The Right Deal at the Right Time: Strategic Opportunities for 2005

Timing is everything in the acquisition market and 2005 holds some interesting possibilities for opportune buyers. In this roundtable, the industry’s top dealmakers discuss bank market conditions, buyers’ and sellers’ expectations, and a few of the year’s best deals and why they worked.

Bank Director: What’s ahead for bank valuations? Have we reached the peak?

Mike McClintock: Our view is that bank stocks generally perform in lockstep with interest rates. They outperform when rates are declining and they underperform when rates are rising. So with rates moving up, that’s going to have a negative impact on valuations.

Bill Hickey: I think the biggest concern for all banks this year is the flattening yield curve, which gives bankers pause about putting a lot of assets on the books at current levels. The other issue is that fundamental deposit growth is very challenging–it’s back where it was prior to 2000/2001. We’re emerging from a period when there were very low interest rates, a lot of deposit growth, and many people got out of the stock market. But now with rates rising a bit, and the equity markets showing signs of life, deposit growth is going to be really tough to come by. So that, together with a flattening curve, doesn’t spell a great year for valuations.

John Duffy: On the valuation issue, I’d split it. The larger banks, we think, are fairly valued. There may be some upside opportunity. As you go down the size ladder, though, takeover speculation has crept into the prices and there are more examples of banks being overpriced–the small caps are trading at the biggest premium relative to the large caps as they have in 10 years. Usually that’s a pretty good signal that you’re at the top–or very close to it. So I can’t paint the entire group–even the entire small-cap group–with one brush. In fact, there are some great success stories of small banks that have had very good growth. Sometimes this has been because of the demographics of the region or because they are getting fallout from some large bank mergers. So I don’t think every bank in the small-cap group is overpriced, but for many, I don’t see where the earnings growth will come from in 2005. We’ve actually seen that reflected in some recently announced deals–the premiums aren’t particularly robust because the targets have already been “bid up,” so to speak.

Steve Hovde: My sense is we can probably maintain where we are through at least the first six months of 2005, but as we move toward fall, there could be some signs of slowing. Obviously no one has a crystal ball, but the last time we peaked was in ’98, and after that, it got pretty slow. Where I think there is still good opportunity is with some of the smaller banks. A lot of California banks have very heavy noninterest-bearing deposit levels: 20%, 30%, 40%, 45%. They are actually doing pretty well in this rising interest rate environment. But in general, and certainly in the thrift industry, it’s not going to be as favorable as it’s been.

Duffy: I’ve got a little different view. I think the first half of the year may be slow because valuations are still high, and I don’t see buyers who are in a rush to pay those prices, so we might be in a bit of a gridlock. However, with the passage of time, maybe even more than six months, I think sellers’ expectations may moderate. It depends on what happens to stock prices, and that obviously depends upon earnings and interest rate levels.

Hickey: I would agree with that, John. Because of the issues associated with Sarbanes-Oxley, Section 404, the Bank Security Act, and the USA Patriot Act, we may have a lot of bankers who decide that the cost of competing and the regulatory burden is just too great, and you’ll probably see some go-dark [going private] transactions–although those are very difficult to do. But I believe where we will see some M&A activity is from folks who are spending a half a million dollars on regulatory expense on a $500 million institution and then realizing they can’t be competitive. So some activity may occur with small institutions because of that regulatory burden.

Kerrie MacPherson: Also, the weak dollar certainly makes it a lot easier for the Europeans to come in and build up footprints–there’s plenty of that going on. We are also starting to see a lot of activity with U.S. institutions looking at South America and Latin America, which had slowed for a period of time. So that seems to be coming back, too. There will be ups in some areas and downs in others.

McClintock: Statistically, if you look at M&A premiums, 1986 was a big peak, 1998 was a big peak, and 2004 was another peak but there are a lot of years between each of those peaks. So if rates stay flat, we may have more activity. I also think if you’re a small-cap company, it’s a great time to think about going public because investors love the growth and income stories. But when it comes down to it, right now all the big buyers are folding their hands and the sellers still have big expectations, so I don’t see a great deal of activity.

Duffy: I agree, there’s a dearth of interest on the part of big banks looking at smaller players. There’s always an exception or two, and we might see some big deals, but those are harder to predict. As you go down the size ladder, the ability of the larger banks to do deals is a lot weaker than it was a year ago.

Hickey: Valuations are bifurcated at the current time; the large caps are trading at 13 times earnings and the small caps are trading at 16 times. I think we’ll see activity among like-sized companies. Does that mean another round of MOEs? Maybe, but certainly what we can say is that like-sized companies can afford to buy each other. But I also think you’re right, John, I don’t think we are going to see any other really big deals. They can’t–when you are trading at 12 or 13 times earnings, it’s tough to pay 20 times earnings. The math doesn’t work real well.

Bank Director: Are there regional pockets that appear to hold more opportunities?

Hovde: It comes back to growth demographic markets. With high-growth demographics, you can afford to get higher prices. Florida in ’04 was a massive market with high pricing. We did 11 deals there–an all-time high–and I think the dynamics are still good there for a bit because the demographics are so strong compared to the rest of the country. Texas is another market where you can still get pretty good valuations if you are a seller. I think there are pockets in California, and in the urban areas of Tennessee. And, interestingly enough, even though Chicago has been a laggard and has never been able to reach the pricing multiples found in those other markets, Chicago (relative to what Chicago has been historically) has opportunities. There’s simply way too many banks there and still a lot of buyers.

Hickey: Another good market is in the Southwest. It’s interesting, in Nevada and Arizona–where there weren’t any banks five to eight years ago–now there’s a lot of de novos. And while they’re not quite on the radar screen, there’s a ton of $300 million, $200 million, and smaller banks that are going to do IPOs. When you are talking about demographics, these markets look pretty darn good as well.

Duffy: Some of the markets where there has been activity are those where there’s been a lot of fallout from large banking transactions. Bank One has given up enormous market share in some of its markets, including the Southwest. There are a lot of little guys that are five to 10 years into it, and now that they are reaching several hundred million dollars, they are getting big enough to start thinking about doing deals themselves.

Hovde: This is a little different take on your question, but it’s still pertinent. A wealthy family asked me the other week, “If you could pick any market in the United States and invest $15 million and have a 10- to 15-year hold period, assuming you can find good management, which market or markets would you pick to start up a new bank?” Part of it goes to the same question you had as to what regions are hot. Mike, where would you pick if you had $15 million to invest?

McClintock: I would probably argue for Texas over Florida just because it seems to be going great guns and doesn’t have the infrastructure issues that Florida has–Highway 95 South is just jammed; it’s a nightmare.

Hickey: It’s a tough call because if you have $15 million invested in four or five markets, your returns will vary based on the skills of the management team in place. I’d rather say, “Here’s the right management team, let’s raise $50 million around them.” While it’s great to be in good markets, it’s people that drive profitability–the people running the show. You can raise a lot of money around good management.

Duffy: I’d pick any growth market where there’s been consolidation among the big players, and if they’re owned out of state, better yet. Phoenix is a pretty good example of that. Houston would have been 10 years ago, but the start-ups are now of reasonable size. I think you still have that opportunity in Florida. It’s not as good a commercial base as Texas probably is, or maybe Phoenix, and it may be too dependent on real estate, but if you went in there and added a successful bank and put a wealth-management piece or an asset-management piece with it, the demographics would really work in your favor. But there are no big, state-centered banks there. Everything is being run from five states away and with a focus on large business. So if you offer reasonable service to small and mid-size business accounts, the growth potential is probably pretty good.

Hovde: In the Midwest, you’ve got a lot of either privately held or closely held banks building capital, and a lot of them are wondering if the grass is truly greener on the other side. So they are looking in the Southwest or the Southeast to either open a de novo or try to buy a small bank. It all comes back to the demographics and the growth market.

Duffy: Back to your point, Steve, about there being too many banks in Chicago. And yet, if you talk to 90% of the guys out there, they are doing pretty well. Why? Because Continental is not around, First Chicago is not around, and ABN Amro is owned by guys 5,000 miles away, so they probably don’t feel like there are too many banks. They’d probably prefer less, but they are all making decent money. It’s a good market, and you don’t have any dominant player in there.

So even though it’s not a growth market, in the same context of a Florida or a Texas, it’s got pretty good demographics.

Hovde: You’re right, you don’t have any great competitor with JPMorgan/Bank One. But we did an analysis of net-interest margins in Chicago and, because of the large number of competitors compared to other parts of the country, they are almost a full 100 basis points lower. And it’s just because so many community banks are beating the tar out of each other. The other big dynamic is that Washington Mutual came into town roughly two years ago and opened up 170 branches. Everybody went de novo crazy to protect market share! So there are 500+ branches either on the drawing board or already opened, and they are paying up for deposits.

Duffy: There are a lot of markets in the Midwest where depositor growth has been pretty anemic and the banks have had to rely more on borrowed funds.

McClintock: There are just tons of de novos in every market. I’d love to invest in Hartford–there are seven de novo banks in greater Hartford. That is a lot of de novos.

Duffy: It’s not the most exciting market, but it does meet the definition where market share is being controlled out of state.

McClintock: It will just take longer to get the return.

Hickey: When you look at the New Jersey de novos, approximately half of them will make it. Of the 10 de novos, I will say that four will reach maturity and the other six will be merged or sold.

Bank Director: So the tremendous growth in de novos is going to jumpstart pure financial–as opposed to strategic– consolidation in many markets?

Hickey: At 8,000+, we’re still overbanked. We had 13,000 banks in 1990, and everyone thought there would be half that many by this time or even less than half, so certainly de novos have slowed the pace of decline in the number of banks.

Bank Director: Could you each share an interesting case study from the past year that is instructive in terms of a deal that increased shareholder value?

Hickey: Perhaps Steve should talk about his Florida deal.

Hovde: I presume you are talking about First National’s deal with Fifth Third in Florida. That one goes back to the issue of hot markets and demographics–if you look at the demographics of the west coast of Florida compared to the demographics of Ohio, they are dynamically greater. Obviously at 628% of tangible book value and 27.8 times estimated 2004 earnings, the price was pretty steep, but I think the growth potential of First National over time supports the price. I know many people debated that, but it is a good market and if Fifth Third can execute, there is a lot of opportunity.

Hickey: We had an interesting one in Florida as well, when FloridaFirst Bancorp announced its intention to sell to BB&T before the OTS-required three-year limitation was truly in force. Unfortunately, the restriction was enforced during that period of time. FloridaFirst had to wait a year, and then it ultimately did a transaction with SouthTrust at a fixed-price floating-exchange ratio. Then, lo and behold, four months later, SouthTrust is acquired by Wachovia. This shareholder group has been up and down the track but finally ended up with a deal that is about 40% greater than the deal announced at the beginning of the year. So while it was an emotional roller coaster, at the end of the day, the shareholders of FloridaFirst enjoyed a pretty good ride–the classic double-dip scenario.

Duffy: Focusing on larger deals, in three of the 10 or 12 largest deals last year, the acquirer’s stock price actually outperformed the bank stock market since the day before the announcement. One of the three deals was Toronto Dominion/Bank North. TD’s stock has done well because the bank is expanding outside Canada, where the five biggest Canadian banks are bumping into each other. The government isn’t going to change the law so TD decided to head south. This was a logical move for TD, and it’s been well received by the market.

The one that surprised me a little was the announcement of the Wachovia/SouthTrust deal, which has outperformed the market. There’s significant overlap, and while they paid a large price, it wasn’t off the chart. They paid a large price for a good franchise and the target was a good company, so I think the market is perceiving relatively low integration or execution risk. And [G. Kennedy] Thompson at Wachovia has convinced the market he is a more disciplined acquirer than his predecessor.

The third deal was National City Corp./Provident Financial, which I think is an example of an acquirer buying something relatively cheap–at least relative to other large deals. Nat City got major market presence in a good market–Cincinnati–and while the target was a marginal performer, with Nat City being in the same geographic area, the market feels it will be able to raise the performance of the target fairly easily. So those are a few of the reasons why those three stocks have done well.

Hickey: And Nat City looks like a pretty good investment right now, at least on a relative basis. It is trading at 11 times earnings, so it’s apparent the market isn’t loving the mortgage business right now.

Duffy: But it has done a better job of managing than Wamu or others.

Hickey: National City has a low earning multiple and excess capital, so it will be tough for Nat City to do an all-stock deal, but it’s a currency I would want as a seller. As we all say, if you sell a bank, you really don’t sell it if you sell it for stock–you’re investing in another bank.

Hovde: Another one we like, again out of Florida, is the deal on the west coast between Premier Community Bank (PCB) and Colonial. Interestingly enough, PCB was a relative de novo that has really grown up over the last eight years to what was about $700 million in assets at the time of the sale in December 2003. The deal was a stock transaction at a mid-20 PE and about 430 in tangible book. We took stock in Colonial when it was trading at 17 and now, roughly half a year later, it is trading at 22. They both had a pretty significant price up front, had some good price appreciation in the acquirer’s stock, and the dividend flow off Colonial’s stock was about 80% of earnings. So it was a nice dividend flow, nice stock appreciation, a good price, and a lot of liquidity. And Colonial could very well be the proverbial double dip down the road some day.

McClintock: In terms of megadeals, I would bring up BofA/Fleet. Who would have thought that a bank merger would reach the national deposit cap? That to me is just mind-boggling. And then there’s J.P. Morgan buying Bank One–where JPM basically turned the keys over to another management team, which I also think is earth-shattering. It is surprising for an acquirer to say, “I’m buying you, but why don’t you take it over?”

Hovde: In Chicago, where I’m located, a lot of Bank One shareholders were not pleased with that transaction. They viewed it from the Bank One end as selling out cheap simply to attain the senior management role for Jamie Dimon at JP Morgan. And when you compare Bank One’s price to what Fleet got out of BofA and you look at other large deals, did Bank One have to sell at that point in time and at that price? Did Bank One have to go with J.P. Morgan? A better hookup might have been with Wells, for instance.

Duffy: The stock hasn’t done well. The shareholders have reason to be upset.

Bank Director: How does a board determine when it is time to pursue an acquisition or external growth strategy versus focusing on internal growth? In terms of what everyone has been saying about the M&A market this year, is this a better time to focus on internal rather than external growth?

Hovde: Some privately held banks are saying they will wait for the market to cool off and hopefully do some cheaper deals down the road. One banker I spoke to says he is hoping for an economic hiccup so things will get cheap again and he can make acquisitions then. So that’s the case for privately held companies that can just hold their capital and wait. Another nonpublic company we work with has a family with a controlling interest and 150 other smaller shareholders. The bank has excess capital. The controlling family asked whether, as an alternative to using the excess capital to buy somebody else, they should look at it as an acquisition of the rest of our bank, and just pay a fair value to the other 150 shareholders. It would pay a full, reasonable takeout price and use its capital that way, rather than go out and pay somebody else full value. The owners’ position is, “We like our bank and we like how it is doing. We have a build-up in capital, and so we’ll turn to our existing shareholders and basically go more private.”

Bank Director: How did you respond to that?

Hovde: We supported the idea. He’s got to treat his existing shareholders fairly and yet pay a reasonable price.

Duffy: It may not be the highest return, but if you don’t think you can go out and acquire, if you don’t have the management team, if you can’t execute, it’s a lot simpler to buy out some minority shareholders and retire the capital. It may not be as sexy, but it may be the smartest thing to do. And I also agree with what was said earlier: There are some companies that are just going to say, “To heck with this.” There’s just so many regulations, and they don’t want to hire a person simply to do compliance with 404 and Sarbanes Oxley, not to mention the Bank Secrecy Act and the Patriot Act. For the small public companies it’s a big nut to cover.

Hickey: A lot of banks don’t have a choice today as to whether or not they do an acquisition. Companies are sold–they are not bought. We all work with boards that take their budgeting process and their strategic planning process very seriously, but there comes a point where the companies that realize they can’t grow their earnings at an acceptable rate are going to see themselves as sellers. What I see, from a practical perspective, is boards don’t like to throw in the towel until they’ve evaluated all of their alternatives on the buy side. But you don’t have the luxury of making someone sell–ultimately, companies sell because they have exhausted their other opportunities as buyers. And I think it is an astute board that realizes when the bank is not meeting its hurdle rates of return and it can’t buy; it is better to sell to provide value to their shareholders. So it’s great to be an acquirer if you can be one, but a lot of companies find that very difficult to do today.

MacPherson: I agree. To be a buyer, you have to have your own house in order and you have to have incremental management capacity. But then, what if your next-door neighbor is for sale? That’s the scarcity factor–the kind of opportunity you have to jump on. So you also have to be opportunistic if the moment arises.

Duffy: M&T is an example of a disciplined acquirer that is not afraid to buy when things are cheap. On the other hand, there are so many institutions that, when acquisitions are in the news, feel the pressure. So sometimes I think the need to do deals is board-induced. I wouldn’t place the blame on management’s shoulders all the time. Sometimes the board thinks, “Gee, the bank in the next town bought somebody, why aren’t we buying somebody?” But the bank may not be prepared. It may not have thought about whether prices are reasonable or not. Even so, they want to get in the hunt and they want to win, and sometimes they wind up overpaying. A board like that doesn’t understand its own capacity to pay and hasn’t really thought about why one target is more valuable than another.

MacPherson: Generally I get involved with our team for the first time after there is a letter of intent, so already, the wheels are in motion and people are in love with the deal. So much of the time, the most important thing we bring to the table is the willingness to ask the tough questions. Someone has to wear the black hat because once the board understands the diligence, it sometimes turns out the directors don’t want to do the deal after all.

Duffy: The bottom line is, a bank’s strategic position may be weak, but that is not a valid excuse to do a bad deal.

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