Comerica could put the pieces together for better long-term returns
Short-term success in investing often depends on an investor’s ability to read and predict sentiment, but longer-term success usually depends on understanding companies and their sectors, and identifying which companies have the courage to move forward up over time. I mention this as open to discussion about it Comerica (NYSE:CMA) because I think there may be changes underway in this bank’s operating philosophy that could result in better, more consistent performance and a sustained higher multiple for the shares over time.
Since my last update, in which I thought the stock’s performance prospects were good, but not great, the stock is down about 12% — pretty average overall performance. At this point, however, I’m more interested in the stocks. There are many banks trading too cheaply before I expect them to post strong profits in fiscal 2023, but if Comerica can actually make some positive adjustments to its operating strategy, I think there’s a better case for long-term ownership.
With an unusually large base of sticky, free deposits (non-interest-bearing deposits) and a loan mix that tilts heavily toward adjustable-rate commercial loans, Comerica is often one of the most asset-sensitive banks in its peer group, and as interest rates rise (or fall), this bank has a proportionate impact experienced greater volatility in their net interest income (and hence profits and book value).
This volatility has been alternately a “feature” or a “fault” of the Comerica model for years, depending on your perspective, but even those investors who liked Comerica as a way to trade the interest rate cycle will likely appreciate that Comerica’s model is more volatile and gains harder to predict, which in turn has often resulted in lower multiples for the stocks.
Management seems to be changing that. Not only was the company relatively conservative about its prospects for Fed rate action earlier in the year, the company has also been actively (and proactively) reducing its interest-rate leverage ratio. Mainly through the use of fixed rate swaps, management has reduced the bank’s sensitivity to a 100 basis point interest rate movement from 12% at the beginning of the year to 3% at the end of the second quarter.
Asset sensitivity assumptions/models are never perfect and there are still risks here. Deposit betas could be higher than expected (although Comerica appeared more conservative than some banks here), and it’s also possible that the bank jumps in early and misses out on some upside if the Fed acts even more aggressively to contain inflation. But the bottom line is that the probability is increasing (at least in my opinion). cuts later in FY 23 and/or FY 24, I think Comerica is making a good decision to de-risk its net interest margin for the next several years.
A new industrial revolution for the US?
There’s been a lot of talk about shifting manufacturing to the US, and while I still don’t believe this move to shift manufacturing and supply chains will reach the more optimistic estimates, there’s definitely evidence that the move is real.
As a mostly mid-market C&I lender (just over half of its loans), this could be a boon to Comerica’s loan growth prospects over the next three years or more. Mid-market companies are more likely to turn to debt to fund investments (as opposed to large multinationals), and with Comerica’s influence in growing states like California and Texas, this could be a significant driver.
However, I will reiterate that this is not a risk-free opportunity. like banks pnc (PNC) have been aggressively trying to expand their own mid-market lending business, and Comerica is facing increasing competition from the largest banks (Bank of America (BAC) and JP Morgan (JPM)) to more equal sized banks (like PNC) to smaller banks like Commerce Bankshares (CBSH) and Zion (ZION) in the medium-sized credit sector. Comerica’s long tradition of focusing on “relationship banking” should make its lending relationships stickier, but I don’t want to portray this commercial lending growth opportunity as a risk-free situation.
Speaking of relationships…
Comerica has done a good job of reducing operating costs and improving operational leverage, and I think efficiency ratios can be maintained in the low-to-mid 50% going forward. The “but” is that cost cutting rarely translates into better consumer experiences, and it’s not uncommon for banks to report slower growth in the wake of cost restructuring.
Comerica’s management talks about relationship banking, but the reality is that the company’s Net Promoter Score (a measure of consumer satisfaction) isn’t great at just 22. Bank of America, Commerce and U.S. Bancorp (USB) are in the low to mid 30’s and PNC and JPMorgan are in the low 40’s while a few banks like Cullen Frost (CFR) and First Republic (FRC) are over 60, so Comerica still has work to do. I fully agree that NPS isn’t an all-encompassing method of measuring customer satisfaction, but listening to management’s comments over the last year (including earnings calls and conference presentations) it seems they agree that this is an important focus for the next few years. To that end, incremental cost reductions are reinvested back into the business from here, and I would expect the bank to invest in customer-centric features to improve the banking and lending experience.
If CMA can manage its interest rate risk more proactively, drive improved C&I loan growth with higher domestic capital spending, maintain an improved operating leverage profile, and increasing customer experience (which in turn should result in even better custody costs, cross-selling, etc.), I see an opportunity to generate better ROEs over time, generate higher revenue, and hold a better multiplier versus lagging norms.
I’m starting to incorporate some of these opportunities into my modeling prospects. Sure, there’s a risk that Comerica can’t/won’t execute here and that my earnings estimates are overestimated as a result, but ignoring these opportunities would also risk underestimating future profitability and potentially being overly pessimistic about the long-term potential of the business.
Over the long term, Comerica’s ROE averages around 9% to 11%, but I’ve seen it move into the mid-teens over time, especially as I think the bank will start generating excess capital that allocated to shareholder returns (although not immediately as the CET 1 ratio is still slightly below management’s target).
If my assumptions of a more stable NIM and improved profitability (higher ROE) and higher returns on capital hold true, Comerica should deliver long-term core earnings growth of around 3% to 4% with lower peak-to-trough volatility than it has in the past (it will definitely give somejust not that much).
The final result
Discounted core earnings and forward-looking ROTCE P/TBV support a fair value in the low $90s and a projected total annual return of just over 10%, making Comerica a bank worth considering (if not even the cheapest looking bank). . The AP/E based methodology is now more difficult as bank valuations are recovering from a recent low and 2023 is likely to be a short-term earnings spike (and therefore deserves a lower multiple). However, I’m now looking for $10.55 EPS in fiscal 2023 so investors can decide for themselves the “right” multiple.
All in all, I see opportunities for Comerica to become a more profitable and higher rated bank. Odds don’t guarantee execution, but there’s more here now than just the typical story of interest rate cycles of yesteryear.