Alvin M. Keeling 
Comedy (NYSE: CMA) is one of the best bets on rising interest rates in the banking industry due to its rate-sensitive balance sheet.
Company overview
Comerica is a holding company providing several financial services, primarily to customers in the United States. It operates mainly in Texas, California and Michigan, which account for around 80% of its loans and deposits, although it also has a presence in other states.
Its total assets stood at around $88 billion at the end of 2020, thus being a relatively small bank within the US banking system. It is listed on the New York Stock Exchange and currently has a market capitalization of around $10 billion.
Comerica has approximately 460 bank branches and operates in three main segments, namely merchant banking, retail banking and wealth management. However, around 90% of its loan portfolio is concentrated in the commercial banking space, while retail banking and private banking make up the rest. In the past, the bank had a relatively high exposure to the energy sector, which was clearly negative when the price of oil crashed in 2014, but Comerica has reduced its exposure to this industry and today the energy represents less than 4% of its overall budget. loan book.
Asset-liability composition
Over the past several years, Comerica’s business has experienced moderate growth during a period of positive economic growth. Indeed, Comerica’s loans have remained stable around $50 billion from 2016 to 2019, while in the past year they have increased to more than $52 billion (+3.8% YoY). annual).
This means that Comerica maintained its strong underwriting standards, despite a positive economic backdrop and did not push much loan growth, which should now be positive for its asset quality due to the impact of Covid. -19 on business customers. Comerica has historically had above-average credit quality as measured by its net write-offs ratio, which should bode well for credit quality in this period of economic downturn.
Source: Corica.
Over the past five years, deposits have grown at a faster rate than loans, especially over the past year. In 2020, deposits grew 27% year-on-year to $72.9 billion, resulting in a loan-to-deposit ratio of 72%. Note that a loan to deposit ratio below 100% is generally considered positive, so a ratio of 72% is quite conservative and shows that Comerica can become more aggressive in pursuing loan growth in the future.
The bank has used higher deposits to increase the size of its investment securities portfolio, which is good for its liquidity profile but has lower asset returns than loans to customers, hurting its turnover margin.
Source: Corica.
Beyond potential loan growth in coming years, a major source of earnings growth for the bank is rising interest rates. Comerica has a fairly unique asset-liability mix, being one of the banks most exposed to higher interest rates. Indeed, on the asset side, a large portion of its loans are floating rate loans (62% are Libor-based loans), which revalue periodically, while on the liability side, a large portion is consisting of non-interest bearing deposits.
As the following graph shows, Comerica is the bank with a higher share of non-interest bearing deposits, while it also has one of the lowest funding costs in interest bearing deposits, a very positive profile for its medium-term earnings capacity.
Source: Corica.
This asset-liability mix results in strong asset sensitivity to interest rates, while deposit betas are somewhat low. On the other hand, this also means that Comerica’s net interest margin (NIM), the difference between what the bank earns in interest minus what it pays relative to average loans, can be quite volatile.
Indeed, its MNI rose from 2.68% in 2016 to 3.58% in 2018, benefiting from higher interest rates, but collapsed to 2.55% in 2020. This has a major impact on the bank’s results, taking into account net interest income (NII), is responsible for approximately 69% of Comerica’s income. This means that Comerica is highly exposed to interest rates, both due to its asset-liability mix and the composition of its income which is largely dependent on the NII.
In this context, it is not surprising to see that the NII fell by 18% in 2020 compared to the previous year, ending a trend of positive growth from 2016 to 2019. The other important income line for the bank is that of commissions and fees received, which represent 29% of revenues, and were also weak last year (-2.9% year-on-year), while trading revenues are negligible for its turnover figure. ‘business.
Given this business profile, Comerica is clearly a bank more exposed to interest rates than its competitors. Therefore, Comerica is very well positioned to benefit from the economic recovery expected over the next few quarters with the deployment of the Covid-19 vaccine, both from loan growth and from the potential increase in interest rates in the coming quarters. next 2 to 3 years.
Recent income
Regarding its financial performance, Comerica was able to post good financial numbers during a period of rising interest rates, but that changed markedly in 2020 with the Fed lowering interest rates due to Covid-19.
As I mentioned earlier, Comerica’s revenue has been impacted by both lower margins and lower commissions over the past year, causing revenue to decline 14% year-on-year to $2.75 billion. of dollars. This is in line with its revenue generated in 2016, showing that Comerica’s revenue is highly exposed to interest rates.
On the cost side, Comerica has been able to maintain strong cost discipline as its operating expenses have declined at a compound annual growth rate (CAGR) of 1.9% over the past five years. This means that the bank’s efficiency improved significantly from 2016 to 2019, but deteriorated last year due to the sharp decline in revenue. Indeed, its efficiency ratio reached a low point (less is better) of 54.5% in 2019, but increased to 65% in 2020. This is still a good level within the banking sector, but revenue is expected to remain the main factor impacting the bank’s efficiency as cost reductions are expected to moderate going forward.
On credit quality, like most of its peers, its net charges increased markedly in the first two quarters of 2020, while in the second half of the year it returned to more normal levels. . Provisions for loan losses increased to $537 million from just $37 million in 2019. This is a negative for earnings, but if credit quality remains strong over the coming quarters, the bank can make reversals, which can be a tailwind for earnings growth in 2021/22.
Source: Corica.
Given the combination of lower revenues and much higher provisions, Comerica’s net income plummeted in 2020. Its net income was $474 million, down 60% year-on-year, and its return on equity (ROE) ratio was 6.1% (compared to 16.1% in 2019). This ROE is quite close to the level recorded in 2016, showing that the improvement in profitability achieved in recent years has been completely wiped out.
Going forward, according to analysts’ estimates, Comerica’s revenue is unlikely to recover much over the next two years, while its net income is expected to increase significantly due to lower provisions. I think there are advantages to the current consensus as the economy recovers in 2021/22 and interest rates could start to rise sooner than the market currently expects. Loan growth may also play a role in earnings recovery over the next two years, but the potential impact is clearly more limited than interest rates.
return on capital
Regarding its capitalization, Comerica is in a good position given that its Core Equity Tier 1 (CET1) ratio was 10.35% at the end of 2020, well above the capital requirement ratio of the regulator of 7% and its own target of 10%. This means that Comerica has a buffer of more than 300 basis points (bps) for its capital requirements, which leaves plenty of room to support both business growth and capital returns for shareholders. .
Source: Corica.
The bank had a good track record of capital returns, both from dividends and share buybacks, but that changed in 2020 due to Covid-19. Comerica maintained its dividend payments, but suspended share buybacks. It intends to resume share buybacks when economic conditions become more predictable in the coming quarters.
Regarding dividends, Comerica has a good history with a growing dividend over the past few years, while more recently its dividend has remained stable. Its current dividend is $0.68 per quarter, or $2.72 per year, virtually unchanged over the past two years. At its current share price, it offers an attractive dividend yield of around 3.80%, above the average of its peers (at around 2.80%).
However, due to lower earnings, its dividend payout ratio based on 2020 earnings is 84%, which is a high level. This is justified by the sharp decline in the bank’s profits and for the dividend to be sustainable, the bank clearly needs a recovery in its results. Therefore, while I don’t expect a drop in dividends in the near term, I don’t believe Comerica’s investment case is earnings-based at this time given that the uncertainty related to Covid- 19 is still high.
Conclusion
Comerica has good fundamentals and is clearly a heavily interest rate focused bank, which can be a double edged sword. Assuming economic activity continues to recover over the next few quarters, earnings revisions should be positive and the outlook for higher interest rates over the medium term should be a key driver of Comerica’s outperformance within the banking sector.
The bank is currently trading at 14x earnings and 1.3x book value, which seems fair right now, so there’s no rush to buy its shares, but it’s definitely a bank to own when the market is beginning to expect Fed rate hikes which may occur in the second half of the year.
