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Short-term success in investing is often down to an investor’s ability to read and predict sentiment, but longer-term success is usually tied to understanding businesses and their sectors and figuring out which companies have the mettle to rise to the top over time. I mention this as an open to a discussion on Comerica (NYSE:CMA), because I think there may be changes underway in the operating philosophy of this bank that could lead to better, more consistent, performance over time and a sustainably higher multiple for the shares.
Since my last update, wherein I thought the performance prospects of the shares were good but not great, the stock has fallen about 12% – a fairly average performance on balance. At this point, though, I’m getting more interested in the shares. There are a lot of banks trading too cheaply ahead of what I expect will be strong earnings in FY’23, but if Comerica can in fact make some positive adjustments to its operating strategy, I think there’s a better case for long-term ownership.
Going Counter-Cyclical
With an uncommonly large base of sticky no-cost deposits (non-interest-bearing deposits) and a loan mix that skews heavily toward variable-rate commercial loans, Comerica is often one of the most asset-sensitive banks in its peer group, meaning that as rates rise (or fall), this bank sees a proportionately larger swing in its net interest income (and by extension, its profits and book value).
That volatility has alternately been a “feature” or a “bug” of Comerica’s model for years depending on your point of view, but even those investors who’ve liked Comerica as a way to trade the rate cycle will likely acknowledge that it makes Comerica’s earnings more volatile and harder to predict, which in turn has often led to lower multiples for the shares.
Management seems to be looking to change that. Not only was the company relatively conservative at the start of the year with respect to its outlook for Fed rate actions, the company has been actively (and proactively) managing its rate leverage lower. Largely through the use of fixed-rate swaps, management has reduced the bank’s sensitivity to a 100bp rate move from 12% at the start of the year to 3% exiting the second quarter.
Asset sensitivity assumptions/models are never perfect, and there are still risks here. Deposit betas could end up higher than expected (though Comerica has seemed more conservative here than some banks), and it’s likewise possible that the bank is locking in too soon and could miss some upside if the Fed acts even more aggressively to tamp down inflation. On balance, though, with an increasing likelihood (in my view, at least) of rate cuts later in FY’23 and/or in FY’24, I think Comerica is making a sound decision to de-risk its net interest margin over the next couple of years.
A New Industrial Revolution For The U.S.?
There has been a lot of talk of “reshoring” manufacturing to the U.S., and while I still don’t believe that this move to re-localize production and supply chains will reach the more bullish estimates, there’s definitely evidence that this move is real.
As a predominantly middle-market C&I lender (just over half of loans), this could be a boon to Comerica’s loan growth prospects over the next three years or more. Middle market companies are more likely to turn to loans to finance capex (versus large multinationals), and with Comerica’s leverage to growing states like California and Texas, this could be a meaningful driver.
I will note again, though, that this isn’t a risk-free opportunity. Banks like PNC (PNC) have been moving aggressively to expand their own middle market lending businesses, and Comerica is seeing increased competition from the largest banks (Bank of America (BAC) and JPMorgan (JPM)) to more peer-sized banks (like PNC) to smaller banks like Commerce Bancshares (CBSH) and Zions (ZION) in the middle-market lending space. Comerica’s long history of focusing on “relationship banking” should make its lending relationships stickier, but I don’t want to portray this commercial loan growth opportunity as a risk-free situation.
Speaking Of Relationships…
Comerica has done a good job of reducing operating expenses and improving operating leverage, and I think efficiency ratios can be maintained in the low-to-mid 50%’s going forward. The “but” is that expense cuts rarely lead to better consumer experiences, and it’s not uncommon for banks to report slower growth in the wake of expense restructurings.
Comerica management talks about relationship banking, but the reality is that the company’s Net Promoter Score (a measure of consume satisfaction) is not 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 rare few banks like Cullen Frost (CFR) and First Republic (FRC) are above 60, so Comerica has some work to do. I’ll fully admit that NPS is not an end-all be-all method of measuring customer satisfaction, but listening to management commentary over the last year or so (including earnings calls and conference presentations), it sounds as though they too believe this is an important area of focus for the next few years. To that end, incremental cost cuts from here are going to be reinvested in the business, and I would expect to see the bank make investments in customer-facing functionality designed to improve the banking and lending experiences.
If CMA can more proactively manage its rate exposure, drive improved C&I lending growth on increased domestic capex, maintain an improved operating leverage profile, and boost the customer experience (which, in turn, should drive even better deposit costs, cross-selling, and so on), I see an opportunity to drive better ROEs over time, generate higher earnings, and maintain a better multiple relative to trailing norms.
The Outlook
I’m starting to factor in some of these opportunities into my modeling outlook. Sure, there’s a risk that Comerica can’t/won’t execute here and that my earnings estimates end up too high as a result, but ignoring those opportunities would also risk understating future profitability and possibly being too bearish on the long-term potential of the business.
Over the long term, Comerica’s ROE has averaged around 9% to 11%, but I could see that moving to the mid-teens over time, particularly as I think the bank will start generating surplus capital that can be allocated to shareholder returns (though not right away, as the CET 1 ratio is still a bit below management’s target).
If my assumptions of more stable NIM and improved profitability (higher ROE) as well as greater capital returns work out, Comerica should generate long-term core earnings growth of around 3% to 4% with less peak-to-trough volatility than in the past (there will definitely be some, just not as much).
The Bottom Line
Discounted core earnings and forward-looking ROTCE-P/TBV support a fair value in the low $90’s and a prospective total annualized return of a bit over 10%, making Comerica a bank worth considering (though not the cheapest-looking bank). A P/E-based methodology is trickier now as bank valuations are rebounding from a recent trough and 2023 will likely be a short-term earnings peak (thus deserving a lower multiple). I’m looking for $10.55 in FY’23 EPS now, though, so investors can decide for themselves about the “right” multiple.
All in all, I see opportunities for Comerica to become a more profitable, more highly-valued bank. Opportunity doesn’t guarantee execution, but there is more here now than just the typical rate cycle story of years past.
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