Mercantile: Vaulting Higher?
With its strong balance sheet, focus on commercial banking, and a track record of strong revenue and earning per share growth, we believe Baltimore-based Mercantile Bankshares (MRBK; recent price, $34) is a well-run company. That, along with our outlook for continued substantial growth in commercial loans and strong loan-portfolio credit quality, leads us to think Mercantile is poised to outperform its peers.
Right now, Mercantile's stock is trading in line with its mid-cap regional banking peers (on a price-earnings basis based on 2007 estimates), a level that we think leaves ample room for its p-e ratio to expand. In our view, Mercantile's fundamentals warrant a 24% premium to the current peer p-e level. The expansion we see stems from both our expectation for increasing regional banking stock prices and our view of Mercantile's superior earnings growth potential. We project a five-year earnings growth rate of about 12% for the company, which is higher than what we anticipate for the peer group.
After reaching an all-time high of just over $40 on Dec. 1, 2005, the stock has traded down in the last few months along with declines in the S&P 500 Regional Banks index and the broader market. We believe the recent sell-off provides a compelling buying opportunity for investors, and have a 5 STARS (strong buy) recommendation on Mercantile.
Mercantile owns 11 banks and a mortgage banking company. The company's banks are located in Maryland, Virginia, and Delaware, and operate through a total of 240 offices. The company has two reportable business segments: Banking, and Investment & Wealth Management. The largest bank, Mercantile-Safe Deposit and Trust Co., (MSD&T), provides nearly all of Mercantile's wealth-management operations and specialized corporate banking services.
The Banking segment, which generates about 86% of total revenues, is comprised of retail, small-business, commercial, and mortgage banking and offers standard banking products. As the company's products involve credit risk, Mercantile aims to control this risk by restricting its participation in multibank credits—i.e., syndicated loans—where it is not the managing or agent bank, and by setting an internal limit for each affiliate bank on the maximum amount of credit that may be extended to a single borrower to well below the regulatory limit.
The Investment & Wealth Management segment, which generates about 12% of revenues, provides an array of proprietary investment products and carefully selected outside managers in a range of asset classes, including equity, fixed-income, and alternative investment products, through investment vehicles including separate accounts and mutual funds. These services are delivered through branch facilities. As of Dec. 31, 2005, Mercantile had $20.6 billion of discretionary assets under management and $46.5 billion in assets under administration.
In 2004, Mercantile reorganized its 11 affiliate banks into four remaining banks, which featured a more prominent Mercantile identity. One reason for the reorganization was to enhance the company's ability to expand in the Washington, D.C., and Northern Virginia markets.
In March, 2006, Mercantile announced an agreement to purchase James Monroe Bancorp for $142.9 million. The deal has received all necessary approvals and was expected to close on July 17; James Monroe will be merged into MSD&T. In May, 2005, Mercantile completed the acquisition of Community Bank of Northern Virginia, which operated 14 branches, for $82.9 million in cash and 3.7 million common shares; Community Bank was merged into MSD&T.
Mercantile has been actively acquiring smaller banks as it seeks to expand in the fast-growing Washington, D.C., metropolitan area. We believe the company will close its pending acquisition of James Monroe before it releases second-quarter earnings, which are expected on July 25. This will add six branches to Mercantile's existing 35 Virginia branches, and the company expects the acquisition to add to its earnings immediately.
In the future, we expect Mercantile to pursue expansion through bank acquisitions in Northern Virginia and Washington, D.C., and pursue acquisition opportunities in Maryland that will enhance its current operations or help better serve commercial clients. We think the company's acquisition strategy is sound.
We also believe that Mercantile could be attractive to any banks that would like to expand in or into the mid-Atlantic market. According to Highline Data, a provider of bank industry data, the company ranked second in terms of total deposits in Maryland as of June 30, 2005, seventh in Virginia (sixth assuming the completion of the James Monroe acquisition), and eleventh in Delaware; it also has a small presence in D.C. and Pennsylvania. In addition to what we see as the company's attractive service territory, it has a commercial focus, a quality that we view as a positive in the current market.
The company's loan portfolio is weighted more heavily toward commercial lending than consumer lending, an attribute that we find attractive. Commercial, leasing, and commercial real estate loans comprised 56.2% of the company's loan portfolio as of Mar. 31, 2006, and construction loans account for 14.9%.
According to the Federal Reserve, commercial loans grew 10.4% nationally on average during 2005 and 13.1% in the first half of 2006. We think that commercial loan growth will continue through the rest of 2006 and into 2007, which should help Mercantile to continue growing its loan portfolio. The company's five-year cumulative average growth rate for its daily average loans is 12.3%.
Mercantile's balance sheet is also weighted more heavily toward loans than toward securities. Loans (yielding 6.87%) made up about 70% of the company's assets as of Mar. 31, 2006, while securities (yielding 4.05%) accounted for about 20%. Additionally, Mercantile's loan-to-deposit ratio of over 90% indicates that it is putting a large amount of its deposits to work in higher-yielding assets.
Mercantile's interest rate spread (the yield spread between interest-earning assets and interest-bearing liabilities) has been narrowing slightly in recent quarters, as growth in certificates of deposit has outpaced growth in lower-yielding interest accounts during that time period. Net interest margin was up slightly in 2005, to 4.44%, from 4.34% in 2004, but declined in the first quarter to 4.36%. We expect the net interest margin to fall only slightly in 2006, to 4.42%, despite the current mild inversion of the yield curve.
Credit quality of Mercantile's loan portfolio remains extremely strong, with loan loss reserves at six times nonperforming assets, loan loss reserves to total loans of 1.21%, and nonperforming loans to gross loans of 0.20% as of Mar. 31, 2006. In 2005, net charge-offs declined to near-zero levels and the company reported a net recovery in the first quarter of 2006. Loan-loss provisions were also minimal in 2005. We expect charge-offs and provisions to remain very low through the end of 2007.
The company's expense measures are also strong, with an efficiency ratio—a measure that compares operating expenses with total revenues—of 47.7% in 2005, which improved from 49% in 2004 and 49.6% in 2003. We believe that Mercantile's efficiency ratio will improve to 46.5% in 2006 and 46% in 2007. The company's efficient operations stem from disciplined spending, with the goal of limiting spending to projects that either enhance revenues or reduce expenses.
We expect that regional banks, including Mercantile, will report reasonable earnings growth in the second quarter, which we think will provide a boost to relatively depressed current valuations. We expect the exception to be banks that have already warned of slower-than-expected earnings growth.
Using our dividend discount model and our relative valuation analysis, we arrive at our target price of $43 for Mercantile's shares, which is 25% above the current market price and implies a target price-to-earnings multiple of about 15.7 times our 2007 EPS estimate. Our dividend discount model assumes a discount rate of 8.4%, and a terminal growth rate of 4.0%. We note the company has traded in a forward p-e range of 11-18 times since 2002.
SUPERIOR TO PEERS.
Mercantile's stock recently traded at 12.6 times our 2007 EPS estimate, in line with other mid-cap regional banking stocks. However, in our view, the stock should trade at a substantial premium to its peers. Our 12-month target price indicates that we think the shares should trade at roughly a 24% premium to the current 2007 peer p-e ratio, which we believe is reasonable given the currently depressed valuations in regional banking stocks, the company's superior fundamentals, its strong loan-portfolio quality, and our forecast for higher EPS growth than peers.
Overall, we have a favorable view of Mercantile's corporate governance practices. Aspects we view favorably include the presence of a majority of outsiders on the board, the ability to amend the charter or bylaws with a simple majority vote by shareholders, the ability to approve a merger with a simple majority vote by shareholders, partial equity compensation to directors, and an audit committee that is composed of independent directors. Items that we view negatively include the absence of cumulative voting rights for shareholders in director elections, the presence of a poison pill, and the absence of disclosure regarding stock-ownership guidelines for executives and outside directors.
Risks to our recommendation and target price include the possibility of a more steeply inverted yield curve than currently exists, a slowdown in the regional economy that results in a combined slowdown in both commercial and residential loan demand, a degradation of the company's loan-portfolio credit quality, and the possibility the company's operational performance may not match our expectations.