Top 10 Turnarounds for 2006, Part 2

The flat yield curve is the root of Commerce's earnings woes. Commerce is particularly vulnerable to a flat yield curve because of its combination of conservative lending policies and rapid deposit growth. It isn't an aggressive lender, so its rapid deposit growth is plowed into fixed-income securities. A flat yield curve squeezes profitability by squeezing the spread between the fixed-income yield and the rate Commerce pays on deposits.

But a simple syllogistic inference makes the case for Commerce here: Earnings per share at Commerce are depressed because of a flat yield curve. Historically, flat yield curves never last more than three or four quarters. Therefore, it is faulty, or misguided, to value Commerce going forward on the basis of a flat yield curve.

Calculating the normalized earnings power at Commerce isn't difficult. If the yield curve were to be normal for all of 2006, the earnings power of the company would be $2.75 per share, not the $2.05 per share expected by most analysts. Normalized earnings power is about $3.20 per share for 2007, based on a normal yield curve. Of course, the yield curve will not revert to a normal slope in the next month or two. But we will have a normal yield curve again in the not-too-distant future.

When the market recognizes this certainty, look for Commerce's quote to move quickly into the $50s. Expect a quote north of $60 per share sometime in 2007. Even these estimates may prove to be conservative, based on a price-to-earnings multiple of 18 with a normal yield curve. That's because you can't find a 20% annual grower that sells for a P/E of less than 20. Organic growth, as opposed to the riskier growth via acquisitions, is valued very highly by the market. You can't find a 20% organic grower like Commerce that sells for P/E lower than 25. Most sell for 30 to 45 times earnings. Whole Foods(WFMI Quote) and Starbucks(SBUX Quote) are a couple of examples.