COBH is a ‘growth’ stock on a growth P/E with negative EPS growth.

As you can see, CBH is already expensive on a P/E basis and COBH trades at a significant premium to CBH. This despite negative expected EPS growth and COBH operating in less attractive markets than CBH (Central PA vs. NYC, DC, and Southern Florida)

There are very few banks out there on 20X P/Es (except for overcapitalized recently demutualized thrifts) and the few that are have very high rates of expected EPS growth.

Many other small banks with low teens ROE trade on P/Bs of 2X or more, but that is almost always due to takeover premium speculation. In this case there is no likely acquirer for COBH besides CBH and a bid at a premium would be extremenly difficult to justify.

CBH owns 11% of COBH (and CBH CEO Vernon Hill owns 2%) and would block any potential deal from an outside buyer as it would lose high-margin fee income and lead to a shrinkage of the Commerce network. CBH is unlikely to want to buy COBH as the cost savings usually generated in a bank merger from closing redundant back office and overlapping branches is not possible in this case. This is because CBH already runs the back office for COBH and the branch network is contiguous, but not overlapping. Also, CBH is growing in markets that are more affluent and faster growing (NYC, D.C., and now southern Florida) than those where COBH operates. As COBH is more expensive on a P/E basis than CBH, and has negative EPS growth, any such purchase of the bank by CBH would be dilutive to earnings and would slow the larger company’s growth rate. Thus, a premium buyout of COBH by CBH as long as COBH’s P/E is higher than CBH’s is extremely unlikely.

I have asked management of COBH why their stock is more expensive than CBH’s. Their answer was 1) “we wonder that every day” (not too reassuring), and 2) “No Mr. Vernon Hill” (not reassuring either as Mr. Hill’s CBH runs the back office, marketing and regulatory functions for COBH).

IV - COBH owners who might want to sell

1) First of all, COBH’s largest owner is CBH itself which is hungry for capital as it continues its very rapid expansion. It’s stake is ‘only’ worth $20M but that could build a lot of branches in its new Florida expansion and the tax gain could be offset the next time CBH takes a security portfolio restructuring charge (likely if the yield curve becomes inverted).

2) COBH is 30% insider owned and many of those holders have big paper profits. Management does accept that several insiders are starting to think about exit strategies. Mr. Hill actually sold 25% of his stake in the last six months and is down to 2.3%. A Mr. Gibson has also been selling and is down 30% to 2.7%. If Mr. Hill and long-time holder, Gibson, are getting out this must start to create a bit of a prisoner’s dilemma for other +1% individual holders of the stock.

3) Wellington and FMA Advisory each own hefty positions of more than 8% of the stock. COBH has been a great performer in the past, but the valuation has climbed significantly and EPS is going the wrong way – if either of these investment firms decided to even trim their positions, we could see pressure on the share price.

V - Risks to COBH EPS

1) COBH is clearly sensitive to a flatter or inverted yield curve. Management told me that they would likely try to hold the line on non-interest expenses if the curve were to remain flat, but there is only so much that can be done if the Fed keeps raising overnight rates and the 10-year yield remains in its current range.

2) Asset quality is pristine with problem loans/loans under 25bps. COBH’s market area is one focused on light manufacturing where continued higher commodity and energy prices are likely to start to bite.

3) Separate from the problems of a flattening curve is pressure on deposit rates. COBH has a very healthy NIM of more than 4.00%. Management has admitted that pressure is starting to grow to increase deposit rates, especially on business and personal DDAs (checking accounts) which are currently paying 0.15%. A squeeze on the NIM as lagged deposit rates catch up could mean that estimates are too high.

VI - Target price

By the end of this year I expect we will have lived with several months of an inverted yield curve. This should lower current year EPS for COBH to the $1.25 level (estimates are $1.36 now) and ’07 estimates to $1.40 (from $1.50 currently). I doubt that CBH will see its P/E expand in such an environment as it is also sensitive to an inverted curve. As CBH will be showing much better EPS growth than COBH, I expect that COBH’s P/E will fall to that of CBH’s forward multiple of 15X by the end of this year. Thus, $1.40 x 15X = $21 which would represent a 30% return on a short position on the stock.

Catalyst

1) Loss of P/E premium as EPS growth sputters out, 2) inverted yield curve lowers earnings below consensus, 3) potential for large insider sales.