Tickers in this Article: CBSH, BAC, USB, WFC
When a bank has significantly below-average funding costs and non-performing assets, and didn't have to take a dime of TARP money, it's a pretty good sign that management is doing something right. And to be sure, conservatively-run Commerce Bancshares (Nasdaq:CBSH) is a high-quality Midwestern bank with top-four deposit share in both Kansas and Missouri. That quality is not lost on the Street, and today's valuation doesn't leave a lot of value on the shelf for new investors.

Decent Q1 Results, But Definite Areas Of Pressure
On balance, Commerce's first quarter results were okay. Going forward, I would think investors and analysts could have some discomfort with the pressure on net interest margin (NIM) and the extent to which the bank is growing the balance sheet, but I don't see these as serious company-specific issues.

Operating revenue fell 1% from the year-ago level and 6% from the fourth quarter. Net interest income (about 60% of operating revenue) fell 5% and 7%, as the company saw serious net interest margin erosion. Although average earning assets increased 7% and 3%, NIM declined almost 40bp from last year (to 3.07%) and 28bp from the fourth quarter. NIM pressure is commonplace in banking today, but Commerce's pressure was magnified by lower TIPS income and the absence of special dividends on equity investments.

Fee income was mixed (up 6% and down 3%), as good trust fee growth was offset by sequentially weaker card fees and deposit charges. Expenses were largely on track, but the efficiency ratio worsened by about two and a half points, and pre-provision net revenue (akin to operating income) fell 8% and 10%.

Quality Improving, And The Balance Sheet Is Growing
Commerce's non-performing asset (NPA) ratio has been low for a while, distinguishing the company from rivals like Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), and even U.S. Bancorp (NYSE:USB). Additionally, credit quality continues to improve. The NPA ratio improved (declined) 35bp from last year to about 0.6%, while the net charge-off ratio declined 17bp to 0.32%.

Banks don't make money just sitting on their hands, and Commerce management did grow the balance sheet this quarter. Loans were up 8% and 2%, with strength in agriculture lending and commercial leasing, while the balance of investment securities increased by 9% and 4%. Deposits were also up strongly, up 9% and 4%, and I was surprised to see the growth in money-market and jumbo CD balances. Perhaps there was a timing issue at work here, as I don't see why the bank would be in any hurry to grow these higher-cost funding sources when the bank has ample capital.

SEE: Money Market

Turning back to the agriculture lending for a moment, it's true that the weather predictions for the Midwest are not looking good at this point (ongoing serious droughts). It's also true, though, that many of these loans are secured with collateral like farmland and crop insurance offers another layer of security.

Growth Plans Will Take Time To Bear Fruit
I happen to regard Commerce Bancshares as a smaller version of U.S. Bancorp in many respects. Both are conservatively run and both look to fund their loan book with deposits while also building large fee-based income streams. To that end, Commerce is a somewhat larger presence in wealth management and payments processing than its balance sheet size may suggest – and I expect growing these businesses will remain a priority. I also wouldn't be too surprised if Commerce looked to grow the insurance business. Crop insurance, for instance, has been a lucrative business for Wells Fargo, and it would seem to fit with Commerce's Midwestern presence and agriculture lending activities.

The Bottom Line
Nothing has really changed in my long-term valuation of Commerce Bancshares. I continue to believe that fair value lies in the high $30s, based both on a long-run return on equity of 14% and a price to tangible book multiple of 1.5x to 1.7x. With the shares already above $39, I don't see substantial undervaluation in these shares. While that does not mean that I expect these shares to decline, I believe there are more promising risk/reward opportunities for investors looking for exposure to banking.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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