The Consolidation Game: Winning Strategies in Cautious Times

Despite a slow-growth economy, opportunities for growth can still be found for both buyers and sellers. This roundtable session focuses on current market fundamentals for bank M&A, the downswing in strategic buys, looming regulatory and legal issues, and characteristics of acquirers who are leading the pack. Deborah Scally, editor of Bank Director, served as moderator.

Bank Director: Describe the current market fundamentals for M&A.

JOHN DUFFY: We’ve had a couple of slow years. Things are picking up a bit, but buyers still have a heavy degree of caution. There may be a greater desire or need to do a deal than some banks have had in a while, but generally, given the environment, in terms of the market and where the stock prices are trading, the vast majority of management teams we’ve talked to are still pretty cautious. There’s interest on the part of buyers, but many from the last wave of activity are still in the penalty box or no longer exist. Caution may be the ruling word of the day.

MICHAEL MAYES: I jotted down in my notes that the watchword this year is caution, so I agree with John. We have come through a period of difficulty for buyers in meeting the expectations of sellers, not only due to caution, but also to the actual level of share prices. In the last few months there has been a gradual lift in share prices, especially in the community bank sector. We are starting to see more activity on the part of buyers and a softening of the expectations of sellers, so that gap is starting to close a bit. Absent what may happen over the next month or two in the market as it relates to international events, we expect 2003 to be more active than 2002.

BILL BOYAN: I agree with both of you that people are cautious, although at the beginning of the year many people were making statements about what they planned to do in 2003. It seems as though every other bank executive says they want to expand into Texas, and now even the big institutions such as J.P. Morgan and Wachovia are saying the same thing. Regions and SouthTrust have also renewed their interest in Texas. There is interest in other markets, as well. More banks are going on fishing trips and taking exploratory steps to see what’s available; for example, if they make public statements, it might attract some sellers to come out of the woodwork. But it’s difficult to put some of these transactions together. There’s some expectation on behalf of sellers of prices that might be higher than buyers are willing to pay. Buyers are trying to make up for that difference by offering a bit more cash in the transaction, since the P/E differential between the acquirer’s stock price and the M&A takeout value is still a significant gap. So cash will certainly become a component of valuations.

KEVIN O’KEEFE: The strength in the financial institutions capital markets is helping to fund the necessary cash and capital buyers require. The trust-preferred market, in particular, is very strong for both small and larger banks, and the ability to finance transactions at currently attractive levels is helping to counteract the sluggish stock prices of the acquirers.

DUFFY: That’s a good point. The fixed-income component of the transaction is probably as favorable as it has been in a long time, or maybe ever, in some strata. But we sometimes question a client that looks at a deal that is all cash or mostly cash, yet doesn’t have enough capital flexibility to proceed without tier-one financing. We have to caution that client about the receptivity in the marketplace for a common stock deal. The ease of raising common stock makes it a different kettle of fish than the trust preferred or debt market. A lot of money has left the equity market. Although banks have obviously outperformed the S&P, the NASDAQ, the Dow, or whatever index you want to use, it can still be a difficult chore to raise the necessary capital for an all-cash deal.

BOYAN: It will be interesting to see what happens with the trust-preferred market and whether there is enough volume or interest in buying the equity in some of these securitizations so that we can continue to put these pools together. If for some reason there aren’t enough buyers for the bonds or the equity pieces, then I assume that a lot of our trust-preferred securitizations will struggle, and it’s possible that this could limit the amount of capital available to potential acquirers. So I agree, it’s going to be difficult with the liquidity of some of these issues to raise common stock. Many banks are accessing the trust-preferred markets to make up for that shortfall.

O’KEEFE: The other side of the favorable interest-rate environment for issuers of debt capital is the margin compression affecting many banks’ balance sheets. Some companies we deal with are going to be seriously pressured this year to reach internal budgets or Street estimates. And that’s going to cause some institutions to initiate discussion on the sell side that we haven’t seen over the last year or so.

BOYAN: One of the most challenging things is getting people to the table. Then they pull out their budgets and say, “I know we talked about a price, but tell me how we are going to justify earnings growth?” We’ve seen many clients with pretty flat asset yields that are picking up margin or maintaining margin by repricing longer-term CDs. The fact is a lot of banks have already repriced most of their CDs, and earnings will probably be relatively flat this year. What we really need is a hike in interest rates to get earnings growing. Perhaps valuations would follow suit and then we might see some more M&A activity, but I don’t see that happening in 2003. It’s more likely to be the end of 2003 going into 2004.

DUFFY: Pressure is building for more M&A activity from the earnings equation, as Bill just alluded. We are seeing continuing margin compression. I read a recent earnings release about the difficult environment. The company complained about the flat yield curve. I thought the CFO must be new to the job because he doesn’t really remember what a flat yield curve is like! Our research department took our earnings estimates for 2003 down pretty much across the board last September when we were getting a hint of what the third quarter was starting to look like, and we didn’t see any release valve on the pressure. So we’ve got fairly modest earnings growth cooked into the group now. That’s what’s driving a bit more vigor on the part of some buyers. It is the old consolidation game—“Let me see if I can buy something and take out some expense and consolidate because I don’t see the growth in the economy to generate loan volume and this margin picture is not getting better. In fact, it’s probably getting worse.” That doesn’t necessarily translate into high bids for target franchises, but the small banks are having the same degree of difficulty in terms of earnings growth as the big institutions. The pressure is building. It’s a question of when the two lines will cross.

MAYES: Earnings pressure, margin compression, and investments in technology are motivating a lot of the small and medium-size banks to join forces with other banks. Although they see a need on the part of customers to provide more technology and more access to customer information, they just can’t rationalize the cost, nor do they have the capacity to provide it. That’s driving some boards to look at partnering with other banks.

BANK DIRECTOR: These all sound like things that are part of the traditional consolidation game. In the last two years, there was more momentum to talk about strategic buys. This year, for the first time, we’re not hearing that at all. Is it simply a matter of economics?

DUFFY: I think so. You must first take care of your own basic business before you start thinking about strategic acquisitions. If your core franchise isn’t growing, whether it’s because of the economy or your inability to move the market share needle, that’s a challenge, and it may get the board or management thinking about other strategic options. Sometimes that is the wake-up call for boards or managements to ask, “Can we stay independent?” I’m not saying that it should force people to sell, but we are in a different environment from what we’ve seen in a long, long time. People may have to moderate their thoughts about what’s acceptable growth, what’s an acceptable earnings-growth rate, and what’s acceptable ROE. I’m not sure the benchmarks we’ve been using for the last 10 years or so are the same benchmarks to use for the next couple of years.

BOYAN: In terms of strategic buys, we don’t foresee many. As John was saying, I think that more banks are buying market share to take out expense. And I agree with Michael. Looking at what banks in the smaller asset sizes have to go through to compete is difficult. Since 1998, around 48% of the transactions were less than $100 million in assets; 36% were between $100 million and $500 million in assets. So most of the M&A activity is taking place among smaller institutions that are either a source of market share or an opportunity for balance-sheet growth for banks that are a bit larger. Clearly, directors or managers of those smaller institutions wouldn’t sell unless they felt they had realistic prospects to break through the $500 million level on their own. More banks have fallen into this category because there have been more de novos started over the past few years, particularly since the 1996-1997 heyday. Investors wanted to put banks together so they could sell them five to seven years later. Some people are probably selling a bit earlier than they would have thought.

O’KEEFE: The larger institutions’ strategic prizes might turn out to be smaller deals, which return a focus to core banking. J.P. Morgan is an example of a company that has recently said, “Look, we want to go out and buy a bank, not a non-depository business, to make a statement saying we’re once again focused on the banking business.” Larger banks—not J.P. Morgan specifically—have done so many deals in other lines of business in an effort to become more diversified that some strategic buys for these companies might be straight-vanilla mergers with smaller banking organizations.

MAYES: This is the first time in quite a few years where we’ve seen banks and boards pulling their horns in a bit, and you see it in corporate America, too. Companies are refocusing on their core competencies and what they do best. Boards are also being much more active with their managements. Earlier John referred to some of the benchmarks, and I think they are revising those benchmarks to be a little more realistic in terms of what can be accomplished over the next year or two. We also see boards and managements putting much more effort, attention, and resources into evaluating the profitability of different lines of business in their own banks.

Many boards are beginning to find that normal lines of business, which are sometimes core businesses, aren’t as profitable as they once believed.

DUFFY: Tie that into the relatively low M&A activity levels that we are experiencing, and suddenly de novo branching is like soup du jour. But there should be a little caution. Your investment is less than paying a huge premium for somebody else’s franchise. Obviously you don’t get the cost savings or their book of business, but it’s generally viewed as lower risk, and perhaps a longer return rather than a lower return. I’m sure boards and managements debate this all day, but how many banks in the past year have indicated that they are going to open branches? This is a really huge change from what we were dealing with four or five years ago.

BOYAN: And it’s produced even more results on the growth side in terms of deposit and loan growth for those companies, which has turned into earnings growth. There are certainly some small companies in the $400 million to $1 billion range that have taken that tactic to go out and open a de novo branch a couple of times every year. The good news is this has been successful, and sometimes there’s a premium multiple as a result. The scary part is, what happens if they make an acquisition? Will that multiple change as a result of a change in strategy and will the attitude of investors change as to the type of companies they like to invest in?

DUFFY: While it varies from market to market, Commerce Bank (Cherry Hill, N.J.) is probably the best example of the success that some of these banks have had from de novo branching and picking up market share. It got its first huge shot in the arm from the way First Union bungled the Core States acquisition. Fleet does Summit, and it’s been on a roll. They’ve benefited from fallout from other deals. It will be interesting to look back in a year or two if we have a prolonged period where there is not a lot of M&A activity. Will there be that much market share to pick up because there isn’t a fallout from big deals? You had it in the Southeast, with First Union/Wachovia, and other deals like BB&T, where the smaller guy was picking up market share. But now you are getting people talking about de novo branching in markets where there hasn’t been any. Chicago is an interesting example. Fifth Third and Nat City have been making noise about opening branches. There are a lot of independent banks there and maybe it’s an underbanked town—that wouldn’t be my instinctive thought coming out of the gate—but I’m curious to see if there are that many good corners left in Chicago for that many banks to open that many branches. So again, a lot of people may run into competition in the next year or two, which will increase the pressure to do deals, because I’m not sure de novo branching is the cure-all.

BOYAN: It has made it extremely competitive in a lot of places to find branch locations. You have de novo banks and the money-centers fighting over the same locations. It’s certainly going to make it difficult for people to continue with that strategy. Commerce is probably running into that already because it is trying to go in so many different directions. Commerce is already trying to make bids on some acquisitions, and what happens to its multiple at that point? Has it ever made an acquisition of any size such that investors would be willing to sit by and see if it can figure it out? I don’t know.

O’KEEFE: The other side is that Commerce is very good at what it does. Its CEO, Vernon Hill, is a highly skilled branch builder, and some of the smaller institutions that might want to try to copy that blueprint may run into time frame issues, meaning it will take time to learn to do branching well. Most won’t have a year or a year and a half to let that deposit base build up with anemic earnings behind it. If a company experiences margin compression in the short term, will investors wait around for the earnings growth from a de novo strategy?

BOYAN: The question is for those banks that need capital. Where do they get it? With the M&A markets and purchase accounting the way they are and the goodwill that’s being generated, where is all the capital going to come from in the years ahead? There’s the trust- preferred market and small-equity offerings where we certainly have seen an upswing in $8 million, $10 million, $15 million, $20 million offerings for small banks. The question is, are there investors who will support those efforts? Our hope is that there will be. But what happens when investors come down market and run the risk of buying big stakes in small companies? If there’s fallout and the mutual funds have redemptions, will they be willing to take the risk and then not be able to meet those cash calls?

BANK DIRECTOR: How do you help a board that’s trying to make the determination between de novo branching and an acquisition as a growth strategy?

BOYAN: Banks have to be opportunistic on the acquisition side. For most small companies, acquisitions are not a reality. But occasionally there is an opportunity they truly get excited about where, for example, they want to buy their next-door neighbor at all costs. Then people like us have to come in and write a fairness opinion, which sometimes can limit banks’ ability to put transactions together. Different institutions have different strengths and weaknesses, and I would have to say that de novo branching is a much safer and easier road to follow.

MAYES: It is safer and easier. Of course, getting to critical mass takes longer. More banks are looking at branding. We like to illustrate over a three- to five-year period the outcomes of different expansion options. Depending on whether a board is predisposed to a more conservative approach or trying to grow and meet size targets will have a lot to do with what path it chooses. The trust-preferred securities we have been talking about have clearly become the security of choice, particularly in financing branch acquisitions. Currently, the low interest rate environment makes this security very attractive. The market for common stock of community banks is also strong. With deals now requiring purchase accounting, whether it’s trust preferred or common equity, banks are generally looking to raise capital to finance their acquisitions. The deals themselves continue to involve a fairly high component of stock as well; they are not just all-cash transactions. As I mentioned earlier, valuations are coming up a bit and this has encouraged some banks to consider options they wouldn’t have considered last year.

O’KEEFE: I think the best way for our clients to analyze their overall strategy is to look at each particular strategic alternative separately and then attempt to be opportunistic in using a combination of available options. A company may start down a path of building branches, but when an acquisition opportunity comes up, the board and management have to have done their homework in terms of what the bank can pay, what it should pay, and who else could pay a competitive price for that property.

MAYES: There’s branch fallout, too. We are still seeing the larger banks offering branch clusters. The typical branch buyers tend to be the smaller local community banks. Regional clusters are very attractive transactions for them. On a unit basis, they are generally much lower in cost, much less complicated, and the downsides are smaller relative to whole-bank transactions. We are seeing a fair amount of these.

BOYAN: We’ve made a bet that the retail franchises that America’s banks have put together are attractive today and will be attractive in the future. We have funded a REIT which is buying bank branches. It picked up 200 branches from Wachovia recently, 150 from BofA, and will continue buying branches. We will lease back to community banks or Jiffy Lube or McDonald’s, but clearly the target market is going to be the community banks and smaller banks that need access to locations. One day we hope it will be a public company, and we will continue to fund the growth of that company.

O’KEEFE: It seems to come up frequently that the current trust-preferred market has helped the smaller banks tremendously to compete in the acquisition arena, providing those companies the ability to raise tier-one capital so that they can, for instance, buy a branch when it comes up for sale. Trust-preferred pools have been a real boon for the smaller institutions. Since the introduction of trust preferred to the banking industry, the larger institutions have had the ability to raise capital on their own. The pooled structures have really been an effective vehicle for the smaller companies.

BANK DIRECTOR: Are there any sensitive regulatory or legal issues looming?

MAYES: There’s a growing regulatory discomfort with too much trust-preferred capital. There are regulatory limitations in place regarding how much will qualify as tier-one capital and there is some pressure to reconsider those limitations.

DUFFY: What we hear the most concern about is the industry financing itself. That’s where the regulators have the biggest problem; they don’t want to see banks owning other banks’ securities.

MAYES: Another area of concern coming out of Sarbanes-Oxley and increased SEC scrutiny is historical accounting, particularly as it relates to public disclosures in financings or for business combinations. We see much more scrutiny on audited statements from prior years, especially where there’s been a change in auditors or a former Arthur Andersen client. It’s not a complicated matter, it’s just time-consuming and often costly for some of the issuers.

BOYAN: We’d like to see a little more clarity on what FASB and the SEC think should happen with core-deposit intangibles and premiums, what’s acceptable in terms of the deposits you apply the premium to, and what exactly should we be looking for in terms of CDI amortization. We’ve gotten a little bit of guidance on the latter, but I still think a lot of people are making assumptions in their M&A transactions that may or may not prove to be correct. And ultimately, there needs to be more evidence as to how banks should apply premiums for core-deposit intangibles.

O’KEEFE: With regard to Sarbanes-Oxley, just the specter of aggressive accountability guidelines for directors could cause some smaller institutions to examine selling their company as opposed to undertaking, in some smaller communities, a difficult process to find appropriately qualified people to sit on various committees of the board.

MAYES: A lot depends on the boards themselves. Some become more fearful of increased scrutiny. It can become difficult to bring on new directors. On the other hand, because banking is a regulated industry, many boards feel as though they’ve always had that scrutiny through regulatory oversight and the examination process. In that respect, Sarbanes-Oxley really has addressed problems more in the corporate, manufacturing, and nonregulated industries, where there was little regulatory oversight. Because of the regulatory examination process, banks and bank boards have been more involved. The new rules have caused many bank boards to be even more active and involved.

DUFFY: Without question, directors are taking their jobs more seriously. Due to Sarbanes-Oxley, some of the smaller banks believe that they need to be prepared for everything that’s required of them, so they are being forced up the curve more quickly. My sense is that the regulators are being a little tougher. There seems to be a hot topic every six to nine months in Washington, whether it’s credit card lending or subprime. There are periodic “witch hunts” because the sense is, right or wrong, that there are abuses in these areas.

BANK DIRECTOR: What issues should bank directors be thinking about most?

MAYES: I would go back to where we began. Caution is the watchword buyers and sellers should keep in mind as it relates to expectations and what they hope to accomplish over the coming year. We do believe, once we get through the next few months, that we are going to see a continuing gradual lift in share prices and that will fuel additional M&A activity. The trust-preferred market remains strong as a method for financing acquisitions. We encourage some of the smaller companies to continue to evaluate their own businesses, whether they are traditional lines of business or new, nontraditional lines. They should also continue to explore ways to rationalize related costs, whether it’s the expense of branching or investments in technology, and look at the benefits of partnering with local institutions.

BOYAN: People have to look at their businesses and be realistic about their long-term growth rates. Either they are good at what they are doing, or they’re not. If they can’t achieve a reasonable growth rate—it doesn’t have to be every year or every quarter—but if they are not putting up attractive numbers for investors, then they should find ways to combine with other companies where they can either get cash and/or stock and get out, or find a stock that they think will grow faster than they are growing. Trying to predict their future growth could be an important step for some of the smaller banks that don’t spend as much time in the budgeting process as they should.

DUFFY: I agree with Bill, and to follow up, one of the by-products of a slow-growth environment is that banks are going to generate a fair amount of capital and not know what to do with it. Then it becomes more an issue of how do you give the excess back to your shareholders if you are not going to sell the organization? And obviously, Bush’s proposal on dividends and the elimination of double taxation would be huge in this kind of environment in terms of excess capital. Returning it to the shareholders might be the best thing they could do and certainly beneficial to the sector in terms of valuation, because it is one of the few sectors that actually generates cash earnings. The financials, including not only banks but insurance companies and everything else, are 20% of the S&P 500, but they are 28% of the S&P 500’s earnings. So there’s real earning power in the financial services industry. Is there growth? Maybe not a lot in the current environment. The board’s message to management should be to do something boring rather than something stupid with this excess capital.

MAYES: The move to purchase accounting has been good for the industry. I’ve seen buyers be much more disciplined. That’s positive. And on the issue of dividends, if it’s passed the way it’s been proposed, you’ll see more equity financing, which is also beneficial.

BOYAN: The only problem is that the elimination of pooling limits what some of the smaller companies can do to combine with similarly sized companies within their own communities, and the goodwill carryover can just be too much for some of these transactions. What happens is the middle-market players or larger buyers are the ones that are successful—certainly the larger buyers seem to have a bit of an edge in terms of access to capital—and when a larger company is bidding against a smaller company, its dilution of tangible book value is going to be nominal for the larger company compared to what it might be for a smaller acquirer.

O’KEEFE: Bill, you are exactly right about the smaller institutions needing financing to facilitate acquisitions because of the pressure on capital. But I think even though we are seeing so many trust-preferred pools helping to finance tier-one capital pressures in the M&A market, and with as much other debt financing in the market as there is today, we may still be a cash- and capital-starved industry sometime in the future. It’s going to be capital starved if M&A continues to be as strong as we hope it will, taking into account the more prevalent use of cash in transactions and the long-term goodwill component of buyers’ balance sheets.

BANK DIRECTOR: Which banks do you think are the really good acquirers today and why?

DUFFY: There’s certainly BB&T. I wasn’t in the boardroom the day it approved the purchase of First Virginia, but it was definitely viewed as a strategic deal. First Virginia is the last meaningful franchise left in the state, and it is a different kind of franchise. Most of you are probably aware of the asset mix. BB&T feels that it can do a lot with the franchise that hasn’t already been done, and there’s also a lot of consolidation opportunity overlap to make the numbers work.

BOYAN: BB&T was conservative in laying out its expectations for the market. The cost savings are going to be enormous, but in D.C., where First Virginia has a fair amount of presence, it does a great job on the deposit side, but doesn’t do anything on the asset side. So if BB&T can train enough people and staff those markets to actually lend within those markets, there could be some revenue enhancements to come from this deal. I think it will be a good bet in the long run, though it’s certainly challenging the earnings accretion theories a bit.

MAYES: BB&T has been a good model over the years. Look at the company today and compare that with where it was 10 or 15 years ago. It’s been a real success story. The other company I think of in New England is Banknorth. It has articulated a strategy in New England and has generally stuck with it. It’s been aggressive when warranted and disciplined in other cases. It offers a lot to the smaller banks and it’s been successful in its forays into other New England states.

BOYAN: I agree. BB&T effectively integrates people, business lines, and different cultures into its organization and that is what has separated it from many of the other acquirers. Its fundamental performance has been very strong, but its stock performance has not followed suit, and I think the financial world assumes that ultimately it will stub its toe and turn into BofA or First Union/Wachovia. I do think BB&T is unfairly punished in its stock valuations from time to time. Meanwhile, there are other good acquirers out there. Wells Fargo has done a pretty darn good job. It tends not to buy companies that don’t fit its model of what it thinks is a good company, thus leaving the poorly performing companies for other acquirers. Fifth Third has also done a good job if it can get the target’s efficiency ratio down into the low 40s. North Fork’s done a great job and its efficiency ratio is approaching its return on equity; one is going to eclipse the other! Companies that have done well certainly have an edge over others that have not put acquisitions together, because the executives of a selling company or selling shareholders are going to be concerned about turning over the business they’ve built all their lives to someone who doesn’t necessarily share that experience. We expect to see cash become a bigger portion of the consideration when you have inexperienced acquirers. With successful acquirers, you tend to see more stock being acceptable.

O’KEEFE: You used a great word to describe BB&T, which is conservative. Being conservative in the way a company approaches its acquisitions and the outline for its analytics is a very positive thing for a good acquirer. The best acquirers are conservative, they make good assumptions, and then they execute. But decisions on which deals to pursue or not to pursue can make the real difference. North Fork is a perfect example of a company that is probably one of the better acquirers today for not having done some deals recently.

DUFFY: In the last two years, North Fork has not been on the radar screen. I don’t think that means it isn’t interested, it just means it has found a better alternative.

O’KEEFE: It will continue to be a great acquirer because it knows how to do deals and will not stretch for overpriced deals. There are other companies with strong capital levels and well-positioned stocks who are poised to become good acquirers. There’s a company in the Maryland area, Mercantile Bankshares, with great capital ratios as well as a great stock. Mercantile is an up-and-comer. It puts deals together in the correct manner with the correct analytics. And then there are companies with community-based acquisition tactics that are strong. United Community Banks in Georgia is a good example. Jimmy Tallent, CEO at United Community, spends a lot of time meeting prospective targets, pitching not only a strong performance and a good stock, but also the community bank solution for merging with a larger partner, so to speak.

DUFFY: One of the barometers that signifies a good acquirer is a willingness to lose periodically. Mike mentioned Banknorth. There are clearly deals it missed in New England where Citizens or another bank decided it had to win and Banknorth was willing to lose, and I think the same thing was true with North Fork being out of the market. These banks really have discipline, and it shows over a long period of time. If you go back to the early 1990s, whether with Banknorth or North Fork or BB&T or almost any of the names that we’re reciting, and look at what they were 10 years ago, they were a fraction of their current size. I remember doing a recap of Banknorth—I think its total assets were $2 billion, with a market cap of $20 million. Look at it today. The shareholders who got into any one of those names a long time ago are never going to sell their stock because of the dividends.

MAYES: One of the characteristics of a good buyer is being aggressive, but also knowing when to move on to the next deal and let one go.

O’KEEFE: And another is taking time to digest. BB&T is clearly going to need to take some time to digest, and I guess the other side of that is Union Planters back in the late 1990s not allowing itself enough time to digest and feeling it in its performance and stock price. Banknorth is also taking time to digest its latest flurry

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