The Sweet Spot: Midsized Banks Reshape the Landscape

One of the most interesting trends in the banking industry today has little to do with the well-worn topics that have been discussed and debated over the past few years. It isn’t about technology, interest rates, regulatory relief or too-big-to-fail banks. It’s instead about a handful of rapidly growing banks with $10 billion to $50 billion in assets that are in the process of reshaping the landscape of the regional banking space.

“There’s an ascendant group of community banks that are doing very advantageous deals because they have highly elevated currencies,” says veteran bank analyst Nancy Bush. “These banks have high valuations, so every time they do a new deal, they get a lift to their tangible book value. It’s a virtuous cycle that I’ve never seen before in banking.”

Over the past nine years, Bank of the Ozarks has grown its balance sheet by a factor of six, going from $3 billion in assets on the eve of the financial crisis up to $19 billion today. This growth has been fueled by a series of 15 acquisitions, extending the reach of the Little Rock, Arkansas-based bank throughout the Southeastern United States, as well as into Texas, California and New York.

An aggressive acquisition streak like this would ordinarily weigh on a bank’s valuation, as sophisticated investors are wary of deals. “The history of this industry, and the history of corporate America, is that the majority of acquisitions, something greater than 60 percent, fail to add value,” says Tom Brown, founder and CEO of hedge fund firm Second Curve Capital.

This isn’t an issue for Bank of the Ozarks, however, given its successful track record when it comes to mergers and acquisitions. By structuring its deals as all-stock transactions, Bank of the Ozarks has benefited from the fact that its stock trades for a premium to its peers-priced at 2.0 times book value compared to the median multiple on the KBW Nasdaq Regional Banking Index of 1.7, as of early July. This helps explain why Bank of the Ozarks’ book value per share increased 42 percent in 2015, as all three of the deals it entered into that year, one of which was its largest ever, were financed with its highly valued stock and designed to be immediately accretive to book value per share.

Another bank that fits this profile is Nashville, Tennessee-based Pinnacle Financial Partners. In the wake of its latest deal, a merger with BNC Bancorp, a $7.4 billion asset bank headquartered in High Point, North Carolina, Pinnacle’s pro forma assets now exceed $20 billion. That represents a fivefold increase in nine years. Yet, Pinnacle’s shares continue to trade for a premium to its peer group-1.86 times book value per share as of July 3, 2017.

“We’ve got an advantage stock, and it has been rationally deployed,” Pinnacle CEO M. Terry Turner said on a conference call late last year. “We are fundamentally an organic grower at heart, that’s what we think about, that’s what we love to do. But we do have an advantage stock and that puts us in a position to create even more operating leverage and even more [earnings per share] growth, which we believe we’ve done.”

One more bank that investors put into this category, though its stock trades at a more modest premium to book value, is Prosperity Bancshares, a $23 billion asset bank headquartered in Houston, Texas.

“They are in the business of buying banks, and they are very good at it,” says Dory Wiley, CEO of Commerce Street Holdings, an investment bank and advisory firm. “David Zalman, the chairman and CEO, can go to the street and say, ‘I’m going to start buying banks,’ and investors are comfortable with it because he’s got a good track record and because he’s been able to keep his earnings stream going and his multiples high for not one, two or three years, but literally for two decades.”

“There’s a lot of enthusiasm for these stories,” says Bush. “They’re the growth stories in banking right now. It’s not at the top, it’s in the middle.” Bush’s point is underscored by the fact that the nation’s largest banks, those on the KBW Bank Index, trade at an average of 1.4 times book value per share, which is meaningfully less than the 1.7 average multiple among midsized regional banks on the KBW Nasdaq Regional Banking Index.

Banks are benefiting from this increase in value to do deals, but it’s worth noting that it’s not just the banks making acquisitions that benefit from the prevailing enthusiasm. Potential acquisition targets have also seen their share prices, and thus valuations, respond favorably.

Michael Perito, an analyst at investment bank Keefe, Bruyette & Woods, points to an inflection in banks stocks following a pair of deals in the big banking space. The first was Royal Bank of Canada’s purchase of City National Corporation in 2015. Shareholders of City National received a 50 percent premium to the bank’s pre-announcement share price. The second was Columbus, Ohio-based Huntington Bancshares’ acquisition of FirstMerit Corp. the following year, which was done at a 30 percent premium to FirstMerit’s pre-announcement price.

Before the City National acquisition was announced, the KBW Nasdaq Regional Banking Index was down 10 percent year to date, which compared at the time to a 1 percent drop on the S&P 500. But in the month following the announcement, this gap fell to under 3 percentage points, despite an absence of other fundamental reasons for the improved outlook for bank stocks relative to the broader market.

“The financial stocks were underperforming dramatically into those deal announcements, and then the conversation changed,” says Perito. “All of the sudden it was difficult to get too negative in a space that is still in a very active consolidation cycle.”

After this story was prepared for publication, Bank of the Ozarks stock fell more than 11 percent when news broke that Dan Thomas, vice chairman and head of the real estate specialties group, had resigned.