M&A: Opportunities on the Horizon

While this year’s pace for mergers and acquisitions is hardly record breaking, several factors are luring banks back to the negotiating table, signaling a possible end to the recent lull.

For one, acquisitive banks in years past may be awakening from their relative hibernation. San Francisco-based Wells Fargo & Co. announced in May a deal to purchase Seattle-based Pacific Northwest Bancorp. And money-center and superregional banks such as Wachovia Corp. and J.P. Morgan Chase & Co. have said publicly that they are open to deals.

Meanwhile, a number of converging events are compelling banks of all sizes to mull over either buying or selling. Lower interest rates have crimped margins, putting pressure on banks to sell at a premium or buy another company to boost revenues. Higher stock premiums and dirt-cheap financing costs have made acquisitions all the more alluring. Foreign buyers continue to view acquisitions in the United States as a way to grow quickly. And market saturation is still the rule, with more than 7,000 banks in the country.

“What we will see is a continued overall competitive pressure to consolidate,” says Andrew Senchak, president and co-head of the investment banking group at Keefe, Bruyette & Woods in New York. “Companies will take advantage of their ability to compete, expand, grow earnings, or renew management. Or they will capitulate.”

At first glance, the pace of recent merger and acquisition activity would hardly qualify as the basis for a new reality television show. So far this year, merger activity has been flat versus 2002. Through mid-June, there were 88 deals announced year-to-date on volume of $8.9 billion, versus 97 deals worth $9 billion for the same period in 2002, according to SNL Financial, a research firm in Charlottesville, Virginia.

Yet dealmaking may soon come back into vogue. Banks formerly occupied with integration of past acquisitions are once again buying. Winston-Salem, North Carolina-based BB&T Corp. announced in January it would purchase First Virginia Banks of Falls Church, Virginia for $3.4 million in stock. Wells Fargo will pay $591 million for Pacific Northwest Bancorp, and Philadelphia-based Sovereign Bancorp said in June that it would buy First Essex Bancorp of Andover, Massachusetts for $400 million.

There are further rumblings just beneath the surface. Investment banks are predicting a stronger second half, thanks to a spike in contracts they sign to advise banks on services such as valuation, market analysis, and helping institutions decide whether to buy, sell, or focus on organic growth. In general, activity at Ryan, Beck & Co., an investment banking firm in Livingston, New Jersey, was twice as high in June as it was in January and February, according to Ben Plotkin, chairman and chief executive officer. “It’s a forward indicator,” he says. At Hovde Financial, merger and acquisition advisement is at a clip not seen in 12 to 18 months, according to Stephen Nelson, a principal at the investment banking firm’s Chicago office. That’s in part due to more realistic expectations on either side of the transaction, as the bid and ask spread between buyers and sellers has also narrowed. “Historically, that is one of the things that had slowed things down,” Nelson notes.

Another catalyst for more dealmaking is margin compression. The Federal Reserve’s aggressive rate cutting has taken its toll on bank earnings. The most recent cut of the federal funds rate in June to 1% will take another chunk out of future profits. “That is absolutely going to hammer some of the earnings in the ’03 and the ’04 outlook for many smaller regional banks,” says Thomas K. Brown, chief executive officer of Second Curve Capital, a New York hedge fund firm. Many banks will be hard pressed to go it alone, adds Plotkin: “If your outlook for earnings growth is lower, then it makes you more willing to be a seller, because you can’t otherwise justify financial independence.”

The lower interest rate environment also motivates buyers. With lower margins, companies are looking to the old formula of growing earnings by snatching up other institutions. “Revenue growth is very, very, tough,” says Frank Conner III, a partner at Alston & Bird, a Washington, D.C. law firm. In many instances, “it is much easier to buy a book of business and cut out the excess capacity, extract the cost savings, and improve your earnings.”

The Sarbanes-Oxley Act is another motivating factor for smaller banks to find buyers, since the law adds another layer of regulations for some institutions. “Certain cases are somewhat exacerbated,” Conner says. “It is becoming increasingly difficult from both an operational and regulatory context.”

Meanwhile, deals have become easier to finance for acquirers. Lower interest rates make servicing debt cheaper than ever. Raising cash through trust-preferred securities is now a widely used vehicle, as banks can count the issuance as Tier 1 capital. Also, the value of stock at large banks overall is gaining on that of their regional peers, making stock purchases a more palatable option. For the top 12 banks, average P/Es are 12 times 2004 earnings, versus 12.5 times for the next group of 35 banks, according to Second Curve Capital. Two years ago, large banks trailed the regionals by about 2.5 multiple points.

If a spate of mergers is indeed on the way, the difference this time around is that expectations are far more modest than in the acquisition wave of the late 1990s. The large buyers “are not looking for major, blockbuster-type transactions,” Conner says. “They are looking for smaller transactions to fill in existing franchises that would not be subject to the scrutiny and concern of the marketplace. Very large transactions that are pricey continue to run into significant resistance in the analyst community.” Case in point: the recent Wells Fargo deal with Pacific Northwest, a $3.1 billion-asset bank. Wells Fargo, with $370 billion in assets, would pay $35 a share, at a 23% premium to Pacific’s closing stock price the day of the announcement. The deal, expected to be completed in the third quarter, would give Wells 58 more branches in Washington and Oregon, strengthening its presence in the Northwest.

Experts expect more deals like this to follow. “The regionals are looking at acquisitions of much smaller institutions because they want to grow their retail franchise, and they realize that a small transaction has a lot less risk in it,” Ryan Beck’s Plotkin says. For example, Sovereign’s purchase of First Essex would give it 20 branches, bring it to $1.1 billion in deposits, and make it the biggest bank in New England markets such as Salem, New Hampshire and Lawrence and Lowell, Massachusetts. While Sovereign agreed to pay 286% of tangible book value in the transaction, the deal is much smaller than its $1.4 billion purchase of 278 branches divested by Fleet Financial Group and BankBoston Corp. after their 1999 merger.

Prices paid will also be more modest. Deals will likely have premiums in the 20% range, down from 30% to 40% in years past, says Brown of Second Curve Capital. Banks in growth states such as Florida, California, and Texas will fetch a bit higher prices. F.N.B. Corp, a Naples, Florida, bank with $7.8 billion in assets, announced in February it would purchase the $700 million Charter Banking Corp. for $150.3 million in cash. F.N.B. paid 3.9 times Charter’s tangible book value for $3.4 billion in assets in 61 Florida branches. That ranked it as one of the most expensive deals in Florida in the last five years for banks in Charter’s size category. Other southern states may exhibit more expensive deals such as BB&T’s purchase of First Virginia Bank. In that transaction, expected to be completed in the third quarter, BB&T paid 3.2 times tangible book value, giving it 364 more branches in Virginia, Maryland, and east Tennessee.

Some banks are selling off branches to concentrate on more profitable operations. Northern Trust Corp. revealed in April that it would sell one of its Chicago branches to First Midwest Bancorp of Itasca, Illinois, saying it would redeploy the capital to areas with greater growth potential. Similarly, smaller banks with rural footprints are selling off less active branches and migrating to more profitable growth areas, such as suburbs and urban markets, says Nelson of Hovde. For instance, Gold Banc Corp. reported in June that it would sell two Kansas branches to Labette County Bankshares of Altamont, Kansas. Gold Banc, a $4 billion institution based in Leawood, Kansas, has been retooling its branch network to concentrate on high-growth areas. Banks such as Gold Banc “eventually realize they need to access some higher-growth markets, whether it’s suburban or urban areas, from a lending perspective,” says Nelson. Meanwhile, other banks are simply concentrating on their footprint. Huntington Bancshares, a $26 billion bank in Columbus, Ohio, announced in February that it would sell four of its branches in Martinsburg, West Virginia to First United Corp of Oakland, Maryland. The four branches in Martinsburg are essentially marooned from the rest of its core branch system in the western part of the state, a three-hour drive away.

Acquisitions by foreign banks of U.S. institutions will likely continue. Royal Bank in Canada expects to speed up its expansion plans south of the border in the wake of signals that the Canadian government would not approve any big mergers within the country for some time. Royal Bank has spent roughly $5.5 billion buying U.S. financial institutions since 2000. Other foreign banks such as Netherlands-based ABN Amro, through its subsidiary La Salle Bank in Chicago, and Royal Bank of Scotland, through its U.S.-affiliate Citizens Financial Group in Providence, Rhode Island, are poised to do more deals, too, as the fragmented American market offers a strong growth channel. “There is an opportunity for them to pick up significant size and scale,” says Brian Sterling, principal and co-head of investment banking at Sandler O’Neill & Partners in New York. “The opportunities here exceed those they have in their home markets.”

In all, expect a stronger second half of 2003 for mergers and acquisitions. “The drumbeat is getting louder,” says Brown of Second Curve Capital. “We are getting better alignment now.”

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