This column was originally published on RealMoney on July 11 at 11:00 a.m. EDT. It's being republished as a bonus for readers.

Commerce Bancorp ( CBH) shares dropped 7% last Wednesday, representing a loss of about $400 million in market value. This was in response to a Jesse Eisinger column in The Wall Street Journal that heaped negativity on the company.

The drop in Commerce's stock, which currently trades around $32 a share, is good news for bargain hunters. My calculations indicate that Commerce will be worth more than double the current quote, or $67 a share, by 2008, and worth triple the current quote, or $100 a share, in four years.

Investors interested in the upside opportunity in Commerce stock have to be able to see through the negativity in Eisinger's column. At a minimum, the bulk of the argument is misleading. I'll review where his conclusions go awry.


Eisinger first takes issue with Commerce's comparable-store deposit growth. According to disclosures made by Commerce, same-store deposit growth in the first quarter will be about 18%, and total first-quarter deposits will be up about 24%. The 24% total increase is derived from same-store deposit growth plus growth in deposits from new stores. The 18% same-store growth rate for the first quarter is down from an average same-store growth rate of 20.3% for 2005.

Consider this comment from the Journal column:

"The growth rate is falling ... the slowdown is just one sign that Commerce's vaunted business model is breaking down." To divine meaning from a slight decline off a high base is quite a stretch, particularly when it's based on just one quarter of data. To say that it is an indication that the "business model is breaking down" is nonsense.

The column also pointed out that Commerce's deposit growth was 29.7% in 2002, presumably so that readers could see a trend from 29.7% in 2002, to 20.3% in 2005, to 18% in the first quarter of 2006. The problem there is that Eisinger selected the peak rate -- 29.7% in 2002 -- and did not tell readers that the rate was 14.2% in 1999 and 15.1% in 2000.

Even if we assume growth has slowed, it is far from a sign of impending doom. Organic growth of 18% is extraordinary for a company in any category. Every banker in the country --- with the notable exception of Commerce CEO Vernon Hill --- would be thrilled if they could achieve a third of that rate.

My valuation model, by the way, assumes a gradual slowing to a 15% rate over the next four years. More than a third of Commerce stores are 3 years old or newer. As the store base matures, it's reasonable to expect deposit growth will moderate. The average Commerce store has collected $120 million in deposits and is gathering new deposits at a pace of $20 million per store per year. By way of comparison, it takes branches of other banks about 10 years, on average, to accumulate $50 million worth of deposits.

Balance Sheet

"Perhaps most worrisome are concerns about the bank's liabilities" is a criticism that sounds scary, but is inconsistent with the facts. Commerce's balance sheet is quite healthy, with no long-term debt and credit risk far lower than its peer group.

Eisinger selected one issue from the balance sheet to make his "most worrisome" case, but then failed to identify a critical mitigating factor. Here's the issue: Commerce generates deposits much faster than it can make loans. Rather than get aggressive in lending and absorb extra credit risk, Commerce invests a large percentage of those deposits in AAA-rated income securities, such as mortgages. These fixed-income instruments mature in four years, on average.

Because interest rates have recently moved up, the market quote for these securities has declined. As a result, Commerce has a "paper loss" on these securities. As Eisinger points out, if Commerce holds the securities for the duration (about four years), there is no actual loss, because it will receive 100% of the face value. So far, so good. This is an issue worth noting.

Eisinger then reports that "Commerce's paper losses look to be the worst among the banks Morgan Stanley analyst Chris Chouinard follows." That doesn't tell the whole story. Other banks struggle with deposit growth rates of nil to 5%. Commerce total deposits this year will grow by 24%, and by about 50% over the next 24 months.

A large percentage of these deposits will be invested at the new higher rates. This deposit flow mitigates interest rate risk in a material way. It's an interest rate hedge that other banks don't have and that the Journal neglected to mention.

Earnings per Share

The next statement to challenge: "The bulls ... have stuck with the company despite surprisingly lackluster earnings per share." There is only one reason earnings have been "surprisingly lackluster," and it has nothing to do with the efficacy of the operating model. Earnings are temporarily lackluster because of the yield curve. Because Commerce is a deposit-gathering machine with large investments in AAA-rated income securities, its earnings are unusually sensitive to the shape of the yield curve.

The long-term average net interest margin (NIM) for Commerce is 4.3%, with a peak of 4.76% (2001) and an all-time low of 3.4% expected for this year. It's not difficult to calculate the impact that a return to a normal interest rate curve would have on Commerce earnings. For example, if next year's NIM is slightly below the long-term average, at, say, 4.1%, Commerce's EPS would be $3.42. While I can't predict when the curve will revert to a normal slope, this illustrates the earnings power of the operating model.

By the way, underlying my $100 target for Commerce in 2010 is a gradual slowing of total deposit growth to 19% (same-store growth of 15% plus deposits from new branches), a 10% expansion in the shares outstanding and a NIM of 4.1%. That implies EPS in 2010 of $5 to $5.50. Even at a NIM of 3.75%, which would be well below the long-term average, my 2010 valuation target for Commerce stock is 2.5 times today's quote.

I believe it is reasonable to expect the yield curve will revert to a more normal slope over the next couple of years -- either short rates will decline or long-term rates will increase. Over the last 100 years and more, flat to inverted curves have proved to be transitory because of the economic dislocations and distortions that they cause (e.g., affecting the incentive to invest and lend).

My assumption of a price-to-earnings ratio of 18 to 20 in 2010 for Commerce is conservative, in my view. Great organic growth stories are exceedingly rare, and typically are priced by the market with price-to-earnings ratios in the 25 to 35 range. Further, most great organic-growth stories do not have earnings leverage as powerful as the Commerce operating model.

Most models increase earnings by selling more product. In order to sell more product, they need to acquire or manufacture more product. That increases the cost of goods sold. Commerce has a major advantage in this regard. Once a Commerce store matures and operating costs are covered (almost always by the second year), there is negligible cost of goods sold associated with additional deposit growth. This provides a significant magnifier effect to the model's earnings leverage, something observers will see as the store base matures.

Liquidity in the Financial System

The fans long have figured the stock was worth the price because they thought Commerce had cracked the growth code. But the model wasn't so mysterious: It worked because the world was awash in cheap money. When rates were near zero, it doesn't matter what a customer gets on a certificate of deposit. Friendly service stands out. But as rates have risen, customers have started to relearn that Spinal Tap tune, "Gimme Some Money."

That is a cute characterization, to be sure, but it's false. It is inaccurate to say the model "worked because the world was awash in cheap money." Either Eisinger did not check Commerce's record or has to make the embarrassing case that the world has been "awash in cheap money" for more than 20 years.

The Commerce model has thrived as a deposit-gathering machine each and every year, in all varieties of interest-rate environments, for more than 20 years. It's interesting to note that Commerce's long-term business value growth does not correlate to whether money is cheap or tight. Rather, the business value of Commerce has moved upward in concert with deposit growth.

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At time of publication, Alsin and/or ACM was long Commerce Bancorp, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.

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