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Commerce Bancshares Inc.’s (CBSH - Analyst Report) second quarter 2012 earnings of 80 cents per share significantly outpaced the Zacks Consensus Estimate of 72 cents. However, after considering loan recoveries and interest income on non-performing commercial loans as well as early pay-off of commercial real estate loan, the company reported earnings of 84 cents.

This also compares favorably with the prior quarter’s earnings of 75 cents per share and the year-ago quarter’s earnings of 74 cents.

Commerce Bancshares’ year–over-year results benefited from higher net interest income and a decrease in operating expenses, partially offset by a lower fee income. Moreover, credit quality and capital ratios continued to show improvements.

Net income for the reported quarter was $74.3 million, up 12.9% sequentially from $65.8 million and 7.6% year over year from $69.0 million.

Performance Details

Commerce Bancshares’ quarterly revenues were $272.0 million, up from $260.3 million in the prior quarter but down marginally from 272.1 million in the year-ago quarter. Total revenues were also ahead of the Zacks Consensus Estimate of $261.0 million.

Taxable equivalent net interest income was $171.2 million, surging 3.3% sequentially and 0.2% year over year. Both the increases were largely attributable to rise in inflation income. Net interest margin in the reported quarter stood at 3.55%, up 10 basis points (bps) sequentially but down 30 bps year over year.

Non-interest income jumped 6.6% from the previous quarter but fell 0.5% from the previous-year quarter to $100.8 million. The sequential improvement was mainly due to higher bank card transaction fees, trust fees and other fees. However, dip in bank card transaction fees along with deposit account charges and other fees were largely responsible for the year-over-year decline.

Non-interest expense inched up 0.1% from the prior quarter, but declined 1.9% from the year-ago quarter to $150.7 million. The sequential rise was mainly attributable to higher deposit insurance expenses as well as data processing and software costs, while significantly lower other expenses led to the year-over-year fall.

Efficiency ratio, in the quarter under review, improved to 56.39% from 58.91% in the prior quarter and 57.40% in the year-ago quarter. The fall in efficiency ratio implies an improvement in profitability.

Credit Quality

During the quarter, Commerce Bancshares’ credit quality continued to witness considerable improvement. Total nonperforming assets declined to $82.3 million or 0.88% of loans outstanding from $87.5 million or 0.95% at the end of the prior-quarter and $103.3 million or 1.12% at the end of the prior-year quarter. Further, allowance for loan losses as a percentage of total loans was 1.90% compared with 1.96% in the prior quarter and 2.07% in the previous-year quarter.

Moreover, net charge-offs declined 26.4% sequentially and 46.0% year over year to $8.2 million. Likewise, provision for loan losses decreased from $8.2 million in the prior quarter and $12.2 million in the year-ago quarter to $5.2 million.

Balance Sheet and Capital Ratios

Average loans (excluding loans held for sale) inched up 0.4% quarter over quarter but dropped 0.2% year over year to $9.24 billion. Further, total deposits increased 0.3% sequentially and 7.5% year over year to $16.8 billion, reflecting growth in non-interest bearing deposits.

Commerce Bancshares’ capital ratios improved in the quarter under. As of June 30, 2012, the company’s return on average assets was 1.45% compared with 1.29% as of March 31, 2012 and 1.47% as of June 30, 2011. Additionally, as of June 30, 2012, the company’s return on average equity climbed to 13.42% from 12.04% as of March 31, 2012 and 13.12% as of June 30, 2011.

Similarly, book value as of June 30, 2012 was $25.51 per share, up from $24.83 as of March 31, 2012 and $23.38 as of June 30, 2011.

Share Repurchase

During the quarter, Commerce Bancshares repurchased 1,033,000 shares at an average cost of $38.76 per share.

Our Viewpoint

With a strong capital base and an excellent liquidity position, Commerce Bancshares is robustly poised to expand inorganically. Moreover, the company’s direct retail and commercial banking franchise are expected to perform steadily. Its focus on developing in the high-growth areas and efforts to reorganize expenses are encouraging.

However, prevailing low interest rates, diminishing loan demands and muted economic growth are expected to hurt Commerce Bancshares’ overall performance. Also, recently proposed financial rules and the stringent regulatory reforms are matters of concern.

One of Commerce Bancshares peers, TCF Financial Corporation (TCB - Analyst Report) is scheduled to announce its second quarter 2012 results on July 19.

Commerce Bancshares currently retains a Zacks # 3 Rank, which translates into a short-term Hold rating. Also, considering the fundamentals, we are maintaining our long-term ‘Neutral’ recommendation on the shares.

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