M&T Bank Offers Rate And Operating Leverage, But Execution Is Crucial (NYSE:MTB)

Integrating a large merger is never easy for bank management teams, but M&T Bank (NYSE:MTB) has the added challenge of navigating a challenging funding environment and an uncertain economy while it tries to leverage the large People’s United transaction. Higher deposit costs bear watching, as does credit quality within the CRE portfolio, but M&T Bank does look poised for double-digit pre-provision profit growth across the next two years, and that’s not necessarily going to be easy to come by.

I have some concerns about employee and customer attrition, and my base-case outlook for banks has long been a worse macro and higher deposit betas than the Street and bank managers were expecting (at least as of early-to-mid 2022). Still, M&T Bank shares look fairly attractively-priced today.

A Core Beat When Many Have Missed

Among the group of banks that I would consider peers of M&T, fewer than half have posted pre-provision profit beats, so although M&T didn’t exactly blow the doors off this quarter, I’d call it a good result. Year-over-year comparisons are of more limited value here due to the inclusion of People’s in the results.

Revenue rose 6% sequentially, narrowly beating expectations (less than 1%), but representing about $0.045/share of upside to the sell-side estimate. Net interest income rose 9%, a slight miss, with net interest margin as expected (up 148bp yoy and 38bp qoq to 4.06%), while earning assets shrank a little more than 1%.

Non-interest income fell 3%, beating by more than $0.055/share, as mortgage banking (15% of non-interest income) slipped further (down 1%) and trust income (36% of non-interest income) rose more than 4%.

Operating leverage was the star of the quarter, as M&T achieved 6% revenue growth with basically no growth in adjusted expenses. Adjusted for merger-related expenses, the efficiency ratio was about 150bp better than expected and expenses added $0.125/share relative to expectations.

Pre-provision profits improved 12.5% qoq, a better-than-average result, though modestly above expectations (about 3% to 4%). Still, a $0.17/share beat at the pre-provision line isn’t bad, and M&T also posted a lower-than-expected provision expense, helping drive the $0.16 bottom-line core beat (higher taxes clawed back some of it).

M&T Has Ample Liquidity, But Deposit Costs Remain An Issue

M&T Bank saw a 30bp qoq increase in deposit costs – one of the better results among similarly-sized banks – and total deposit costs of 46bp remain comparatively good. Even so, interest-bearing deposit costs rose 75bp yoy and 51bp qoq (to 0.80%) and with further erosion in non-interest-bearing deposit balances (down 3.6% on average and 10% end-of-period), the cumulative deposit beta is now 36% versus management’s guidance to a peak in the high-30%’s to low-40%’s.

M&T has ample cash on the balance sheet ($25B with other banks) that it can use to invest in securities and/or offset deposit erosion, but managing the bank’s asset sensitivity and deposit costs is going to get more challenging. On a more positive note, while management had previously guided that 4%-plus NIMs were not sustainable, it looks like NIM could stay above 4% through 2023 and possibly through 2024, though Q4’22 is likely to be the peak for the cycle.

Loans grew 1.5% sequentially on an average-balance basis and 2.6% on an end-of-period basis, and M&T saw good growth in C&I lending (up more than 4%), with ongoing strength in dealer floorplan lending, while continuing to pull back on CRE lending (down more than 1%). Like many banks, M&T expressed caution about its office portfolio (about 4% of total loans), but management continues to see improvements in their hospitality portfolio, with less than half of the portfolio now criticized.

Overall credit quality remains good, with charge-offs at just 0.12% of loans (below peers). The non-performing asset ratio was basically stable, and I’d note that the bank has reserves equal to almost 1.5% of loans versus a Day 1 CECL level of around 1.3%.

The Outlook

My biggest concern about M&T Bank right now is one of the hardest to quantify – the impact of the merger on its relationships with customers and employees and what that will mean for profits and margins in the years to come. Management previously acknowledged some issues with the systems conversion, and there have been reports of customers having various issues with their accounts since the merger. Likewise, there were reports earlier in the year of significant employee unhappiness regarding workforce reduction plans.

It’s normal for banks to see attrition after a big merger – Pinnacle (PNFP) has literally built its business by picking off high-quality loan officers from banks undergoing M&A disruption, and it’s likewise not uncommon to see merged banks lose customer accounts (I’ve seen reports that the rate of attrition is three times higher for banks in the first 12 months after a merger) and see lower satisfaction scores. With M&T barely above the average bank Net Promoter Score (and People’s about in line with it), M&T could be vulnerable, and that’s particularly important at a time when sticky low-cost deposits are so valuable.

It’s hard to quantify dissatisfaction until you’re well past the events (Net Promoter Scores are lagging indicators), but I’d keep an eye on non-interest-bearing deposit outflows and commentary from banks in overlapping areas about picking up new customers at a higher pace.

Outside of that concern, there’s a lot I like about M&T. Net interest income should remain strong throughout 2023, and I expect management to deliver on operating leverage (something they’ve been reliable about in the past). All in all, I’m expecting around 10% to 11% pre-provision profit growth from 2022 to 2024, against a peer group average closer to 8% to 9%, so I do think M&T will stand out on growth.

Longer term, I’m expecting core organic earnings growth around 3.5%. For the next three years, my EPS estimates are about 1%-2% below the current sell-side average.

Between discounted core earnings, ROTCE-driven P/TBV, and P/E, I believe M&T shares are undervalued below $185; 10x my ’23 EPS estimate gets me to $178, while the other two valuation approaches give me higher fair values that lift up the range.

The Bottom Line

Concerns about whether the merger will ultimately disappoint in terms of revenue and cost synergies, to say nothing of alienating employees and customers, are not trivial. Still, the financials look to be in good shape and while I can’t call this my favorite name now, I do think it deserves serious consideration from investors looking to own bank stocks at a time when sentiment is still quite weak.