Analyst Forum Interview: What Investors Want in M&A

1-22-14-analyst-forum.pngBrad Milsaps is managing director with Sandler O’Neill + Partners, L.P. in Atlanta covering small and mid-cap banks, mostly in the Midwest and Texas. He talks about M&A deals in his coverage area, what size banks are most likely to acquire, and what investors like to see in a deal. A shorter version of this interview appeared in the first quarter issue of Bank Director magazine.

What kind of M&A activity are you seeing?

The bulk of the activity has come from the west and Texas. They had better earnings multiples and the banks they were targeting had better asset quality [than other parts of the country]. It was easier to make the deals work. Most recently, ViewPoint Financial, Independent Bank and Prosperity Bancshares have all been very active acquirers. M&A for the largest banks is really not in the cards. The regulators are not going to allow those banks to get larger. What you are seeing is the emergence of these super-regional banks, the $2-billion [asset] to $25-billion [asset] banks are the ones with the best currency because efficiency is so much more important now. They have the currency to acquire and they can go in and get cost savings pretty easy.

What about the level of deal activity?

The deal activity is kind of on pace this year with last year. Our hope is it accelerates. I think it can as other markets get healthy. As Florida and the Pacific Northwest continue to get better, their banks will get better currencies. The banks that could sell will see asset quality continue to improve, and I think you will see more deals.

How has the market perceived the deals on the banks you cover?

Generally the reaction has been pretty positive. The Texas market deals have been very well received. The Texas banks get a premium to everywhere else in the country but they are still trading at less than before the financial crisis.

What do you look for in a deal?

First and foremost, you look at pricing. What are you getting for what you paid? I look at tangible book value dilution. What are the strategic merits? How much earnings accretion will the buyer get out of it? What is the driver of that earnings accretion? If you are making a lot of assumptions about the target’s growth, those deals I’m less enthused about it. You don’t know what’s going to happen in the future. If you lay the maps over each other and there is overlap, there are easy-to-see cost savings, and you take some capacity out of the system, those are my favorite deals.

Is M&A thawing?

The acquirers are telling me there are a lot more conversations. A lot of the social issues are tough to work through. What happens to the executive management team of the target? If they don’t own a lot of stock, what’s the incentive for them to sell? Those have historically been the big stumbling blocks. But to the extent the regulatory environment is the way it is, more costs are getting driven down to the smaller institutions, your costs are going up and to earn a reasonable return is going to be tougher and tougher to do. That’s going to drive M&A.

What size bank is going to have a tough time making a reasonable return?

Certainly anything below $1 billion will have a tough time. It’s going to be more costly for everyone. We did an equity conference in Florida a couple weeks ago and John Kanas [the CEO of BankUnited in Miami Lakes, Florida] spoke at our conference. He was the CEO of NorthFork Bank before they sold. They were a $63 billion bank, they had 27 people working in risk management, and that cost $5.5 million per year. Now he’s at BankUnited, a $14 billion bank, and he has more than 100 people working in risk management, and it costs him $30 million per year. It’s costing six times as much money.

Do you think banks don’t want to go above $10 billion in assets because of the increased regulatory burden at that level?

There is more stress testing and the Durbin amendment applies, which is less revenue. It’s a big decision. MB Financial hung out for several reporting periods in that $9-billion to $9.5-billion [asset] range, but they said if they were going over $10 billion, they were going to do it with gusto and go way over. They did that with the Taylor acquisition.

What do investors want in deals?

If you start to see less accretion from the deal, those are the ones people will start to scratch their heads on. Cost savings are things people can get their arms around. You can eliminate branches and achieve efficiencies. But if you say the bank is going to grow X, well, it may or it may not.

Analyst Forum Interview: Brian Gardner

The Brown-Vitter bill proposes to break up the big banks. There is a proposal to bring back the Glass-Steagall Act, which separated commercial banks from investment banks. With lots of pending legislation and new, as yet-unwritten rules coming out of the Dodd-Frank Act, Bank Director magazine decided to talk to Brian Gardner to get a sense of how much of this legislation is really going to pass and when to expect finalization of some of the new banking rules. Gardner is senior vice president of research in Washington, D.C., for Keefe, Bruyette & Woods, a division of Stifel Financial, and he spoke to Bank Director magazine at the end of June, shortly before publication of the final Basel III rules.

A shortened version of this interview appeared in the third quarter issue of Bank Director magazine.

What is the mood now in Washington?

There is little chance the Brown-Vitter bill will pass. There are a number of senior Democrats who have been critical of big banks that are not supporting it. Legislation has two purposes: To pass and change policy, or to move legislators in a certain direction. The timing and reaction to the bill coincided with an overall movement in regulatory circles questioning how successful Dodd-Frank was in ending too-big-to-fail and what else needs to be done. I think you see an environment in Washington which is more favorable to smaller banks and less favorable to large banks. That is not to say Washington or the regulators have turned into a bunch of small bank advocates. I hear from bank managements regularly on the problems and challenges they have of dealing with regulators. I don’t take issue with any of that. My observation is a relative one. Certainly compared to larger banks, the rules are being geared toward smaller banks in a more favorable light. 

What’s the evidence of that? 

In Dodd-Frank, the Collins amendment eliminated hybrid forms of capita called TRUPS [trust preferred securities] from being included in Tier 1 capital, but grandfathered banks under $15 billion in assets. Community banks had a lot of problems with the original Basel proposal that changed risk weightings for mortgages. Aside from requiring banks to hold more capital for mortgages, just the complexity of the added calculations for capital was tougher for smaller banks. I think regulators will drop that from the proposal, so at least on the margin, it will be more favorable to smaller banks. [Editor’s Note: Gardner was right. After he spoke to Bank Director magazine at the end of June, the Federal Reserve Board came out with a revised final Basel III rule that dropped the controversial risk weightings for mortgages. The revised final Basel rule also grandfathers TRUPS for banks below $15 billion in assets.]

What, in your view, is the banking regulation that is going to have the largest impact on banking?

Finalization [of these different rules] would have the biggest impact right now. As for Basel, banks are already gearing up to make sure they can deploy capital effectively. At least they can get some clarity, finally. Sometimes, it’s not whether it’s a bad rule or a good rule, it’s just a matter of knowing the rule. On the Volker [Rule], we’ve been waiting for two years now and it is supposed to be done by year-end. But these are deadlines that have been missed regularly. The big banks were already spinning off their proprietary trading desks well before the Volker rule [was written to ban big banks from proprietary trading]. I’m not convinced the Volker rule will have the impact that people think it will, because I think it’s largely been implemented already by larger banks. I don’t expect to get a lot of clarity on risk retention and QRM [qualified residential mortgages] over the next couple of months. The debate over [the future of] Fannie Mae and Freddie Mac will go on for years. That debate is getting started right now.

How are investors seeing the banking industry right now? 

Clients I talk to are more predisposed to the smaller banks because of regulatory issues. It is but one factor. The rules that tend to be more pro-consumer, such as the Credit Card Act a few years ago, create barriers to entry and make competition less likely. The larger credit card companies are consolidating their hold on the industry. From an investor standpoint, regulation is not always a negative [for all companies]. It can also be a positive and I think that’s the case in the credit card space. In the end, though, I think it’s monetary policy rather than regulatory policy that is driving the view of banking right now.

Originally published on August 5, 2013.

Analyst Forum Interview: Jim Sinegal

Sinegal_4-22.pngJim Sinegal, an analyst at the independent research firm Morningstar Inc., in Chicago, talked with Bank Director magazine Managing Editor Naomi Snyder in March about the recovery in bank stocks and why he likes Wells Fargo & Co., Capital One Financial Corp. and FirstMerit Corp.

There has been a huge recovery in big bank stocks in the last six months or so. How long can we expect this to last?

I think we could see a pullback. The market has gone up a lot. I wouldn’t be surprised if most of the gains are here to stay, though. The banks are in really a good position to deal with another downturn. They really have high capital levels. Earnings power has recovered. It is hard to see people getting as pessimistic as they were a year or two ago.

In November, you said the big banks were a good deal because they were trading at less than 10 times earnings, and you expected revenues to go up and expenses to come down. Their stock prices have since gone up a good deal. What do you think about that prediction?

I do think a lot of these banks were trying to cut expenses for a few years now and it will get tougher going forward. JPMorgan [Chase & Co.] recently announced additional layoffs and that’s something they are still trying to do. But we could see revenues rebound even faster than we expected.

I have heard that investors treat all the big banks the same, based on how they feel about the economy, rather than what’s happening at the individual banks. Do you agree, and do you see that changing?

I think there is a little bit of that. The banks that have had less trouble [after the financial crisis], JPMorgan and Wells Fargo, haven’t done as well [with their stock prices lately] as the banks that had trouble. The high-quality banks that didn’t have a lot of problems to fix were trading based on the economy. Bank of America Corp. and Citigroup Inc. had a lot of problems to fix so that’s one of the reasons they have performed so well. There could be a little more upside, but I would be surprised to see them rally too much.

What is your favorite stock and why?

Of the big four banks, I think we like Wells Fargo the best. It’s still the most traditional bank. It is majority funded by deposits and they have an excellent deposit base. They have funded themselves about 20 percent cheaper than their peers. Further down in size, we like [McLean, Virginia-based] Capital One Financial Corp. and [Akron, Ohio-based] FirstMerit Corp.

Capital One is a half-bank, half-credit card lender. It has really expanded so that it’s as much a bank as anything. Its reputation might have been tarnished by its past as being somewhat into subprime lending [with its credit card business]. We think it’s one of the more undervalued stocks that we cover. It’s the same story with FirstMerit. It bought Citizens Republic Bancorp [in Flint, Michigan], which had been troubled and turned itself around a lot. I think people hadn’t realized the extent that bank had improved. No one likes the Michigan economy. It’s easy to see why investors didn’t like it. The whole Midwest is the rust belt. But we think [FirstMerit is] doing a pretty good job expanding.  

Analyst Forum Interview: Collyn Gilbert

Gilbert_4-22.pngCollyn Gilbert, a managing director at Keefe, Bruyette & Woods, first talked to Bank Director magazine at the launch of Analyst Forum two years ago when she was with Stifel Nicolaus. Stifel purchased KBW in February and she moved over to KBW, which is focused on the financial sector. She still covers small to mid-sized bank stocks and revisited in March what she said then.

We talked to you in the first quarter of 2011 for our first Analyst Forum interview. You said at the time that there was a great opportunity to own a basket of potential sellers, and that you expected considerable amounts of M&A in 2012 and beyond. How do you feel about that now?

I do think M&A is going to be a key component of the industry. Why did it not take place starting in 2012? I think what we missed was the unwillingness of management teams to pull the trigger.  In 2012, you still had good earnings growth for the sector but as we look to 2013 and 2014, earnings growth is going to slow considerably. That could be the catalyst we need to facilitate M&A. It’s a real struggle to grow earnings, especially for the small and mid-sized community banks that may be more real estate dependent and dependent on net interest margins. There is, finally, some degree of capital clarity and what the future looks like for growth. I think we’ve definitely seen a pickup in M&A. In our universe of small and mid-tier banks, we have had 11 acquisitions close in the last 12 months. It’s there. It’s not the big names like the Fifth Thirds and the BB&Ts. The median asset size for sellers has been in the couple hundred million dollar range.

What have those deals looked like?

Because they are so small, some of these [sellers] were trading at tangible book value. [Their stocks] are illiquid in nature. It allowed buyers to get decent pricing on them. You actually have seen these deals accrete book value for the buyers. We have not seen the premium M&A, where banks trading at 1.5 tangible book sell for 1.7 to 2 times tangible book. There is still a lot of bottom feeding. There are banks still challenged and management teams that are fatigued. There is no need to acquire deposits right now because there are a lot of deposits and not much growth in lending. If interest rates rise, that will be a factor to help M&A.

When we talked last, you predicted the banks that would do well would do so because of declines in non-performing assets and reserve levels and net interest margin improvement.

That was true. Now, looking at 2013, we’ve sort of exhausted that. There are some situations where banks are carrying higher-cost funding, which they can re-price lower, but materially lower deposit costs in 2013, I don’t think it’s going to happen. Margins are going to continue to come under pressure this year. I hope we start to see the trough by the end of the year but that’s tough to say.

You will see fewer banks that are able to improve their margins?

It’s virtually impossible. If they are getting better margins, how are they doing that? Are they getting riskier assets? You kind of have to wonder. Are they going farther out on the interest rate curve? You have to be a little bit cautious. {Editor’s note: The latest issue of Bank Director magazine has a story on this topic.}

Two years ago, we had a high level of capital in the industry. It’s still high. Do you see banks using this effectively?

The industry is sufficiently capitalized at this point. The small and midsized banks still follow the trends at the larger banks and keep an eye on what the regulators are saying at the larger bank level. I think that you’ve seen some [regulatory] relief there, and you’ll see more banks move to deploy capital, either in buybacks or increasing dividends. 

We talked two years ago about efficiency. What do you see banks doing with their efficiency levels now and is that a focus for investors or not?

It should be a focus [for investors]. With margins under pressure and growth being limited, these banks really need to think about their efficiency level. The past couple of years they have been cutting some of the fat. Now, we’re in a position where banks have to take a hard look at the expense level and the biggest part of that is the branch network. The one thing I don’t hear enough of from the banks I follow is: How are you rationalizing your branch networks? With consumer behavior evolving at a very rapid clip, if you’re not addressing that, you’re going to be taken to the woodshed. I’m kind of surprised banks aren’t talking about it. Banks have been so wedded to bricks and mortar through so many different cycles and technology has not been the hallmark for the banking industry at the mid-tier level. It’s going to take some time to kick in. [Waterbury, Connecticut-based] Webster Financial Corp., which we follow, is doing a good job shrinking the branch network and [expanding] mobile banking and responding to changing consumer behavior. They said they would reduce investment in branch infrastructure by 20 percent. The theme is starting to trickle down from the bigger banks. The smaller banks, their behavior lags the bigger banks by nine to 12 months.

What should small and medium sized banks do to make themselves more attractive to investors?

You have to be a lot more efficient and look at what the expense structure is. At the same time M&A needs to be an important part. No bank wants to sell. No CEO or board wants to give up their position and their compensation, or whatever the case may be. If putting two institutions together allows you to cut costs and improve returns, that is certainly beneficial to the shareholder.