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Commerce Bank

(CBH) - Get Report

, the fast-growing New Jersey bank with a maverick CEO and a cult following among investors, is spending unheard-of sums as it expands its branch network. But it is these outsized capital expenditures that are now coming under scrutiny as analysts and investors inspect the go-go bank's growth model.

Skeptics wonder whether the giant capex numbers are evidence that Commerce is keeping expenses off its income statement by classifying them as capital expenditures and thus placing them on its balance sheet. Commerce's investor relations executive, Ed Jordan, vehemently denies this charge. Though he didn't break down in detail where capex was being deployed, he said such an exercise would take place at an investor meeting in New York scheduled for April 29.

The Cherry Hill, N.J.-based bank, built and led by Vernon Hill, has wowed investors for years with its ability to open branches and provide services that cause customers to leave sleepy, unfriendly rivals in droves. Earnings at Commerce are romping higher, jumping 35% in 2002, and Wall Street thinks Hill to be revolutionary in the world of retail banking. Though Commerce's stock is down 21% from its 52-week high, it trades at 20 times last year's earnings of $2.04 per share, a sky-high multiple for a bank. That premium may be justified if its earnings can continue to grow at more than 30% annually, but investors also note that Commerce's return on assets, a closely watched measure of bank profitability, was a meager 1.05% last year.

Nesting

There is no doubt Hill and his lieutenants deserve credit for upsetting the customer-unfriendly world of retail banking in Pennsylvania, New Jersey and New York. One reason for Commerce's success is its gaudy, well-placed branches. But these come at a price. Investors can track how much Commerce says it's spending on its branches and other buildings by looking at its cash-flow statement and balance sheet.

For example, Commerce said it spent $195 million on plant and premises in 2002, a year in which it opened 40 new branches. As a Legg Mason analyst pointed out Tuesday, that $195 million is $21 million more than

Fifth Third

(FITB) - Get Report

, a

bank with five times as many assets. Also, the 2002 capex works out at nearly $5 million per branch, an off-the-charts figure. Of course, the capital expenditures were also made on premises and equipment that had nothing to do with branches; factoring those costs in would bring the per-branch figure down.

Banks Are Open
Commerce Bank over a year

However, the difficulty of seeing where capex went exactly has given rise to the suspicions that Commerce is shielding its income statement from hefty costs by "capitalizing" them, or placing them on the balance sheet. Commerce's Jordan said the bank got so tired of this claim -- which he linked to analysts at Legg Mason and Keefe Bruyette & Woods -- that it included a special passage in the bank's 2002 annual report, released Monday, that read: "When capitalizing costs for branch construction, the Company includes the costs of purchasing the land, developing the site, constructing the building (or leasehold improvements if the property is leased), and furniture, fixtures and equipment necessary to equip the branch. All other pre-opening and post-opening costs related to branches are expensed as incurred." He added that CEO Hill would not have certified Commerce's financials in its annual report had they been misleading.

The Trouble With Prosperity

But because they are hard to reconcile with other banks' numbers, the capex figures do deserve a closer look. Jordan says a suburban branch costs $3.5 million to $4 million to build and equip, including land acquisition. Commerce is currently making a big push into New York City. Even though property is leased in New York rather than purchased, a branch in the city can still cost around the same as one in the suburbs to build and equip, Jordan says. That's because building improvements can be very expensive. But that is all part of giving customers "the aura of a great retail experience," Jordan says. He adds: "We're not afraid to spend."

Using Jordan's branch numbers would mean the 40 branches resulted in capex of $140 million to $160 million. That leaves $35 million to $55 million to account for. Jordan says money was also spent on training and administrative buildings, as well as systems. He declined to itemize the remainder.

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There is unease over these numbers because they are so much higher than those at other banks. For example, Melville, N.Y.-based

North Fork's

(NFB)

CFO, Dan Healy, says his bank, also entering the Manhattan market with glitzy branches, pays $1.5 million to $1.7 million to build and equip a branch, both in the city and in its suburbs. "We make every effort not to capitalize soft costs," he adds. North Fork opened 10 branches in 2002 and made a $39 million capex outlay. Healy says $17 million of that was for systems improvements, leaving $22 million for branches and other spending.

When asked about North Fork's per-branch spending, Jordan said Commerce spent more because it picked better-placed locations and probably spent more on fitting out each branch. "North Fork is doing a real good job in Manhattan, but they are best seen as the lost-cost provider," says Jordan. "We want to spend our way into prosperity while they want to save their way into prosperity."

Murder by Numbers

It's a useful exercise to apply lower -- perhaps more appropriate -- branch costs to Commerce and then see how they compare to the 2002 capex bill of $195 million. If we take our yardstick from North Fork and say the 11 Manhattan branches each cost $2 million, that accounts for $22 million of the capex. If half the new suburban branches were on purchased land and thus cost $4 million a piece, that would take care of another $60 million. If the remainder were leased and cost $2 million, that would explain another $28 million. Altogether, that makes $110 million, leaving $85 million for other purposes. If we conservatively assume that half of that went on other buildings and some systems, that's just over $40 million that, in this example at least, goes unexplained. After taxes, that's about 55 cents a share.

True, 2002-specific analyses can be misleading, given the high number of branches being built. But Commerce's capex has been higher than rivals for a while. Premises and equipment, with accumulated depreciation added back in, equaled $680 million at the end of last year. That's $3 million for each of Commerce's 224 branches. North Fork's showed $1.4 million per branch. In addition, at the end of last year, North Fork had $77 million of deposits per branch, vs. $65 million at Commerce.

No one can deny that Commerce is gathering deposits quickly, but that is only one part of being a good retail bank. Deploying those funds profitably is the other challenge. That means being able to make profitable loans. But as deposits ramp up so quickly, Commerce has had to invest many of them in mortgage-backed securities before it finds loan opportunities. As a result, these securities make up a substantial portion of Commerce's assets, and the bank could be vulnerable to the rise in interest rates, which hurts the value of these bonds. A fall in the level of booked gains on these bonds could eat away at Commerce's capital. A higher-rate environment may also reduce the profit margin on the bank's lending business. Jordan says Commerce has managed to maintain a so-called net interest margin of between 4.4% and 4.7% over the past 11 years despite considerable interest rate volatility, and that it sees no problem continuing that performance.

But skeptics wonder whether margins are already getting squeezed, tempting management to capitalize expenses so that earnings targets can be met. Until Commerce sheds more light on the uses of its capex, that dark suspicion will hang over this remarkable bank.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to

peter.eavis@thestreet.com.