Cadence Bank: Better Growth, But Could Get Harder From Here (NYSE:CADE)

The early returns from the merger that created the new Cadence Bank (NYSE:CADE) have been mixed – while the bank is performing well operationally, the stock has been lagging the regional banking group and has seen a sharper sell-off over the last week or two. With that, the stock is down more than 20% since my last update, basically doubling the declines of the regional bank group.

While I can understand investor nervousness on the sector to a point, particularly as funding costs start to accelerate and the macro outlook for 2023 starts to deteriorate, but I think the reaction is overdone in this case. With a strong Net Promoter Score (a reflection of customer satisfaction), an attractive geographic footprint leveraged to many growing metro areas, and better-than-average funding and fee-generating bases, I do believe Cadence should be valued more highly than it is today.

Funding Concerns Getting More Attention Now

Due in part to how non-interest-bearing deposits surged during the pandemic, my expectation for this next phase of the banking cycle has always been that deposit betas would come in higher than expected (I’ve written about this in multiple pieces in 2022) once rates really started moving. That, in turn, would see banks dealing with more pressure on net interest margins than initially expected, and coupled with limited operating leverage, would have a negative effect on core income in 2023 and beyond.

That’s starting to show up in the numbers now. CD rates are now approaching 5% and the deposit beta for CDs is already above the high point of the last cycle – with at least one more Fed rate hike to come as of this writing.

While funding costs are a sector-wide concern, I’m relatively less worried about Cadence. Part of the appeal of the BancorpSouth-Cadence transaction was leveraging the former’s sticky, low-cost deposit base into more lucrative and rate-sensitive commercial lending, and that is what the bank has been doing.

Non-interest-bearing deposits did decline at Cadence in the third quarter, but the 1% sequential decline in average balances wasn’t all that bad compared to many peer institutions and at 35% of total deposits, Cadence is still in good shape with respect to core funding. This shows up in the bank’s funding costs, with a total cost of deposits of 35bp (up 18bp qoq) and a total cost of funding around 47bp that is still comfortably below average. Not surprisingly, then, the bank’s cumulative deposit beta also holds up well, with a cycle-to-date beta of around 9% against a peer average in the low-20%’s.

Management does expect funding costs to accelerate from here, with a target full-cycle beta of 28%. While I could see the actual beta exceeding management’s target, I do still believe that Cadence will see less pressure from funding costs than most other comparable banks.

Credit – Demand And Quality Will Be Watch Items From Here

Loan demand will be a big question heading into 2023, but the data so far has been generally positive. Evidence of slowing loan growth is starting to show up in the Fed’s H.8 data, but the trends are still positive. Through the end of November, loans across the U.S. banking system were up a bit more than 2% from the end of the third quarter, with C&I loans up closer to 3% (2.7%). Excluding the largest banks drops the growth rate a bit, but the overall sequential growth rate is still at 2%, though with a 1% decline in C&I loans and 2% growth in core CRE loans.

Cadence did about average in terms of loan growth in the third quarter (up 3.3% sequentially), with above-average C&I lending growth (up more than 3%) helping the cause. Expanded commercial lending growth opportunities was part of the appeal of the Cadence deal, and the bank is benefiting from core competencies in specialty areas like energy and restaurant lending.

The increased commercial lending activity is also helping the bank’s loan beta, as commercial lending is typically far more sensitive to rate moves. To that end, Cadence saw loan yields improve almost 60bp in the third quarter, an above average performance, and the 4.7% loan yield is likewise above average. With 70% of loans either variable rate or repricing over short time spans, Cadence still has good sensitivity here, and management is benefiting from above-average loan beta.

While some banks have talked about pulling back on lending activity, Cadence management explicitly denied doing so, though they did acknowledge “moderation” in the pipeline. Given a weakening macro environment (and worsening business confidence), I do see some risks to loan demand in 2023 as companies slow or delay expansion/growth plans. Likewise, I believe working capital has been an important driver of C&I loan demand (funding expanded inventories to offset supply chain risks) and given my expectation that inventories will start unwinding in 2023, this could pressure C&I loan demand.

At this point I don’t see much to worry about in Cadence’s credit quality, as the NPL and NPA ratios are both fine. There was an uptick in criticized loans, but it’s not at a level yet where I’d be all that concerned. I would expect higher provisioning from here, though, as I can’t imagine the credit situation getting any better at this point in the cycle.

The Outlook

While spread pressures are a threat to banks in 2023, Cadence offsets this with meaningful fee-generating businesses, including meaningful insurance and wealth management operations. I also like the company’s leverage to faster-growing markets in the Southeast and Southwest U.S., including Houston, Memphis, at Atlanta. In particular, I like the opportunity that Cadence has to leverage a low-cost deposit base centered in smaller, less-competitive communities to drive loan-growth in faster-growing MSAs, as well as the opportunity to selectively add lenders to grow in markets like Dallas, Kansas City, and Miami.

I do have lower expectations for the economy as a whole in 2023, and while I think the geographic footprint Cadence operates in will do better than most, I don’t think they’re immune to more challenging operating trends. Higher earnings in 2022 do help offset weaker earnings in terms of my discounted earnings model, and I’m still looking for long-term growth in the 6% to 7% range.

Multiples-based approaches don’t really credit Cadence for the company’s above-average long-term growth potential, and multiples in the sector are toward the lower end of the historical range. Even so, a 9x multiple on my ’23 EPS estimate can support a fair value of about $29. If and when sentiment gets back to more normalized valuation multiples, there would be upside here into the mid-$30’s.

The Bottom Line

I do see the recent sell-off in the shares as an opportunity. While a recent downgrade to “neutral” (on valuation) and an initiation at “neutral” don’t really help sentiment, I don’t see anything so fundamentally different in the story here to justify the magnitude of the recent underperformance. While Cadence does participate in very competitive markets and there are challenges here on spreads, margins, and growth over the next year or two, I think the risk/reward balance is attractive.