Community Bank: Profits likely to increase next year; The stock looks overvalued (NYSE:CBU)

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Profit from Community Bank System, Inc. (NYSE: CBU) will most likely decline this year due to higher provisioning for expected loan losses. On the other hand, moderate loan growth thanks to healthy pipelines and investments in human resources will likely support the bottom line. Overall, I expect Community Bank System to post earnings of $3.35 per share for 2022, down 3.7% year-over-year. For 2023, I expect the company to report earnings of around $3.69 per share. The current market price is much higher than the target price for the coming year. Therefore, I am adopting a sell rating on Community Bank System.

Healthy pipelines, investments to drive moderate loan growth

Community Bank’s loan portfolio received a decent boost from the acquisition of Elmira Savings Bank in Q2 2022. The loan portfolio grew 9.7% in Q2 from 0.7 % more normal in Q1 2022. Loan growth in Q3 will likely be a bit better than Q1 as the commercial lending pipeline is at an all-time high as mentioned on the last conference call. Additionally, management is confident that loan growth will continue through investment in commercial and mortgage business talent.

Strong labor markets will also likely play a role in supporting loan growth. Community Bank System operates in several northeastern states, namely New York, Pennsylvania, Vermont, and Massachusetts. Three of these states (NY, PA, MA) have unemployment rates below the national average, but all four have phenomenal labor markets when viewed historically.

Chart
Unemployment rate in New York given by Y-Charts

Although mortgage rates have come down recently, they are still very high from a historical perspective. High interest rates are likely to hurt residential mortgage growth as people try to put off buying their homes until better times. Consumer mortgages represent 36% of total loans. However, even in past recessionary markets, Community Bank System has managed to grow its mortgage business by 3% to 4%, as mentioned on the conference call. Therefore, high interest rates will not eradicate loan growth, they will simply slow it down.

Chart
15 year mortgage rate given by Y-Charts

Overall, I expect the loan portfolio to grow by 1.5% in the second half of 2022, leading to loan growth of 12.1% for the full year. I expect the loan portfolio to grow at a somewhat higher rate next year compared to the second half of this year, closer to the historical average.

Meanwhile, deposits will likely rise in line with loans through the end of 2023. In contrast, tangible book value per share will likely suffer in the third quarter as rising interest rates drive down the value of equity securities. investment held on the books. Community Bank System had a large securities portfolio at the end of June 2022, which represented 36% of total assets. Tangible book value per share has already plunged to $14.69 per share at the end of June 2022 from $23.77 per share at the end of March 2022, as mentioned in the earnings release. The following table shows my balance sheet estimates.

EX18 FY19 FY20 FY21 FY22E FY23E
Financial situation
Net loans 6,232 6,841 7,355 7,324 8,211 8,544
Net loan growth 0.4% 9.8% 7.5% (0.4)% 12.1% 4.1%
Other productive assets 2,982 3,088 3,597 4,979 5,756 5,990
Deposits 8,322 8,995 11,225 12,911 13,559 14 109
Loans and sub-debts 414 345 371 330 317 330
Common equity 1,714 1,855 2,104 2,101 1,689 1,793
Book value per share ($) 33.1 35.5 39.4 38.6 31.1 33.0
Tangible BVPS ($) 18.9 20.7 23.6 22.7 14.2 16.1

Source: SEC Filings, Author’s Estimates

(In millions of dollars, unless otherwise indicated)

Mixes of assets and liabilities to limit margin expansion

The following factors will limit the sensitivity of net interest income to rate increases.

  1. Large balance of consumer mortgages. By nature, most residential mortgages carry fixed rates. Therefore, most of them will not reevaluate this year. Consumer mortgages accounted for around 35.7% of total loans at the end of June 2022.
  2. Large balance of non-maturity interest-bearing deposits. These deposits will be revalued shortly after each rate hike. Approximately 62% of the deposit portfolio consisted of interest-bearing deposits not matured at the end of June 2022.

On the other hand, the loan additions expected in the coming year will increase the average yield of the portfolio and, therefore, the margin. Indeed, management mentioned during the conference call that it had already issued loans in the second quarter at a rate higher than the average rate of the portfolio.

The results of management’s interest rate sensitivity analysis presented in the first quarter 10-Q filing showed that a 200 basis point increase in interest rates could increase net interest income of $5.35 million over 12 months. To put that number into perspective, $5.35 million is just 1.4% of net interest income for 2021.

Given these factors, I expect the margin to increase by eight basis points in the second half of 2022 and then remain stable in 2023.

Above-average provisioning likely for the second half of the year

Provisions for expected loan losses represented 150% of non-performing loans at the end of June 2022, as mentioned in the earnings press release. This provision/non-performing loan ratio is too low to be comfortable given the prospects of recession and rising interest rates. Accordingly, I expect provisioning to be slightly above normal in the second half of 2022 before returning to a normal level in 2023. I expect the net provisioning charge to be 0.21% of the total loans in 2022, and 0.14% of total loans in 2023. In comparison, the net provision charge averaged 0.16% of total loans from 2017 to 2019.

Profits are expected to fall 4% this year

Earnings will likely fall this year as higher provisioning undermines top line growth. However, profits will most likely increase next year on the back of moderate loan growth. Overall, I expect the company to report earnings of $3.35 per share for 2022 and $3.69 per share for 2023. The following table shows my income statement estimates.

EX18 FY19 FY20 FY21 FY22E FY23E
income statement
Net interest income 345 359 368 374 415 450
Allowance for loan losses 11 8 14 (9) 17 12
Non-interest income 224 231 228 246 259 253
Non-interest charges 345 372 377 388 427 440
Net income – Common Sh. 168 169 164 189 182 200
BPA – Diluted ($) 3.24 3.23 3.08 3.48 3.35 3.69

Source: SEC Filings, Author’s Estimates

(In millions of dollars, unless otherwise indicated)

Actual earnings may differ materially from estimates due to the risks and uncertainties associated with inflation and, therefore, the timing and magnitude of interest rate increases. Also, a deeper or longer than expected recession may increase expected loan loss provisioning beyond my projection. The new Omicron sub-variant should also be watched.

CBU seems overrated

Community Bank has increased its dividend in the third quarter of every year since 2011 (the annual upward trend dates back 30 years, but the increase was not expected for the third quarter until 2011). If the company increases its dividend from $0.01 per share to $0.45 per share in the third quarter of 2023, the implied payout rate will be 48% next year, which is the five-year average. Therefore, the company can easily continue its dividend tradition next year. Based on the current market price and implied dividend, Community Bank offers a forward dividend yield of 2.6%.

I use historical price/book tangible (“P/TB”) and price/earnings (“P/E”) multiples to evaluate the community banking system. The stock has traded at an average P/TB ratio of 3.01x in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
T. Book value per share ($) 18.9 20.7 23.6 22.7
Average market price ($) 59.3 64.0 60.6 73.8
Historical P/TB 3.13x 3.09x 2.57x 3.25x 3.01x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/TB multiple by the expected tangible book value per share of $14.2 yields a target price of $42.7 for the end of 2022. This price target implies a decline of 36.6% compared to the closing price on July 29. The following table shows the sensitivity of the target price to the P/TB ratio.

Multiple P/TB 2.81x 2.91x 3.01x 3.11x 3.21x
TBVPS – Dec 2022 ($) 14.2 14.2 14.2 14.2 14.2
Target price ($) 39.9 41.3 42.7 44.1 45.5
Market price ($) 67.3 67.3 67.3 67.3 67.3
Up/(down) (40.8)% (38.7)% (36.6)% (34.5)% (32.4)%
Source: Author’s estimates

The stock has traded at an average P/E ratio of around 19.7x in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
Earnings per share ($) 3.2 3.2 3.1 3.5
Average market price ($) 59.3 64.0 60.6 73.8
Historical PER 18.3x 19.8x 19.7x 21.2x 19.7x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/E multiple by the expected earnings per share of $3.35 yields a price target of $66.1 for the end of 2022. This price target implies a decline of 1.8% from at the closing price on July 29. The following table shows the sensitivity of the target price to the P/E ratio.

Multiple P/E 17.7x 18.7x 19.7x 20.7x 21.7x
EPS – 2022 ($) 3.35 3.35 3.35 3.35 3.35
Target price ($) 59.4 62.8 66.1 69.5 72.8
Market price ($) 67.3 67.3 67.3 67.3 67.3
Up/(down) (11.7)% (6.8)% (1.8)% 3.2% 8.2%
Source: Author’s estimates

Equal weighting of target prices from both valuation methods gives a combined result target price of $54.4, implying a 19.2% drop from the current market price. Adding the forward dividend yield gives an expected total return of minus 16.6%. Therefore, I am adopting a sell rating on Community Bank System.

About Barbara J. Ross

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