Does M&A Still Matter?

In 1992, Union County Bank was a $40 million institution in the Georgia hill country about an hour and a half north of Atlantau00e2u20ac”an area that was beginning to see a big influx of retirees moving south from the Northeast and north from Florida. It operated from just one location in Blairsville, Georgia, and in the words of President and Chief Executive Officer Jimmy Tallent, it was a “good bank with strong earnings and a very good reputation.”

It was in that year that Union County did its first acquisition, falling in lockstep with a trend that was sweeping over the U.S. banking industry after nearly two centuries of legal barriers that limited most banks to doing business in one state and, in some instances, just one location. Years earlier, 11 southeastern states, including Georgia, had negotiated a legal compact that permitted interstate bank mergers within the region, and fast-paced acquirers like NCNB Corp. and First Union Corp., both of Charlotte, North Carolina, had already been out doing deals.

Tallent, who joined Union County as CEO in 1984, ended up paying $12 million in cash for a small community bank in North Carolina that was something of a fixer-upper. So fix it up he did, and a few years later, Tallent used those two good banks to buy a third, a fourth, and eventually, many more. “Basically we’ve just leveraged that strategy,” he says.

Located at the very top of the state, Blairsville is within easy driving distance of southeastern Tennessee, the western tip of North Carolina and Atlantau00e2u20ac”all strong growth markets. Now known as United Community Banks Inc., the company owns a string of small banks in all those locations, as well as in the coastal region of Georgia. United Community acquired three more banks last yearu00e2u20ac”bringing its total to 24u00e2u20ac”and with assets of $5.3 billion, it is now the third-largest bank holding company in Georgia.

For Jimmy Tallent, acquisitions are an important part of his bank’s growth strategy. And while he claims that United Community does not need a steady diet of deals to achieve its corporate goal of growing earnings per share by 12% to 15% a year, there is no shortage of attractive candidates in the bank’s service area. So for United Community, M&A still matters.

Although 2004 turned out to be the best year for bank M&A since 2000, conditions over the last 12 months, including the first six months of 2005, have not been particularly conducive to doing deals. Of course, the bank merger market has always been cyclical, either driven or restrained by a variety of economic factors, and most investment bankers believe the industry’s consolidation has a long way to go for the simple reason that the U.S. still has too many banks.
“The fundamentals haven’t changed,” says Bill Hickey, cohead of investment banking at Sandler O’Neill & Partners in New York. “We still have over 8,000 banksu00e2u20ac”many in low-growth marketsu00e2u20ac”and they have to grow to earn their independence. That means they either acquire or end up being acquired.”

But if the consolidation of America’s banks is not yet over, it may be entering a more mature phase, where the large in-market deals that historically defined the market are less and less frequent. After two decades of sustained and sometimes intense merger activity, the number of potential in-market transactions has been greatly reduced. “There are fewer options just because of the math,” says Richard Blumberg, senior vice president for corporate strategy at SunTrust Banks in Atlanta.

Instead, we will probably see a greater number of market extension dealsu00e2u20ac”particularly among the industry’s largest institutions. Of the 10 largest U.S. banks and thrifts, only third-ranked Bank of America Corp. in Charlotte has a true national retail franchise, and most investment bankers expect these other leviathans to pursue their own vision of manifest destiny. But smaller institutions like United Community will also seek to expand their geographical markets through acquisition. Indeed, the industry’s demographic composition favors many of these smaller consolidators.

According to the Federal Deposit Insurance Corp., there are approximately 8,890 insured banks and thrifts in the U.S. The vast majority of these companies are smallu00e2u20ac”indeed, 68% have fewer than $200 million in assets. For the likes of United Community, that should mean a steady supply of takeover candidates.

On the face of it, 2004 seemed to be a stellar year for bank M&A activity. There were 271 deals totaling an impressive $131.5 billion in transaction value, according to SNL Financial, a Charlottesville, Virginia-based firm that collects data on the financial service industry. This compared favorably to 2003, when there were 264 bank and thrift deals totaling $72.4 billion in value. But last year’s numbers were skewed skyward by J.P. Morgan’s whopping $58.8 billion takeover of Bank One Corp. Remove that one deal and the total transaction value in 2004 would have been nearly identical to the previous year, at $72.7 billion.

There were actually two acquisition markets in 2004u00e2u20ac”the first half, when there were 132 deals totaling $119 billion, and the second half, when large deals, for all intents and purposes, dried up. Although deal flow actually increased slightly during the second half of 2004u00e2u20ac”to 138u00e2u20ac”their combined value was a paltry $12.5 billion, according to SNL. The chill was even more pronounced through the first six months of 2005, when there were just 98 deals totaling $10 billion. And if it wasn’t for Seattle-based Washington Mutual Inc.’s $6.45 billion acquisition last June of Providian Financial Corp. in San Francisco, the market’s performance would have been even skimpier.

The decline in merger activity can be traced to a variety of factors. The stocks of large and small banks traded at roughly comparable price-to-earnings ratios through the early part of 2004, when deal flow was strong, but gradually diverged as the year progressedu00e2u20ac”with the large bank group trading at a lower P/E than many small banks. This made it difficult for many larger institutions to afford acquisitions without punishing their shareholders by taking on dilution. “The price of the likely sellers got out ahead of the buyers,” says Andrew M. Senchak, president of Keefe, Bruyette & Woods Inc. in New York

Sandler O’Neill’s Hickey believes another important factor was the requirement under the Sarbanes-Oxley Act that all public companies review their financial controls and include the findings in their annual reports. Last year was the first time public companies had to make these so-called 404 certifications (named after that section of Sarbanes-Oxley), and Hickey says it became such a distraction in the second half of 2004 that many banks simply couldn’t focus on the acquisition market.

A third factor has been the tough operating environment that has confronted all depository institutions over the last yearu00e2u20ac”but has been especially challenging for community banks. As the Federal Reserve has gradually increased the federal funds rate to ward off inflation, the result has been a flat yield curve that has made it more difficult for banks to make money on their investment portfolios. “Everyone’s concerned about the current economic environment,” says Hickey. “Where are rates going to go? This yield curve has not been good for the sector. A flat or inverted yield curve has never lasted a long time, but it is very punitive to savings institutions and only slightly less so to commercial banks.” Generally speaking, banks are less inclined to acquire or merge when their earnings are under pressure.

A final consideration has been the absence of many of the large banks on the playing field. New York-based Citigroupu00e2u20ac”the country’s largest banku00e2u20ac”has a relatively small retail banking franchise in the U.S. despite having nearly $1.5 trillion in total assets, but it is operating under a set of regulatory restrictions that prevents it from doing any acquisitions at this time. J.P. Morgan Chase & Co., the country’s second-largest bank also headquartered in New York, is still focused on the integration of its Bank One deal.

Bank of Americau00e2u20ac”historically a very acquisitive organizationu00e2u20ac”has bumped up against the regulatory ceiling in nationwide deposit market share, which effectively keeps it on the sidelines. And two other large banks that made a significant number of deals in the 1990su00e2u20ac”Minneapolis-based U.S. Bancorp and Winston-Salem-based BB&T Corp.u00e2u20ac”have said publicly that they are foregoing any acquisitions at this time. Both companies stopped doing deals when investors reacted badly to some of its past transactions. The inactivity of all these banks also means that the industry hasn’t had a pacesetter over the last 12 months. Often, the presence of a rabbit in the market can spur other banks into doing deals.

Most investment bankers expect M&A activity to pick up in the second half of 2005. Eric Heaton, managing director of the financial institutions group at Merrill Lynch & Co. in New York, says historically, some of the most active periods for deals have occurred six to nine months after the Federal Reserve has initiated a series of interest rate hikes, and he believes we’re approaching one of those points now. Heaton agrees with the perception that many potential buyers are reluctant to consider an acquisition if there’s too much uncertainty about their future earnings performance. “Once the rate environment stabilizes, they are able to get more comfortable with where their own business is going,” he says. And it’s often at that point that buyers start looking in earnest for possible deals.

Brian Sterling, also cohead for investment banking at Sandler O’Neill, says M&A still has strategic importance to most large institutions. “M&A can get you additional customers,” he says. “It can get you additional products. It can help you build your management team.” Senchak at KBW expects that active acquirers like North Fork Bancorp. in Melville, New York and M&T Bank Corp. in Buffalo will continue to look for deals but may not push the process quite as hard as they once did. “More guys are becoming like themu00e2u20ac”opportunistic rather than systematic,” he says. “They still want to do deals, but they’re not going to do stupid deals.” For his part, Senchak expects to see “sporadic” activity through the remainder of the year, although the market is not totally becalmed. “People are talking,” he says. “There will be deals.”

According to several investment advisers, large banks that are expected to be active over the next few years include the likes of Citigroup, J.P. Morgan, Wells Fargo & Co. in San Francisco, Charlotte-based Wachovia Corp., and National City Corp. in Cleveland. “M&A is still an important part of their strategic plans,” one veteran dealmaker says. In fact, J.P. Morgan could return to the acquisition market in 2006. “It’s been out talking to other banks saying it’ll be back in the market in a year,” says Senchak. BB&T may also drop its self-imposed prohibition against doing deals and SunTrust might also return to the market at some point, investment bankers say, although historically, it has been a cautious acquirer. SunTrust did one deal in 2004, and its previous bank acquisitions were of a small community institution in Florida in 2001 and a large regional bank in Virginia in 1998.

But when the big deals do return, there will probably be fewer of the in-market transactions that once dominated the merger scene. Fernando Rivas, a managing director at J.P. Morgan’s investment banking operation, says large-scale in-market mergersu00e2u20ac”where competitors combine their organizations and aggressively cut redundant costsu00e2u20ac”are waning. Most large urban markets are now so highly concentrated around two or three banks that a merger between competitors would have significant antitrust implications. “Most of the deals you will see will be market extension deals,” Rivas says. “Most acquirers see multiple growth markets they would like to enter and are looking to drive earnings growth in a challenging top-line environment by cutting costs in ways that don’t hurt customer service.”
Heaton at Merrill Lynch takes essentially the same view. “I’d say there’s still a good amount of [consolidation] left to do, but it will be in a different form from what we’ve seen historically,” he says. “The Northeast is reasonably consolidated,” he says. “The West is reasonably consolidated.” And while the Midwest and southeastern U.S. are not quite as concentrated as those two regions, “There’s just not a lot of [in-market deals] left to do,” he adds. Instead, Heaton expects to see large regional players attempt to expand their franchise by moving out.

What remains to be seen is just how supportive institutional investors will be of most market extension deals. One advantage of in-market deals is that they almost always offer significant cost-cutting opportunities through the elimination of redundanciesu00e2u20ac”primarily excess branches and staffu00e2u20ac”that provide investors with a tangible strategy for improving the earnings power of the combined organization. In-market deals rarely offer the same cost-takeout potential, which forces the acquirer to justify the deal on the basis of various revenue enhancements, like selling one merger partner’s superior product set to the other’s customer base. Historically, investors have been leery of deals that base their rationale more on revenue growth than cost reduction. Says Heaton, “[In-market] deals are difficult to do because you don’t have the same level of cost saves.” Heaton adds that institutional investors are generally more skeptical of deals that are essentially regional extensions. “I doubt you’ll find many investors encouraging banks to go out and acquire,” he says.

Still, there were banks last year willing to bet on the concept of geographic expansion. SunTrust paid $7.4 billion to acquire Memphis-based National Commerce Financial Corp. The deal extended SunTrust’s footprint into North Carolina and South Carolina, and the Memphis market, while also expanding its service capabilities. National Commerce was an industry leader in in-store banking, and SunTrust actually retained a National Commerce consulting subsidiary some years ago for help when it began to develop its own set of in-store branches. SunTrust also hopes to sell its advanced trust capabilities to National Commerce’s old customer base.

True to the bank’s conservative nature, however, don’t be surprised if SunTrust waits a few years before it does another large deal. According to Blumberg, the aim of the bank’s overall M&A strategy is to “maintain or improve what we think is the best franchise in the U.S. from a growth and footprint perspective.” That said, SunTrust will continue to be a disciplined buyer. “I think we’re always open to acquisitions that make sense,” he says. “But we are careful and cautious. We’ll have some interest if the price is right, but it’s not an imperative for us.”

One of the market’s more active acquirers in recent years has been National City, which bought St. Louis-based Allegiant Bancorp in November 2003 for $475 million, then did two deals in 2004, including its $2.1 billion takeover of Cincinnati-based Provident Financial Group. Both transactions helped expand National City’s footprint into new marketsu00e2u20ac”beginning with Allegiant, which gave it a strong platform from which to build in St. Louis. “We felt very comfortable that there was an opportunity for another large player like National City to come in and grow market share,” says Armando Ramirez, senior vice president and manager of the bank’s mergers and acquisitions activities. And while it did compete directly with Provident elsewhere in Ohio, National City did not have a presence in the Cincinnati market. “We had Cincinnati surrounded, so I’m not sure that’s a true market extension,” quips Ramirez.

Going forward, National City is more likely to do market extension than in-market deals, Ramirez adds. And he says M&A will continue to be an important strategic growth option for the bank. “It is very important, especially when you look at going into new markets and extending the reach of your franchise,” he says.

On the other end of the size spectrum, United Community also will be in the market to do more deals as it looks to expand further in its tristate region. The company has a unique operating model, where its 24 subsidiary banks retain a considerable amount of autonomy within their respective markets. In fact, Tallent actively seeks out those banks where the incumbent management is both highly capable and willing to stay on and run the business under United Community’s corporate banner. “This isn’t an end game for the people we acquire,” he says.

Last year Tallent spent $73.1 million to acquire three Georgia banks with combined assets of $436 million. Acquisitions are not the only way United Community seeks to grow. When the company announced last April that it would open a new bank in Gainesville, Georgia, it was able to quickly recruit more than 50 experienced bankers to help run itu00e2u20ac”exceeding its allocations in the 2005 budget for hiring new staff. And Tallent likes to point out that United Community’s franchise territory has upward of $50 billion in depositsu00e2u20ac”of which the bank has just $4 billion, suggesting that it has plenty of organic growth opportunities.

But acquisitions will remain an important aspect of the bank’s growth strategy. Tallent cites United Community’s ambitious objective of growing its earnings per share between 12% and 15% every year. “That is first and foremost what we have to do,” he says. “And we want to fit in the acquisitions that will enable that growth.” |BD|