Dissecting the Deals: What Worked and Why

With large mergers and acquisitions making headlines, boards may feel the time is ripe to do deals of their own. Our roundtable participants discuss how these big-name deals have affected the rest of the industry, the latest in bank stock trends, and the key ingredients for successful deals. Deborah Scally, editor of Bank Director, served as moderator.

BANK DIRECTOR: Have recent large-deal announcements, such as J.P. Morgan Chase/Bank One and BofA/FleetBoston, affected the psychology of the market?

Steven Hovde: In my opinion, they are totally different deals. The premium and the pricing multiples on the BofA acquisition are so rich that the market reacted negatively to BofA stock. It dropped roughly 10% right away. It has since recovered and is pretty much where it was prior to announcement, but at the same time, the S&P 500 is up about 10%. So arguably, it’s underperforming the market. J.P. Morgan is a different story. It bought something cheap, therefore its stock didn’t get hurt as bad. So while I think these are two different deals and shouldn’t be viewed in the same light, from the community bankers’ standpoint, they are lumped together.

Charles Crowley: From a market psychology standpoint, I think for years, a lot of people have expected [Bank One’s] Jamie Dimon to return to New York one way or another, either through buying, or in this case, selling. We all remember the Fleet/BankBoston transaction and the effort to ensure that Boston would still be the headquarters of a large independent bank, so the fact that this board decided to sell is significant. You have a $200 billion company that has had some ups and downs, but it’s still a pretty solid franchise. The fact that it decided it was not going to be successful in the long run on its own creates a ripple effect in the market. It gets other people thinking.

William Boyan: I would have liked to have seen J.P. Morgan Chase buy a few smaller banks and then give us more to talk about over a longer period of time. I think there are opportunities for the big banks to buy market share in key markets from sellers that would fit well with their companies.

John Duffy: While these deals are somewhat different, the impact on the rest of the industry is that it increases the pressure to do deals—whether it’s pressure that management puts on itself or whether the board puts it on management or whether the shareholders put it on the board. With this industry on the front page of the Wall Street Journal every other Monday, people start asking questions. “Why haven’t you guys done a deal? Why didn’t you sell out for the kind of premium we got?” Right or wrong, it raises the level of chatter significantly.

Boyan: That brings up the question of what Wells Fargo is going to do. Is it going to come east? The Regions/Union Planters transaction showed that there were no buyers for either of them that were willing to pay a significant premium. They didn’t have an opportunity to sell, so they decided to put together a merger of equals at basically no premium. I still see Washington Mutual and Wells Fargo essentially as West Coast companies that need to move east, probably more so after the J.P. Morgan Chase/Bank One transaction.

Crowley: Institutions on down the ranks are affected, too. Take Sovereign moving into Massachusetts; other banks are asking how they are going to benefit from this. So I think there is a ripple effect all the way down to the community banks.

Hovde: I don’t think it has necessarily forced community banks into doing deals—rather, they look at this as a customer-grabbing opportunity. But it has given a boost to bank stocks, and rising bank stocks have allowed for a greater level of activity that, in some sense, has led to more M&A deals simply because buyers can afford to pay higher prices. So a lot of Chicago-area community banks are looking at it as an opportunity. A lot of Texas banks are also looking at it as an opportunity primarily to grab market share. And if you are an investor in bank stocks, simply having these large transactions in the paper every day has helped fuel stock prices and takeover fever, which has led to more M&A activity.

Ronald Janis: I think it also creates a psychological impact on the boards of smaller community banks that are encouraged by both newspaper articles and investment bankers who are dreaming up deals. It plays on the notion that “Either you are going to be a buyer or a seller, or be nowhere.” And that causes a lot of tension at the board level because there is also the mindset of “If we don’t sell now, we never will.” That certainly was the case in 1998 and 1999.

Duffy: I think that may be true in many aspects. If you don’t have a well-articulated, well-thought-out game plan, you tend to react to external pressure—whether you’re a board member, management, or an uneducated shareholder. I think there are plenty of banks that could care less whether J.P. Morgan and Bank One are getting together. If those banks are in one of their markets, they are anticipating dislocation, which would be good for them. Fifteen years ago, the reaction might have been terror. But what banks have been able to prove, over the last dozen years or so, is if you’ve got a game plan and you’ve got good people, you can compete, at least in certain segments of the market.

So banks with well-thought-out game plans aren’t necessarily going to abandon them and decide they have to sell, or decide they have to buy. But banks without well-thought-out game plans are subject to pressure, and in other cycles we’ve seen banks do bad deals in reaction to that kind of pressure. We’ve seen some overpay and some take currency when they didn’t know what they were getting.

Boyan: But are banks overpaying now? We’ve seen transactions priced at approximately 25 times earnings on a fairly frequent basis.

Crowley: Some clearly are and yet some still work out. We are back to a point where multiples of prospective acquirers are high and the cost of cash is low. So for a given level of cost savings, it’s possible to put a decent premium on the table and still have it work. That’s probably where the market psychology has really changed. If you look at every year since the market cracked in the fall of 1998, there have been fewer deals than the preceding year. Now it has picked up a bit, and people believe this is going to be a busier year. It is a different environment, and these two major transactions have something to do with it.

Duffy: I agree. Banks can afford to pay more today, either because their own currency is relatively highly valued, or the cost of cash or additional capital is cheap. Also, in 80% to 90% of deals, the cost savings seem to be pretty reasonable, at least in a historical sense. I think most of the industry has learned its lesson from others’ mistakes in terms of being too aggressive on that front. Most cost savings are in the range of 20% to 25%. It doesn’t mean every acquirer is getting that, but I think the market is comfortable with this being an achievable range in most instances.

Hovde: The increase in value of bank stock currencies has allowed higher prices on a nominal basis, and sellers, like it or not, tend to focus on nominal value, not the number of shares. They get higher nominal value because stock prices are higher and cash is cheap. More activity breeds more activity. Just like the cycle from 1997 to 1998, as long as stock prices stay up, you’ll see more activity, but once stock prices back off, sellers will continue to have that nominal value in mind, and they are not going to sell. That’s why we went into a trough—because bank stocks were down, sellers couldn’t make their prices and there was a disconnect between buyer and seller expectations. So these larger deals continue to propel bank stock prices higher, which leads to more activity.

BANK DIRECTOR: How long can bank stocks trade at current levels?

Hovde: If you listen to the talking heads, everyone is rosy on the economy, but in my opinion, it’s going to be tough to get rising bank earnings this year. If you look at fourth-quarter 2003 FDIC numbers compared to prior quarters, earnings-per-share (EPS) growth and deposit growth were slow. Unless you’ve got strong loan demand, you will not get EPS growth because as your mortgage or securities portfolio reprices or gets called, there’s going to be margin compression. Interestingly, during an audience survey [at the Bank Director 2004 Acquire or Be Acquired conference], the top concerns were net-interest margin and deposit growth. I would agree those are the two major issues.

Crowley: And now that the stock market is doing better, there will be a little more pressure on banks to report acceptable earnings-growth levels to maintain their multiples.

Boyan: Clearly there is an open window for M&A right now, however, few banks that are potential sellers appreciate that fact. The M&A markets were also pretty wide open in the pooling days. You could always find a bank that had a reasonable trading valuation, and there were a lot more companies available for buying and selling. Today, in every market, there may only be one or two buyers, and if those buyers don’t have a reasonable currency, they may be out of the market. In fact, there are banks that we thought would be acquirers in 2004 that are not—BB&T being one. BB&T has said publicly that it will slow its pace of acquisitions, but I think it is being even more conservative than it had originally stated. If it is going to be on the sidelines for six to 12 months this year, that’s a significant blow to the market. And while now is a good time to sell, if anyone is trying to predict the future, the second six months of this year will more than likely not be a good time. It’s sometimes hard to explain to clients, but potential sellers must understand the cold, hard facts—the window could close sooner rather than later.

Crowley: From a valuation standpoint, many companies are trading close to their acquisition values these days. Most people are satisfied when you have an environment like this—their stocks have gone up quite a bit in the last year or so, and they are feeling pretty good around the board table. So you have some complacency creeping in.

Hovde: The values now are reminiscent of late 1997 and early 1998. Currently, the average publicly traded bank is at 208% of book value, 230% of tangible, 20.6 times LTM earnings, and 20.8 times the most recent quarter annualized. Many banks are trading at close to takeout values. The question is, how long can it last? In my opinion, it comes down to where the economy goes as to whether prices stay up.

Duffy: Right. Will there be a collapse in prices? Is there a Long-Term Capital Management (LTCM) out there? There could be. We didn’t know what LTCM was in the summer of 1998, but there is usually some endogenous event waiting to happen.

The bottom line is we are not predicting robust earnings growth in 2004 for the industry, at least not for the publicly traded companies. We have predicted a more reasonable 6% to 9% earnings increase. With banks trading at a discount to the overall market, you’ve got real earnings. You’ve got nice dividend yields. You’ve got real cash flow. I think it’s a sector that the market generally likes.

Hovde: Looking at the last two years, bank earnings have been powered by one simple thing: residential lending. Low interest rates drove housing price increases, housing increases drove refis, the refi activity drove consumer spending, and consumer spending drove the economy. It hasn’t been business spending, it’s been consumer spending. Now, the refi boom is about over. It peaked in the third quarter of 2003, and then started trailing off in late August. Fourth-quarter data is just coming out and revenue is expected to be around $280 billion, which is up slightly because of the season. So how do you replace that massive income generator?

Boyan: That’s right. A lot of banks have become addicted to mortgage banking income.

Duffy: But community banks are spread lenders with more of a commercial focus. They view mortgage lending as a commodity business and thus don’t do a lot of it. I don’t think they will necessarily be impacted. Most of them are asset-rate sensitive, so they will do better if rates go up a bit. And commercial loan demand can’t get much worse than it was.

Boyan: I agree. But the hope for commercial banks that did some mortgage lending and saw volume drop off at the end of the third and fourth quarters was that rates would rise at about the same time. The next couple of quarters are going to be difficult for them because they will not be getting the margin expansion they had hoped for. So there is quite a bit of second-guessing going on in boardrooms right now.

Boyan: It will be very interesting to see how boards react. Will they patiently wait for rates to rise, or will the directors press management to sell?

Duffy: I don’t think the sector as a whole is overvalued. I do think there are banks within the sector that are overvalued and don’t have a well-articulated game plan or are too dependent on mortgages. I don’t understand why some of these smaller banks are trading above where the large-cap universe is trading. Banks that are buying those overvalued institutions will probably be disappointed. Some of the smaller institutions have unrealistic expectations. Consequently, they may be faced with a take-under or a gradual erosion of their current stock price.

Hovde: One positive for the industry is the level of credit quality and amount of loan-loss reserves as a percentage of nonperforming loans. Nonperformers are declining; chargeoffs are declining. I don’t think there’s any precipitous event that would cause a big drop in the market, absent the general economywide impact of another terrorist act. John is right. You are going to have to be very good at stock picking because all boats are not going to rise in an industry that is unable to grow earnings.

Boyan: But once interest rates rise, what will that do to credit quality? Have banks been lending to customers who can afford a 4% coupon on their debt but who are unable to do the same with 6% paper? It’s going to be interesting to see what happens to credit quality when rates rise.

Crowley: The American consumer is overburdened to begin with. We’re seeing the highest levels of consumer debt in history. So when the rates do go up, consumers who have been doing cash-out refis will be in a more precarious position.

BANK DIRECTOR: Let’s change gears a little. It’s always instructive to look at successful deals and talk about why they worked. Can each of you give an example of either a small- or large-cap deal in the last year that was successful?

Crowley: In the large-cap arena, the ripple effect of the BofA/FleetBoston deal is powerful, because it kick-started the discussion of a new wave of merger activity. When a company that size changes hands, it gets other companies thinking about buying or selling.

One notable small-cap transaction was the $72 million cash acquisition of Jacksonville Bancorp in Texas by Franklin Bank Corp. The nature of the buyer and the presence of a financing contingency made this a very interesting transaction. We represented Franklin and its IPO.

Jacksonville, a $450 million thrift with $42 million in equity, had fairly strong performance ratios with a 1.40% ROA, 15% ROE, and 43% efficiency ratio. The problem was it was not located in the most vibrant markets.

Franklin announced the acquisition in August 2003 and completed it at year-end. The price to book was 159%, price to tangible book was 173%, and the trailing P/E was only 10.7 times. Interestingly, Franklin had the right to terminate the deal if it did not complete its IPO and had agreed to pay Jacksonville a $1.5 million termination fee plus out-of-pockets if the IPO did not take place.

The IPO was very successful. Franklin raised approximately $150 million and closed the deal soon after. The stock has performed very well to date, jumping from $14.50 to $19.50 as of early February.

When the markets are healthy, it opens up interesting possibilities such as these. In a more difficult market environment, both boards may have balked at the structure of this agreement.

Boyan: One interesting transaction we’re involved in is a three-way deal in which New Haven Savings is purchasing Alliance Bancorp of New England and Connecticut Bancshares simultaneously. Our firm represents Alliance. Alliance has approximately $425 million in assets and is in the process of selling to New Haven, which is a mutual savings bank. New Haven currently has about $2.5 billion in assets. At the same time, New Haven is buying Connecticut Bancshares, Alliance’s crosstown rival, which has approximately $2.6 billion in assets. My client had a dissident shareholder, Larry Seidman, whose ownership had reached 9.9%. Initially, Alliance didn’t want to sell, but it eventually saw the opportunity to engage in a creative transaction that would bring a lot of value to shareholders.

At announcement, the [Alliance] transaction was priced at approximately 20 times the latest 12 months’ earnings, or $25 per share. On announcement day, the stock traded to around $33. Alliance shareholders are receiving a fixed exchange ratio of two-and-one-half shares for each share owned in Alliance. As New Haven is expected to go public at $10, each Alliance shareholder should then receive $25 in value per share. Today, Alliance’s stock trades above $40 (over a 30 P/E) and the transaction hasn’t closed yet. So in effect, Alliance is trading as a proxy for where the market thinks the New Haven shares will trade after conversion. I’m sure depositors in New Haven are pleased to see there’s an expectation in the market that New Haven will have a successful offering and that the stock may trade up 30% to 40%.

Janis: I was going to bring up the same deal from a slightly different perspective. I view the issue as risk tolerance. Doing two deals at once is extremely difficult to pull off, and I think all the parties involved have managed it very well. Alliance did a great job in terms of structuring a deal that’s up to 25% cash, although generally almost no one would take cash, and yet Connecticut did.

A similar example is the Progress Financial Corp./Fleet deal, which was an all-stock transaction. Progress wanted downside protection, so it took both a cap and a collar, which gave it a limited amount of downside protection, but in return, it lost a substantial amount of the upside. And although there was a double dip, it got a very limited portion of it.

These deals tell you something about the psychological factors and risk tolerance of some of the banks that were selling last year.

Boyan: Going back to the Alliance transaction, we were initially concerned about the complexity of the three-way transaction. You never know how things will unfold. As it turns out, there has been a lot of political pressure, particularly at New Haven, to not convert the mutual to stock. We tried to figure out how this transaction could go wrong. If the market timing wasn’t right and the transaction was delayed, then New Haven would have to wait until it could find the right market to issue the stock. So we structured an escalator in the pricing, stipulating that every day beyond March 31, Alliance would pick up a penny a share.

Duffy: Even though its shareholders are getting stock?

Boyan: Right, even though Alliance shareholders are getting stock. A penny does not seem like a lot, but the structure provides a daily incentive for New Haven to complete the transaction as quickly as possible.

Duffy: One relatively large deal in the mid-cap arena that was interesting strategically as well as in terms of the market’s reaction to it was North Fork Bancorporation’s purchase of Trust Company of New Jersey for $726 million. We represented North Fork. Strategically, it was a very important move for the bank. The board felt it was important to get into New Jersey, and I think it found something at a reasonable price. It was an all-stock transaction—North Fork’s stock actually rose on announcement, so I think both shareholder groups did pretty well.

Another deal that made a lot of sense strategically—for both the balance sheet and the franchise as opposed to just buying something cheap—was Banknorth Group’s purchase of Cape Cod Bank & Trust (CCBT). That filled in a hole in Banknorth’s Massachusetts franchise. The seller chose not to hold an auction, which in today’s environment is more unusual than it used to be. Today, due to pressure on the board, auctions, or at least modified auctions, tend to be the rule rather than the exception. This board decided to pick its partner and then see if it could negotiate a satisfactory price. I found it interesting that the board approached the situation in that way, and again, it was a very valuable addition to the buyer’s franchise. And I think the market responded reasonably well.

Both the North Fork and the Banknorth deals were all-stock transactions. An example where buyers were smart about doing a nonstock deal is the acquisition of Pacific Crest Capital by Pacific Capital Bancorp in Santa Barbara in a $136 million all-cash deal. Pacific Crest had a slightly different business model, yet I think the buyer understood what it was acquiring. Pacific Capital effectively leveraged its capital base. It could afford to do the deal and, because it was not a big brand franchise, but a specialized lending franchise, the multiple was a little less. So I give the buyer credit for taking the time to understand what it was buying and to have the courage to do the deal and utilize its balance sheet effectively. Meanwhile, the seller got a good price for its franchise, so it looked like a pretty good deal, though we weren’t involved in that one.

Hovde: One important issue is that having a presence in a growing market commands superior pricing. It’s better to be an average company in a very good market than a very good company in an average market. If you are a very good company in a very good market, it’s the perfect environment now, from a seller’s perspective.

One example is Peoples Florida Banking Corp. in the Tampa metropolitan statistical area. The Tampa market is one of the most dynamic growth markets in the country. If you look at Florida’s growth demographics, they far exceed national growth demographic projections. Then if you look at Tampa’s growth demographics, they exceed the Florida demographics. So if you are a very good bank in a very good market, you can get drop-dead pricing. In October, Peoples Florida Banking sold to Synovus Financial Corp. of Columbus, Georgia. Peoples was a high-performing bank—it was earning close to a 19% ROE and a 1.36 ROA. Furthermore, it wasn’t undercapitalized—it had a 7% capital ratio. The transaction ended up being the highest deal price last year on a tangible book multiple; at announcement it was 480% of tangible book and 26 times the last 12 months’ earnings. It also involved a buyer that was very favorable, from a social structure standpoint, to employees. So Peoples not only got a drop-dead price, but also wound up in a situation where the management team stayed involved to a significant degree.

So if you look at good companies in good markets, the pricing for sellers is outstanding. In fact, three of the highest-priced transactions from a price-to-tangible-book perspective last year were in the Florida market, which is telling. Dynamic growth markets will command higher value. And average banks in those markets can still get very attractive pricing. So in many cases, it comes down to one thing—location.

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