Do you remember the heady days in the '90s when banks were bought at just under two times book? And acquirers' value rose to around four times book? Since then, merger and acquisition activity has been relatively quiet. Only 120 open-bank deals were done in 2009, averaging under $400 million of assets. Even as bank prices have come down to around book, M&A activity has not yet responded as much as one might think. Why is that? Should we expect the widely predicted wave of M&A to start in 2011?
There are several obvious reasons the wave hasn't started in earnest yet. First, very few banks have the stomach to take on additional operations with regulator scrutiny on capital adequacy: What if the acquisition leads to unexpected writeoffs? Looking at Bank of America's experience with Countrywide has probably given most boards pause as they consider deals.
Second, bank managements have been totally preoccupied with fixing the problems they already have. Third, many acquirers would need an injection of capital and capital is scarce. Few, if any, banks have cost-effective access to capital, and private-equity investors have been persona non grata with regulators recently.
There is a more subtle reason for the slow uptick in M&A markets: Banks aren't really that cheap. Price-to-book measures are very popular when discussing bank valuations. However, our view is that the long-term key driver of enterprise value is what we call "normalized earnings power," and that has been declining in line with price-to-book ratios. To calculate normalized earnings, we take out one-time events and replace the provision for loan losses with long-term ratios. Our analysis — performed on over 100 banks with assets of $2 billion to $40 billion — compares current market capitalization with what we call "operating value": Normalized post-tax earnings multiplied by the long-term banking price-earnings multiple of 15 times. Over the years, price-earnings multiples have been more stable — and, in our view, more reliable — than price-to-book ratios.
The bottom line is that, on average, banks are fairly priced today to their likely normalized earnings.
So, are there any good deals out there today? Two key points create actionable investment opportunities for well-positioned banks and investors: Some banks are priced well below their operating value and most banks' operating value can be enhanced by expense reduction, and by the synergies inherent in merger integration.
When we examine banks that are already attractively priced, and then add potential revenue enhancements and cost reductions, we find that one in 20 banks offers substantial prospects of return: 100% to 200% appreciation from current market values. We foresee a selective and methodical cherry picking of attractively priced banks by savvy acquirers.
Of course there also may be some acquisitions of banks that do not fit our model. Sterling Bancshares, which recently agreed to be acquired by Comerica, was already priced at about double its operating value, and Comerica will pay a premium. However, before jumping to the conclusion that it's a bad deal, consider the potential for synergy and expense reduction. By our calculation, a well-executed integration can raise Sterling's operating value very close to the acquisition price. Sterling becomes a break-even deal for Comerica, and the parent gains coveted share in the attractive Texas market.
There are substantially better deals out there based on our screening methodology, but there are relatively few of them. The best deal that came out of our screening exercise was Wilmington Trust, which recently agreed to be acquired by M&T Bank at a very deep discount to its long-term operating value. It is true that many acquiring banks will likely take hits to their capital structure, but surprisingly the best acquisitions we uncovered are also well capitalized (averaging 10% of assets), so the likelihood of an outcome like Countrywide is low. Rigorous due diligence should uncover most hidden surprises.
Our analysis focuses principally on buying future earnings at a discount. We have not considered explicitly such factors as geography, business mix or other elements of strategic fit. We have not attempted to assess whether a bank would be willing to be acquired, although we expect every bank board would have to seriously consider any offer at a substantial premium to current valuations.
So, what can we expect in M&A for 2011? Savvy investors seeking a few very good deals.
