Merrill advises convertible investors to remain defensive, focus on higher quality

By Ronda Fears

Nashville, Tenn., Sept. 6 - Continuing to emphasize quality, conservatism and diversification, Merrill Lynch & Co. convertible analysts suggest investors remain defensive.

The group has added Commerce Bancorp's 5.95% convertible preferred to its recommended portfolio.

Previously, the group deleted the AT&T/Cablevision 7% mandatory convertible.

"Profits indicators have yet to show evidence of a strong profits recovery, therefore we continue to argue our cautious stance," said Yaw Debrah, Merrill's head of U.S. convertible research, in a report Friday.

"Our theme with respect to corporate profits has been that profits are indeed improving, but we do not believe that they will improve as quickly nor as strongly as is current consensus, and therefore we maintain our conservative outlook.

"We think that investors should remain relatively defensive and favor higher quality assets. The certainty of earning growth may be considerably more important that will be a lofty projected growth rate."

In adding the Commerce Bancorp convertible, Debrah noted that Edward Najarian, Merrill's regional banking analyst, recently upgraded the stock to strong buy from intermediate buy. The convertible also has an attractive valuation, Debrah said.

"Commerce Bancorp fits our themes of quality, diversification and conservatism," Debrah said.

"Should uncertainty persist in the equity markets, the company is poised to benefit from increased deposit rates, thereby providing investors with somewhat of a contrarian play."

The Commerce Bancorp 5.95% convertible preferred (BB+/Baa1) has a current yield of 5.52%, a 423 basis points advantage over the equity dividend yield of 1.29%.

Assuming a volatility of 35% and spread of 592 basis points, the issue is trading at a 4.5% discount to theoretical value.

The issue has an attractive risk/reward profile, as well. Merrill estimates returns would be 16.8% to the upside and 10% to the downside for a 25% change in the common.

The 30-year convert has strong call protection through March 11, 2005, plus another seven years of 120% provisional soft call protection until March 11, 2012.

"We think Commerce's primary risk is its ability to sustain its superior service culture as it grows larger. However, management seems acutely aware of this risk and is continually working to avoid it," Debrah said in the report.

"We also suspect that the company's recent 40-50% deposit growth rates could eventually slow to a more normalized 20-25% if retail investors shift significant funds back into equity markets and/or if interest rates rise materially - leading to higher yielding investment alternatives."

This year, Commerce Bancorp management expects to expand its branch network by 22% and generate about 45% core deposit growth. For 2002, Merrill expects least 38% revenue growth and 33% EPS growth.

There is a level of security in the quality of Commerce Bancorp's position as essentially a secured lender.

It has no credit card loans, no sub-prime loans, no auto leases, no home equity loans with loan-to-values over 100% and minimal syndicated loans. Over 95% of its loan portfolio is comprised of residential mortgages, home equity loans, commercial real estate and construction loans, and secured small and middle-market commercial loans.

Nonperforming assets fell 10% in the second quarter from the first quarter to just 0.33% of total loans and foreclosed real estate, and management has reaffirmed that it is not seeing credit quality deterioration within the loan portfolio. Further, the company's 30-day delinquency ratio fell to a six-quarter low at June 30.

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