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The New (Lower) Normal for Deal Pricing

Banks looking to sell may have missed their window of opportunity to fetch high valuations for their franchises.

Until recently, a healthier financial industry and several years of sustained bank profitability led to increased stock valuations, which translated into higher M&A pricing when those banks were sold. Buyers felt comfortable paying higher valuations as long as the deal offered two things investors looked for: high single-digit earnings accretion and tangible book value dilution that was less than three to five years.

Now, the bar seems to have been raised for investors when it comes to deal math. And that could result in deals with lower valuations.

“If your intention as a small bank was to maximize the price you’re going to get in an M&A deal, and you wanted to do it ahead of the next downturn-you missed your window to maximize that value in this cycle,” says Joseph Fenech, managing principal and head of research at Hovde Group. “We hit an inflection point last year in terms of how deals are treated by the market.”

Deal activity and prices for 2019 are lagging 2018’s figures. The average price to tangible book value for 2019 deals through May was 165 percent, down from 175 percent for all of 2018, according to a May report from investment bank FIG Partners. In the report, FIG Director of Research Christopher Marinac noted that this year is on pace to have 17 percent fewer deals than 2018.

In the new pricing normal, buyers’ stock now reliably underperforms in bank indexes for up to a year after their deal announcements, according to Fenech. This is happening even if the transaction hits the dilution and accretion targets that kept investors happy for years.

Investors are worried about the risk that acquirers are taking on at this late stage of the credit cycle. They doubt that banks will be able to hit their forecasted forward earnings figures. The post-deal, pro-forma bank must book the costs and dilution of a deal immediately, while the potential future upside of a transaction now has greater uncertainty.

“Simply checking the box on an acceptable level of tangible book value dilution or earnings accretion-that’s no longer sufficient” to predict how a buyer’s stock will react after announcing a deal, Fenech says.

In response, Fenech suggests that buyers and sellers perform more extensive due diligence on each other to ensure they’re not inviting unnecessary risk that could transform into surprise losses once the economy turns. He says it’s more important than ever for sellers to think about the quality of the buyer’s currency they will acquire. It’s critical that sellers pick a partner with a sustainable business model that performs well through the entire economic cycle-and not simply the buyer with the highest offer.

ATMs Face Their Own Y2K

Banks are flirting with a pivotal deadline for the security of their ATM networks.

About 95 percent of the 410,000 ATMs in the United States run on Windows 7, software that Microsoft released in 2009 and will no longer be supported starting in January 2020. That means a large swath of ATMs could become more vulnerable to security breaches, not to mention missing out on other important updates central to their functionality.

Big banks like JPMorgan Chase & Co. and Bank of America Corp. are estimated to have more than 15,000 ATMs, while the average community bank may have 10 or less.

Surprisingly, upgrading their ATM operating systems may not be a high priority for most banks, given that only about 5 percent of ATMs have migrated from Windows 7 to the latest version, Windows 10. The slow pace of migration is driven by the availability of the operating system and service engineers who are required to install the software, writes Carol Specogna, vice president of product strategy and card services at Fiserv, in an email.

Specogna expects migration rates to dramatically increase, hitting 40 to 50 percent within the year.

Moving to Windows 10 may help reduce the risk of cyberattacks and attempts to physically tamper with the machine. It will also close some malware vulnerabilities that were in the previous operating systems.

Upgrades like this are expensive and time-consuming for banks. She says companies may need to create new images to use in the system’s interface or customize various aspects of the software. Banks may find that it’s more cost efficient “to ride an older operating system to the very end,” says Specogna, and pay extra for extended support through January 2023 for Windows 7 from Microsoft. Microsoft will sell support on a per-device basis, and the price will increase each year. Without the extended support, ATMs running Windows 7 will miss out on all future critical security updates.

The migration and potential future updates to ATM networks may also convince banks to outsource this task to an ATM managed service. A managed service could help a bank with this major software upgrade, but also add more consumer features and functional enhancements in the future, Specogna says.

Correction: Gita Thollesson’s last name was misspelled in a Viewpoint article that ran in the second quarter 2019 issue, titled “Why Great RMs Matter So Much.” We regret the error.