Wall Street showed no love Friday for Berkshire Hills Bancorp's (BHLB) latest acquisition.
Executives at the Pittsfield, Mass., company shrugged off a lukewarm response to last week's agreement to buy Beacon Federal Bancorp for $132 million in cash and stock.
The purchase will greatly expand Berkshire Hills' operations in upstate New York, but it will also dilute existing shareholders in the near term.
Berkshire Hills' shares fell nearly 6% Friday. In comparison, the KBW Bank Index lost almost 5% on a day where concerns about Europe and lackluster U.S. employment data also spooked investors.
"We're not surprised. We expected our stock to trade off," said Kevin Riley, the $4.3 billion-asset company's chief financial officer, in an interview.
Beacon Federal is a profitable company in East Syracuse, N.Y., with seven branches and $1 billion in assets. Still, the deal is expected to dilute Berkshire Hills' tangible equity by 7.7%, or $1.26 a share.
Berkshire Hills is no stranger to dilutive acquisitions. The company has forecast dilution of 4% or less for three of its most-recent acquisitions.
Riley said he understood that the dilution of the Beacon Federal deal "has scared some people," but he added that key institutional investors realize that there are long-term benefits to expanding in the slow-but-steady upstate New York. Berkshire Hills entered that market last year after buying two banking companies with operations there.
Berkshire Hills' shares should rebound as the deal "is digested," just as they did from sell-offs that followed other acquisition agreements it has announced, Riley said.
The Beacon Federal deal differs from other Berkshire Hill acquisitions because of the nearly 50-50 split of cash to stock. The company used stock to pay for more than 70% of Connecticut Bank and Trust in Hartford; Legacy Bancorp in Pittsfield, Mass.; and Rome Bancorp in Rome, N.Y.
That split of the recent deal is unusual. Banking companies such as Berkshire Hills that trade at an unusually high multiple to their equity tend to pay for as much of a deal as they can with common stock. Doing so preserves capital and enables the acquirer to make more-competitive bids.
United Financial Bancorp in West Springfield, Mass. on Thursday agreed to pay $91 million entirely in stock for New England Bancshares in Enfield, Conn. Like Berkshire Hills, United Financial trades at a fairly high multiple to its equity.
Berkshire Hills' common stock still trades at 130% its tangible book value despite Friday's decline.
So why was Berkshire Hills so stingy with its common stock this time around? Its other deals were structured to minimize dilution. This one was designed to maximize returns.
Issuing shares reduces earnings per share and shareholder returns. Berkshire wanted to boost its return on assets to at least 1%, compared to 0.59% on March 31. The company aims to increase its return on equity to at least 10%, compared to 6.8% at the end of the first quarter.
Berkshire Hills' pro-forma returns on equity in 2013 are now on track to reach 9%. "Our goal is to get to these high performance ratios," Riley said.
Banks with higher returns have more valuable shares, and thus more strategic options, Riley said.
Another key reason why Berkshire Hills is using less common stock in the Beacon Federal deal involves capital management. The company plans to pay for $6.6 million of the cash portion of this deal with liquidity on hand. Berkshire Hills plans to issue about $26.4 million in subordinated debt, which could cover the rest of the cash consideration.
Regulators do not factor in subordinated debt when calculating the Tier 1 capital used as the main buffer against losses. Still, Berkshire Hills has told investors that it wanted to take advantage of low interest rates by issuing debt to supplement primary capital reserves and add to total regulatory capital. It is using this deal as a chance to do that.
"We continue to focus on minimizing intangible book value dilution, it's important to us and we know it's important to our investors," Michael Daly, Berkshire's president and chief executive, said during a conference call with analysts Friday.
"I think this transaction is an opportunity to right-size the capital," Daly said. "So we are issuing less common stock into this transaction than we have done in prior deals."
A handful of other banks have been subject to steep sell-offs this year after announcing heavily dilutive deals. United Financial expects its deal in Connecticut to dilute its tangible book value by 9%; its shares have fallen more than 8% since announcing its deal on Thursday.