A new trend emerged in bank mergers in 2019: the merger of equals (or “MOE”). While MOEs have been around for decades, few have been announced in the last 20 years. In the late 1990s, there were several famous MOEs such as NationsBank/Bank of America, Norwest/Wells Fargo, Travelers/Citibank, and Chase Manhattan/J.P. Morgan that formed what are now the four largest banks.
TCF Financial and Chemical Financial kicked off the 2019 revival of MOEs in January. BB&T and SunTrust followed with the largest MOE deal of the year in February. Other MOE deals announced were First Horizon and IberiaBank in November, and Texas Capital and Independent Bank in December.
In many bank acquisitions, the acquirer’s stock price does not rise. We interpret this to mean that it is rare for an acquisition to create value for acquirers. Instead, we believe the value creation in a bank acquisition accrues to the shareholders of the acquired bank. Since the acquired bank’s management and board are likely losing their positions, status and incomes, they generally don’t want to sell their banks for no premium. Banks interested in selling often have multiple options of potential banks to whom they can sell, so the value created by combining the banks is naturally captured by the acquired bank.
MOEs are interesting for investors because the value creation is shared by both bank’s shareholders. Instead, the two banks share in the value creation. Value creation in MOEs is usually driven by cost-cutting opportunities. For instance, there are too many bank branches. Bank back offices have too much capacity, and banks have a large number of non-revenue producing staff. Banks in an MOE will close branches and trim non-revenue producing staff without hurting revenue much at all. MOEs capture the value of the cost-cutting and both sets of shareholders benefit from the value created.
MOEs can be difficult due to social issues. The MOEs that run into problems if one bank’s management team thinks they are in charge and the other bank’s management team thinks they are equals. Even though both parties in the deals are considered equals, only one executive can be CEO of the surviving institution. In MOEs, the two different bank cultures can clash. Working through different cultural issues can take years. I believe the clashes between Sandy Weil and John Reed after Travelers and Citibank merged are a classic example of this happening.
If two banks can agree to an MOE and work through social issues, we believe they are an interesting place for shareholder returns. Both sets of shareholders can share in the value creation from cost-cutting opportunities.
We purchased a position in Independent Bank Group (“IBTX”) a few weeks after the announcement of their MOE with Texas Capital Bancshares. The following is our investment thesis on Independent Bank Group:
Independent Bank Group (or “IBTX”) and Texas Capital Bancshares (or “TCBI”) announced a MOE in December. This MOE is unusual because IBTX is 1/3 the size of TCBI, so they are not equal size institutions. But, IBTX’s shareholders will end up owning 45% of the combined bank. IBTX’s CEO, David Brooks, will become the CEO of the combined banks. Because IBTX trades at 2.1x tangible book and TCBI trades at 1.2x tangible book, the merger will be 27% accretive to IBTX’s book value and 26% accretive to IBTX’s 2021 EPS. We purchased a position in IBTX a few weeks after the merger announcement. Although the shares of both banks rallied on the day of the merger announcement, they declined more than 10% by the time we purchased our position.
Investment Thesis:
1) David Brooks is a banking entrepreneur – Brooks has been involved in IBTX since he led the investor group that acquired Independent Bank in 1988. At the time, the bank had $50 million in assets. After the MOE with TCBI, the bank will have more than $50 billion in assets. We believe Brooks is a money- maker and will create value for shareholders going forward.
2) Discounted to peers – IBTX trades at 8.4x 2021 estimated earnings. This estimate of 2021 earnings assumes the merger accretion and 75% of the estimated cost savings. This is the lowest valuation of the 40 other mid-cap banks with market caps between $3B and $8B. We believe this reflects the risk of the merger closing, the risk of the merger integration being difficult, and the risk of TCBI’s large corporate loan portfolio experiencing credit issues.
We think the valuation gap will disappear as the merger closes, the merger integration proceeds, minimal credit issues appear in the TCBI loan portfolio, and organic growth resumes. We believe three years now, IBTX can trade at $110 or 13.5x our 2023 estimate of $8.15 in earnings per share. At $110, IBTX’s stock would double in three years.
3) History of organic growth – IBTX and TCBI have grown deposits per share at 12.3% and 13.9% since coming public in 2013 and 2003, respectively. We expect this rate of organic growth to continue with the merged bank.
4) Conservative cost-cutting estimates in guidance – IBTX/TCBI estimates that they will be able to cut 11% of the combined bank’s expenses. 11% is the same amount of cost savings estimated by First Horizon and IberiaBank (“FHN/IBKC”) in their MOE. The key difference is 73% of IBTX’s branches overlap, and FHN/IBKC has minimal branch overlap. We think IBTX/TCBI will be able to drive better than expected cost cuts.
5) Additional flexibility to grow certain loan categories – The MOE of IBTX/TCBI will bring balance to the loan portfolio. IBTX had a significant commercial real estate (“CRE”) concentration. TCBI had a concentration in mortgage banking warehouse lending and large corporate loans. The combination will diversify the loan portfolio and allow IBTX to grow in CRE.
Issues with the IBTX/TCBI MOE:
1) Different operating models – IBTX and TCBI have different operating models, and they may be difficult to integrate. IBTX has a loan portfolio with smaller loans, and they operate many smaller branches in small towns surrounding larger cities. TCBI is more focused on larger loans and has few very large branches in downtown business districts of the major cities in Texas. IBTX also has a Colorado operation that will represent only about 7% of the combined bank. These two operating models may be difficult to integrate.
2) Credit concerns at TCBI – TCBI was trading at close to tangible book value because of investor concerns about the credit quality of their loan portfolio. In early 2019, TCBI showed troubling trends in its criticized loans. The area of concern was their energy and leveraged loan portfolios. The criticized loan trends improved in Q3 2019. But, non-accruals ticked higher in Q3 despite significant charge-offs. If the economy goes through a credit cycle in the near-term, TCBI loan portfolio is at-risk given that it is already showing some signs of stress.
3) Scope of the combined entity – The MOE of IBTX and TCBI will create a bank with $50 billion in assets. David Brooks, the IBTX CEO, will become the CEO of the combined entity. IBTX was only $13 billion before this merger. Brooks has been with IBTX since 1988 when it was $50 million. He has never worked at a large bank.
Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.