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When I last wrote about Comerica (NYSE:CMA), I commented on the somewhat unusual position I was in recommending a bank I didn’t like all that much mostly on the basis of what I thought was an overly discounted valuation. Since then, though, the chaos in the banking sector and the ongoing pressure on funding costs has weighed heavily on the shares, driving meaningful underperformance versus peers of around 10%.
While I do still believe that Comerica shares are undervalued, I don’t think the asset sensitivity of the bank’s business model (even with hedging activities in place) suits the current market, nor does the bank’s heavy reliance on commercial lending in a slowing economy. Moreover, I still see a longer-term risk to Comerica’s competitive positioning, as it is in many ways an oversized “vanilla” bank that is arguably under-scaled to compete with larger banks moving into its territories.
A Beat That Wasn’t Really A Beat
Although Comerica did report better-than-expected earnings on a core reported basis, the beat was largely driven by lower-quality items that are unlikely to continue into future quarters. Moreover, management’s guidance for weaker revenue and higher expenses underlines the ongoing challenges for this bank in an environment of still-rising deposit cost, flagging loan demand, and weakening credit.
Revenue rose more than 11% year over year but shrank close to 7% quarter over quarter, beating expectations by close to 2% or around $0.08/share.
Net interest income rose 11% yoy and fell 12% qoq, missing slightly (about $0.01/share). The miss was driven by a weaker net interest margin, a very common occurrence this quarter, with NIM up 23bp yoy but down 64bp qoq to 2.93% on much higher deposit costs. Earning asset growth was healthy, up almost 1% yoy and 6% qoq.
Non-interest income rose 13% yoy and more than 7% qoq, beating by $0.09, but the majority of the beat was driven by $11M in FHLB stock dividends and a valuation reserve for available-for-sale securities. Core fee-based income drivers like card fees, fiduciary income, and capital markets income were up modestly on a sequential basis.
Operating expenses rose 11% yoy and fell 3% qoq, but came in a bit ahead of expectations and took about $0.03/share out of earnings relative to expectations. Pre-provision profits rose 12% yoy and fell 11% qoq, beating by $0.05 as reported, but missing by about $0.01 excluding those aforementioned items that boosted non-interest income.
Likewise, lower provisioning expense boosted reported per-share earnings by close to $0.05/share relative to sell-side expectations. While Comerica’s credit quality has remained good and is arguably an underappreciated positive side to the investment thesis, the reality is that the market is likely to be suspicious of provisioning beats at this point in the cycle.
Healthy Loan Growth, But Funding Costs Are Biting Into Profits
Comerica is much more heavily weighted towards commercial lending compared to many of its peers, with far more C&I lending (over 60% as reported) than comparables like Citizens (CFG), Huntington (HBAN), M&T Bank (MTB), PNC (PNC), Synovus (SNV), U.S. Bancorp (USB) whose C&I lending is generally in the range of 35% to 40% of loans.
Comerica likewise has substantial commercial real estate lending exposure (over 30%), though not much office lending. Office CRE lending is only a little more than 1% of total loans for Comerica, which is considerably less than the likes of PNC, M&T, or Regions (RF).
While there’s ample evidence of businesses pulling back on capex/expansion spending and no longer needing to fund working capital builds, Comerica’s middle-market lending focus and presence in growth markets like Texas is still helping the business – overall lending growth (loans up almost 4% qoq) was stronger than the industry, and the nearly 4% growth in C&I lending was well above the average for the sector.
Lending is healthy and loan yields continue to improve (up 29bp qoq), but Comerica is continuing to see real challenges in its funding. Deposit balances declined 5% qoq on an average balance basis, and while total deposits were higher than expected, the mix was less advantageous than expected, with a significant increase in higher-cost time deposits and a bigger decline in non-interest-bearing deposits. Average NIB deposits declined 29% yoy and 16%, meaningfully worse than the sector averages so far in this reporting cycle.
Not surprisingly, then, deposit costs are shooting up and impacting margins. Total deposit costs rose 55bp qoq (to 1.25%) and interest-bearing deposit costs rose 89bp to 2.38%, both of which were worse (higher increases) than other large banks have reported so far (averages of +45bp and +54bp, respectively). Still, Comerica’s skew to non-interest-bearing deposit mix (47% of total deposits) is still well ahead of its peers, though the rate of erosion is a concern.
The Outlook
Weaker guidance for the remainder of 2023 is becoming more common among reporting banks, and Comerica joined that group. Net interest income growth is now looking pretty feeble (up 1% to 2% versus prior expectations for mid-single-digit growth) as higher deposit costs continue to pressure spreads, and management raised opex growth guidance from 7% to 9%, leading to weaker operating leverage and earnings expectations.
Deposit cost pressure should ease up some from here, but weaker loan demand and the potential for worse credit costs are both still potential headwinds. As is evident in management’s guidance revisions, while hedging activities have helped to mitigate some of the bank’s asset sensitivity, it hasn’t altered what is still a fundamentally rate-sensitive and macro-sensitive business model. I’m now expecting a double-digit decline in core earnings for Comerica in 2023 with another decline in 2024 on lower NIM and weak operating leverage prospects.
Although the near-term earnings outlook isn’t particularly good, expectations are low. Low-to-mid single-digit long-term core earnings growth should support a fair value in the $60’s today, and I likewise get a similar result based on ROTCE-driven P/TBV and P/E using lowered ROTCE and P/E multiple assumptions. The biggest downside risk I see is greater share erosion to large rivals moving into Comerica’s key markets, and I think the market would like to see a more dynamic plan from management regarding growth initiatives.
The Bottom Line
While I do think that Comerica is undervalued today, that’s true of most banks and I think there are other banks with more interesting stories or better leverage to the likely macro conditions over the next 6–12 months. To that end, I just don’t see enough undervaluation in Comerica shares to outweigh my longer-term strategic concerns and I don’t think counting on a sector rerating is a great idea until there’s more clarity on new regulations and the end of Fed tightening.
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