S&P says City National is one of the strongest midcap financial institutions it covers, and rates the shares a strong buy
From Standard & Poor's Equity ResearchAlthough the wealth management industry is dominated by Bank of America (BAC), Citigroup (C), Merrill Lynch (MER), Morgan Stanley (MS), and UBS (UBS), all of whom have over $400 billion in U.S. private client assets, our research indicates that the smaller wealth managers, those with about $20 billion in U.S. private client assets, are gaining market share, and we expect this trend to continue. Included in that group is this week's Focus Stock, City National (CNY; $68.15).
We consider City National to be one of the strongest mid-cap financial institutions we cover, based on historical, current, and expected trends in lending profits, credit quality, and wealth management growth. City National does not make subprime mortgage loans and does not hold subprime-oriented mortgage-backed or collateralized debt obligations in its securities portfolio. We think City National has an excellent credit risk profile, which we estimate will result in a lower future level of required loan loss provisions than most peers. We see this as a competitive advantage, as we expect credit headwinds to increase industrywide in 2007 and 2008.
Despite the turbulent market for financial stocks, we view City National as a "best in breed" financial institution, in terms of lending margins, a growing wealth management division, and corporate governance. Based on our price-earnings analysis, we believe that City National's valuation is compelling, and we have a 5-STARS (strong buy) recommendation on the shares.
City National is the holding company for City National Bank, which delivers banking, trust, and investment services through 62 offices in Southern California, the San Francisco Bay area, and New York City.
The company's banking operations consist of lending and deposit gathering as well as other banking-related products and services, including investment and trust services. The company's target market includes small to midsize businesses, entrepreneurs, professionals, and affluent individuals. Investment and trust services include investment management and advisory services, brokerage services, portfolio management, securities trading, asset management, personal and business trust and investment services, estate and financial planning, and custodial services.
City National's loan portfolio of nearly $11.2 billion as of Sept. 30 consists of 38% commercial loans, 17% commercial real estate, 28% residential mortgages, and 12% real estate construction, with the remaining 5% in home equity lines and installment loans. Lending growth in the most recent quarter was 6.2% on an annualized basis, and 12% for the 12-month period ended Sept. 30. The latter figure includes the Business Bank of Nevada acquisition, which closed in March of this year. We estimate that loan growth, excluding BBN, would have been 6% in the last 12 months, which is still an above-industry growth rate, in our view.
As of June 30, 2006, which is the latest available FDIC branch-level data, City National had 60 branches and $12.4 billion in deposits, including, on a pro forma basis, BBN. About 95% of deposits and 87% of branches were concentrated in California, according to Highline Data. In California, City National had 52 branches, $11.8 billion in deposits, and a deposit market share of about 1.4%, ranking tenth in deposit market share. In Nevada, if we count BBN as a unit of City National, it had seven branches, $400 million in deposits, and a deposit market share of about 0.3%, ranking 23rd. City National had one branch in New York.
City National has retained a significant amount of lower-cost core deposits, due to a high degree of loyalty from customers. This in turn has led to City National's ability to generate a net interest margin (NIM) significantly higher than its peers (4.58% in 2006 and 4.46% in the first nine months of 2007). City National has had the lowest borrowing costs of the regional banks we cover: by our calculation, an annualized rate of about 1.91% on total deposits of $12.2 billion, due to the 45.5% of deposits as of Sept. 30 that were non-interest-bearing. The industry median is about 18% non-interest deposits, as a percent of total deposits, by our estimation.
In 2006, non-interest income accounted for nearly 29% of City National's revenues, a figure we expect to increase to 33.5% in 2007 and 35.7% in 2008. Trust and investment fee revenues and brokerage and mutual fund fees rose strongly in 2006, and City National expects growth to continue, particularly from the wealth management unit.
City National has consistently maintained the highest levels of credit quality we have seen in our coverage. Nonperforming loans totaled 0.23% of total loans at Sept. 30, up from 0.2% in June and 0.19% a year earlier. This rate of increase was lower than most peers. In addition, the industry average as of June 30 was 0.9%, according to the FDIC, and we expect this to surpass 1% at Sept. 30 when data are released, and to be in line with historical levels.
City National has taken only one loan loss provision in the past three years, due to the high credit quality of its loan portfolio and because its reserve for future loan losses, as of Sept. 30, was 1.36% of total loans, nearly six times the level of nonperforming loans. City National is a conservative lender, in our view, and avoids exotic mortgage lending. While loan loss provisioning may be required in 2008, owing to industrywide declines in credit quality, we estimate that City National can take up to a $3.8 million loan loss provision in 2008, and still earn $5.10 per share that year.
Company and Industry Outlook
We expect net income to rise 1% in 2007 and 4.4% in 2008. Assuming the repurchase of 919,800 shares, as authorized, in the next four quarters, we see EPS advancing 2.6% in 2007, to $4.78, from $4.66 in 2006. Our 2008 EPS estimate is $5.10, a 6.7% increase.
City National's NIM reached 5.3% in 2002 and narrowed to 4.54% in 2004. Because of City National's ability to attract and retain low-cost deposits, the NIM expanded to 4.79% in 2005, despite a flattening yield curve, and contracted to 4.58% in 2006. For 2007 and 2008, we expect some withdrawals of lower-cost deposits. As a result, we project the NIM to decrease to 4.41% for the full year 2007 and to 4.29% for 2008, both of which are still above our expectations for peers. We expect net interest income to rise 0.1% in 2007 and 3% in 2008.
We think City National is slightly asset sensitive, meaning its loans reprice more quickly than its deposits. In a falling interest rate environment, assuming additional rate cuts may be coming from the Federal Reserve, we therefore expect net interest margins to compress 10 to 15 basis points in the three months after a rate cut, but expand by this same amount in the following quarter, as deposits reprice. However, in the company's latest Form 10-Q, for the period ended June 30, it indicated it has been moving to a more neutral position. In addition, City National uses on- and off-balance-sheet hedging vehicles to manage interest rate risk.
We estimate City National's fee income will total $305 million in 2007, up nearly 26% from 2006 levels, including acquisitions, and will account for 33.5% of revenues. In 2008, we expect fee income to rise 13.8% and to account for 35.7% of total revenues. We expect fee income to contribute to total revenue growth of 7.4% in 2007 and 6.7% in 2008.
Non-interest expense as a percent of total revenues (a measure commonly referred to as a bank's efficiency ratio) increased between 2002 and 2004, but declined in 2005. The 2006 efficiency ratio of 56.1% was higher due to the acquisition of Independence Investment in June, 2006. We project an efficiency ratio of 57.9% in 2007 and 58.5% in 2008, due mainly to increases in compensation and incentive pay in the wealth management business. We are not concerned about these projected increases in non-interest income, as we have seen in the financial-services industry that the percentage of fee income as a percentage of total revenues is often related to the efficiency ratio. We think that City National's relationship of efficiency ratio vs. percent of revenues derived from fee income is in line with industry averages.
EPS growth has averaged 7.7% during the past three years, and we see growth of about 7% annually over the next three years as net interest margin pressure continues in the near term but is offset by future projected growth of fee income.
City National recently traded at $68.15 per share, which is about 13.4 times our 2008 EPS estimate of $5.10, and this multiple is about equal with other regional banks of City National's size. We think, however, that City National should have a higher multiple to reflect the contribution to revenues from wealth management, the high lending margins, and the bank's excellent credit quality. Our target price of $78 is based on a 15.3 multiple on our 2008 EPS estimate. This premium multiple incorporates the higher valuations that asset managers often have, which are generally in the high teens, and it also reflects City National's relatively higher level of profitability.
In our view, City National rates high on a number of corporate governance measures relative to other banks that we follow. For instance, City National does not have a poison pill anti-takeover defense, and it does not have a dual-class capital structure. In addition, the CEO is not involved in related-party transactions, the compensation committee consists entirely of outside directors, and the board is controlled by a majority of outside directors. Furthermore, all directors with more than one year of service own stock, all stock-based incentive plans have been approved by the shareholders, and the company's option plans appear reasonable in terms of size of grants and performance goals. There are a few negatives: a classified board; the board is authorized to increase or decrease the size of the board without shareholder approval; one or more related-party transactions involving a board member; and the authorization of blank-check preferred stock.
The primary risk to our recommendation and target price is the possibility of an economic downturn, which increases the level of nonperforming assets and leads to a decline in the growth rate of the loan portfolio. Since City National has not taken any loan loss reserves in several quarters, a decline in credit quality may force it to start adding to the reserves. Additional risks are competition from larger, global asset and wealth managers; another credit crunch; increases in non-interest expenses; and a decline in lending yields stemming from possible future Federal Reserve interest rate cuts.