Q1 2020 Market Outlook: Bank Mergers of Equals

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February 11, 2020


Alexis Sayers:
Good morning everyone. Welcome to Gator Capital’s Q1 Market Outlook Webinar. Thank you for joining us for our first call of 2020. My name is Alexis Sayers, and I am a Marketing Analyst here at Gator Capital. I’m excited to welcome you today to our webinar. Our Q1 Market Outlook will be presented by Managing Member and Portfolio Manager, Derek Pilecki. The presentation will last approximately 30 minutes. We will open the floor for 10 minutes at the end of the session for some questions and answers. You can submit a question at anytime during the session by clicking the Q & A icon.

Due to time restraints if your question is not answered, we will followup with you individually after this session to answer your question. If you have any questions about Gator Capital, you can visit our website at GatorCapital.com. The format of Derek’s presentation today will begin with an overview of Gator Capital Management, Derek will then discuss our different views of bank M & A’s, and discuss mergers of equals as an emerging trend in regional bank mergers. We will conclude with a question and answer session.

The views and opinions in this presentation are solely those of Gator Capital Management. Gator Capital Management has made very attempt to ensure the accuracy and reliability of this information provided, but it cannot be guaranteed. Past performance is no guarantee of future results.

Okay, let’s begin with a brief overview of our firm. Gator Capital is an SEC registered investment advisor. Derek Pilecki founded the firm in 2008. At the end of December the firm managed $99.7 million. The investment focus since we started is specializing in equities in the financials sector. This is driven by Derek’s work at Fannie May in asset liability strategy early in his career. Derek later worked at GSAM’s, covering financials for their growth equity team. Within the financials sector we focus on deep value part of the sector. We manage three portfolios, all with significant overlap. We manage a long short financials portfolio for our private hedge fund, we manage our long-only financials portfolio in a mutual fund form in the Gator Series Trust. And then, we manage a long/short portfolio for another mutual fund in the Caldwell & Orkin Fund Corporation. The firm is 100% employee owned.

I would now like to introduce Derek Pilecki, Managing Member and Portfolio Manager of Gator Capital Management. Derek, welcome.

Derek Pilecki:
Great, thanks Lexy. Thanks everyone for joining us today. This is our second in our webinar series. We are running the webinar series approximately a month after we release our quarterly letter to cover the investment thesis that we touch on in the investment letter to go in a little bit more detail. In my January letter I talked about bank mergers of equals, and specifically Independent Bank in Texas, which is agreed to a merger of equals with Texas Capital Bank Shares. We think it’s a pretty compelling deal, and want to go through our thesis on that bank. But first, I want to talk about bank M & A.

We have a little bit different viewpoint of bank M & A than a lot of other investors in our sector. We think bank M & A’s been disappointing over the past five or so years, and I think there’s several reasons for that and want to go through why bank M & A’s been disappointing. One of the big reasons is the big three banks, and by this I mean JP Morgan, Bank of America, and Wells Fargo aren’t legally allowed to make anymore acquisitions of depositories. There’s a rule, once a bank has 10% market share deposits nationally, they can’t acquire anymore deposits. So each of these banks has 10% market share, so they can’t acquire anymore banks. If you look at historically, each of these three banks has been very acquisitive, so you have these three big acquisitive players that are out of the market.

There’s some debate whether this 10% deposit cap will be lifted. I think it’s very unlikely unless we get into a crisis similar to the 2008 scenario where regulators need one of these three big banks to acquire a troubled bank. But, unless we encounter that type of scenario I don’t see the 10% deposit cap being lifted.

If you look at branch utilization, and this is the number of people going into branches, it’s down year over year every year since 2010. I think if you think about your own uses of banks, you’re doing a lot more deposits online through their mobile web apps, doing a lot of self serve through their website, online bill pay. Maybe you use ATM’s, but you certainly don’t go to the ATM even as much as you used to. Branch utilization’s down, so a lot of banks are over branched. I would say the nation’s over branched. We’ve seen branch counts decline since about 2012, so I think this is a hindrance to M & A. The banks don’t want to move into new cities and absorb somebody else’s real estate issues.

Related to this, banks can cover metropolitan areas with less branches. My example of this is PNC bought RBC Centura about six years ago, and at the time they said, “We think we can cover Atlanta with 50 branches, whereas five years previous we would have needed 80 branches.” I think today they would say, “We can cover Atlanta with even less branches, probably 30 branches.” Another example of this is JP Morgan’s entering Washington DC, and they’re only building about 10 branches initially. It’s different when you used to go to the bank weekly to get cash or do whatever banking, to go into a bank only once or twice a year, you’re willing to drive further to go to your branch. And so, if you bank at a bank with a strong brand name and you have some tie to that bank, emotional tie, or you do good business with them, you’re willing to drive a little bit further if you only go there once a year.

I think it’s also interesting that banks are able to enter new cities de novo now, so they don’t need to acquire a set of branches to enter a new city. I mentioned JP Morgan entering Washington DC, they’re going to Philadelphia and Boston as well. Now, JP Morgan’s a special case because they can’t make a deposit acquisition, but we are seeing other banks entering new markets without making acquisitions. Capital One’s a prime example, using their national credit card base to enter new cities by just opening one single branch in the downtown area to try to grow deposit accounts.

We’ve also seen the buy side get more aggressive of penalizing banks when they make acquisitions for big premiums. The street is very, or the buy side’s very judicious about the deal economics of each individual deal. If a bank they thought was a seller actually makes an acquisition, they’re not afraid to penalize the acquires stock. I think that’s cooled the jets of a lot of bank executives from making deals, or making acquisitions. That, they don’t want their stock to take a hit. I’d say that’s a healthy development in bank M & A, but its kept a lid on activity.

And then, one of the other reasons why I think bank M & A activity has been tepid is, large regional banks have been treating their persistent discounts to smaller and mid-cap banks. If you look at large regional banks right now, the median PE on this years earnings is around 10 1/2, 11 times. Where if you look at banks in the Mid-Atlantic, or Southeast, or Midwest, the PE multiples tend, median is about 12 1/2 times. On the West Coast and in Texas, it’s even 13 times. It’s harder to get the deal economics to work if the large banks trade cheap to the small banks.

Now, bank M & A is not all bad, right? I mean, we have access … we have over capacity in the banking industry. There’s too many banks, there’s back offices are too big, there’s too much staff. And so, the big positive from bank M & A is expense cutting. You can retain your customers, hack away at the back office, get rid of dual systems, dual accounting, dual executives, staff, dual back office.

M & A also reduces competition, so BB&T and SunTrust merged, those were two of the biggest South Eastern banks. I wouldn’t be surprised if almost every middle market company in the South East had loan packages bid on by both banks, and going forward they won’t be competing against each other. So, bank M & A reduces competition.

M & A can also be value enhancing. If you are able to make acquisitions for low multiples, I think that’s super attractive to potential acquirer shareholders. Bank M & A can also accelerate entry into new markets, so if a bank doesn’t have a strong brand name, or they don’t have any presence in a city, there’s only so many banks who can just de novo, enter a new city like JP Morgan and get big market share quickly. But, an example of this is Western Alliance bought Bridge Capital Holdings to enter San Francisco about six years ago, and then they’ve grown that platform in San Francisco. That can be an interesting way for a bank to not make a big financial commitment, but just get it a little bit a critical scale to grow from.

And then, similar to that, banks can acquire new lending capabilities through M & A. Not every bank has every loan type or expertise. And, by acquiring another bank they can enter a new area, rather than trying to grow it themselves. The rest with bank M & A, I think these aren’t a surprise to anyone, the credit issues, and the loan portfolios of the acquisition target. Mergers create organizational distractions, and there’s of course increased execution risk. So, you might not be focused on, a bank might not be focused on growing organically while they’re trying to integrate an existing acquisition.

But, there’s one development that reemerged in 2019, was mergers of equals. Mergers of equals amongst banks used to be very popular, especially in the late 90’s. A lot of the biggest banks are a result of mergers of acquisition. So, Nations Bank and Bank of America merged in 98, Norwest and Wells Fargo formed Wells Fargo, Travelers and City Bank. And then, these last two groups, Chase Chemical, Chase JP Morgan, and then for Chicago MBD, for Chicago MBD and Bank One, and then they all of course, all those banks got together and form now, JP Morgan Chase.

MOE’s are difficult socially. It’s difficult to negotiate an MOE, right? Because the seller, or the management team that’s not going to be in charge going forward, their board and management team want to get paid for giving up control. And so, this subset of banks that are willing to persist via MOE’s are smaller. Management teams are going to lose their status, they’re going to lose their paychecks potentially. There’s going to be, they know that the people who have worked for them for years are going to, a lot of them are going to lose their jobs. So, on average when two banks do an MOE, 10% of the combined expenses get cut. That’s, if you think about it, maybe a lot of that 10% comes from one of the two banks. That’s a pretty big hacking away at the employee base, and so management teams are just less likely to enter into an MOE, especially since MOE’s imply that there’s not going to be a big acquisition premium for the stock, so they have some of the drawbacks of mergers socially, but they don’t get the financial benefit right away.

Sometimes MOE’s are difficult to integrate. There might not be clarity of whose in charge. It can either create clashes, or it can create a leadership vacuum. And so, the history of MOE’s is not perfect about the integrations. I think that keeps some banks away from negotiating MOE’s. And then like I mentioned, cost cutting’s difficult on a combined organization. I think MOE’s are an overlooked opportunity for investors. I think you can look for opportunities in MOE’s both on the long and the short side. On the long side, if an MOE’s integrated correctly, the cost cutting can be a nice tailwind over a series of two to three years. A lot of times cost cuts are underestimated, and that can provide upside surprises, there can be new capabilities added to the combined bank. So, revenue synergies which usually aren’t advertised at the deal announcement can emerge. I think that the …

And, the other thing about MOE’s is the stock prices don’t tend to react right away, so because there’s no premium, investors don’t get as excited, and there’s not a lot of news, a lot of interesting news coming out of the bank because they’re working on blocking, and tackling, and integrating into the merger. But, the results can be good over a series of years, and it can be a nice tailwind. And also, the financial creation from am MOE can be pretty interesting, especially since the stock prices tend not to move right away.

Occasionally on the short side MOE’s can be a good opportunity. A poorly integrated deal can make a bank stock just dead money for years, and that could be interesting. There can also be issues with the credit book, how they, surprises that they get from the combined company, and they can also run down some portfolios that make the earnings targets hard to come by. I don’t think this is an opportunity like buy all bank MOE’s, I think it’s an interesting opportunity because the outcomes can be variable. They can be either very good, or very bad. If you look at the deals, that can be interesting.

MOE’s reemerged in 2019. There’s five deals that have been announced, TCF and Chemical, BB&T and SunTrust, First Horizon and Iberia, Independent Bank Shares and Texas Capital, and then South State and Center State in Florida recently announced a merger of equals. I think this will be, this is an emerging trend, and I think we’ll see more MOE’s, and I think it’ll just be a new opportunity set for investors.

So really today, I want to talk some about Independent Bank Group. This deal is very financially compelling, so really it’s driven by Independent Bank trading at two times tangible, and Texas Capital trading just above tangible book. It makes the accretion for Independent shareholders very attractive. It’ll be 27% accretive to Independent’s tangible book value per share, and 26 accretive to their earnings per share. Independent’s CEO David Brooks, who’s their longtime CEO and a great bank operator will be the CEO of the combined company.

Independent has a good solid history of operating metrics. They’ve been growing loans per share about 13% over the last three years, similarly on the deposit side. Return on assets is 155, and the ROE’s 15 1/2. Solid numbers, slightly above peers in Texas. But, the valuation is compelling. With the major accretion and the stock price not really moving, Independent trades at 8.9 times 2021 earnings, and only 1.4 times price to tangible book. Whereas, their Texas based peers traded almost 13 times earnings, and 1.7 times price to tangible book. If you look at Independent’s history from 2010 to 2018, they traded at about 17 times on average on earnings, so now here they are only trading at nine times.

Loan portfolio, Independent has had a higher than peer return on their loan portfolios, think it’s due to their small loan size. They’re known for a very granular loan portfolio, so they’re not taking big bets, and their loan portfolio is a mix of commercial and industrial loans, and commercial real estate lending.

Expense base, Independent has a decent efficiency ratio of 55%. I think they come about this through managing the bank very aggressively. I think with the bigger scale of Texas Capital, there’s opportunity for this efficiency ratio to go even lower, just from the Brooks being focused on the expense side, and the merger integration.

The deposit franchise at Independent’s very good. They’ve been growing organically low double digits. I think funding going forward for loan growth is going to be a focus for them. Here’s a map of the branches. Independent also has a little bit of a branch network around the Denver area, but this is, I’m just showing you Texas. The red dots here are Independent’s branches dispersed around the North Dallas area, a little bit in Houston, a little bit in Austin. And then, the blue dots are Texas Capital’s branches.

Texas Capital had a much more efficient branch system. They had much more in deposits per branch, and they’re more focused on the downtown areas. I think they’re going to be able to integrate these branches pretty quickly. If you look at where the Texas Capital branches are, there’s usually an Independent branch pretty close to it. I think they’ll consolidate one or the other in most of the areas, and I think that’s pretty interesting on the cost savings side. Also, down in the bottom middle, you can see in San Antonio, Texas Capital had a presence in San Antonio that Independent did not have. So, it’ll give them a new city, new geography to grow from.

Capital generation I mentioned before, Independent has a 15 1/2 ROE. They use most of their generated capital for organic loan growth. Then, they pay a small dividend. Post closing, I think Independent will have an opportunity to buy back some shares. We’re expecting them to run off, or run down a portion of Texas Capital’s loan portfolio, and that’ll free up some capital. Once they close the merger, they’ll be in a better position to buy back some shares.

And then, another part of this, I think generally I’m pretty interested in the Regional Banks for the first time in a while because the group has low valuations, relative to its history. I think the sector’s cheap because of interest rates, and I think there’s also some recession fears. I’m more bullish economically than I think the typical investor is, so I expect Regional Bank’s valuations to recover to closer to their median levels. Credit risk may be an issue to look at with this deal. I think the street was not happy with Texas Capital’s loan portfolio. They had bigger loan sizes, and they had grown quickly over a period of years. I think the opportunity here is for Independent to manage down the loan portfolio, I think it’s a good economic environment to take risk off the table. I think they’re going to be laser focused on managing the credit risk. I think that they also have a little bit of a period here until the merger closes to deal with problems, and the stock won’t really take a hit if they deal with these problems now.

And then, interest rate sensitivity, Texas Capital historically has been asset sensitive that Independent’s run their book closer to interest rate neutral. I think that’s an interesting place to move the bank to. I think it’ll take rate fears off the table for the combined entity, and it will be less of an issue for the combined bank going forward. I think Independent’s a pretty interesting name due to the merger, it’s trading cheap. I think there’s good underlying organic growth once we get the merger closed, and get the go forward operating model for the company. I can see them returning to … I can’t see them returning necessarily to their median, historical median of 17 times. But, can they trade up to where the peers are at 13 times? Certainly, and I think that gives you a pretty good return on top of normal earnings growth. Just wanted to highlight those things to you, our view of bank M & A, the emerging trend of bank MOE’s, and then one opportunity we see in this space. So, right. Now, I’ll turn it back to Lexy for some Q & A.

Alexis Sayers:
Derek, thank you so much for sharing your insights. Thank you to everyone who submitted a question, we have quite a few here, so we will dedicate the next 10 minutes to questions. Okay, let’s begin. Derek, what are your thoughts on the Truist deal? Are you disappointed with the delay in branch closings?

Derek Pilecki:
Yeah, so Truist is the new name for BB&T and SunTrust. I think it’s a very good deal, I think they’re going to do a good job on integrating the two banks. I think the banks are very culturally similar. The regulators are preventing them from closing any branches until the deals been closed for a year, so they closed the deal in December last year. They’re going to close several hundred branches eventually, it delays those cost savings. If you look at the maps of the two companies branch networks, there’s a lot of towns where their branches are either across the street from each other, or share the same parking lot. And so, keeping those branches open doesn’t really make sense at all. I don’t know what the regulator would get from the delay, I think they’re going to manage stacking levels down, and share employees amongst the branches. But, I think a year from now we won’t even think about it. It’s a near term disappointment, but it doesn’t affect the overall view of that deal.

Alexis Sayers:
Okay, thank you. Our next question is, on the First Horizon deal, what do you think about the cost savings goal given the lack of branch overlap?

Derek Pilecki:
Yeah, so when I look at the MOE’s that have been announced, there’s the five MOE’s. Each one when they announced a deal, gave an estimate of what their cost savings would be. When I look at the First Horizon Iberia deal, they have one of the lower cost savings of nine percent, Independent and Texas Capital estimate 11%, both BB&T and SunTrust, both the Truist deal and the TCF deals estimated a little over 12% cost savings. So, First Horizon already was at the low end of the range, but there’s not much branch overlap between Iberia and First Horizon. I guess of those four deals, that’s the one I’m most concerned with, of that hitting the cost savings, just simply based on branches.

Derek Pilecki:
From the executive standpoint, there is opportunity to save a lot more money on that, but as a percentage deal I think most of the cost savings would come from branches. That’s the one that I’m most worried about hitting their cost saving targets.

Alexis Sayers:
Okay, thank you. Our next question is, on the IBTX TCBI deal, how do you think IBTX management got comfortable with TCBI’s loan portfolio?

Derek Pilecki:
Yeah, I think they had a pretty good window during the due diligence into the loan portfolio, especially with TCBI’s larger loan size, they could go through the larger loans. I think there’s still evaluation of the loan portfolio going through. It’ll be interesting to see, they said on the earnings call a couple weeks ago that there was no surprises in TCBI’s earnings report, that the credit quality weakened a little bit. So, I think they were able to look at through due diligence, but I think the street, it’s going to be an open question for a couple quarters on the street because IBTX is a smaller entity. Even though the management team’s been in place there for a long time, they haven’t mentioned a bank as big as TCBI, let alone the combined bank. I think they’re going to be in a little of wait and see, prove it to me, from the street’s aspect on the credit side.

Alexis Sayers:
Okay, thank you. We have time for one more question and it is, on the last webinar in November you outlined the growth thesis, you outlined your thesis on growth banks. How has this played out, and do you still have this investment thesis?

Derek Pilecki:
Yeah, so the bank that I highlighted in our November webinar was Western Alliance, so certainly the stocks moved up, the thesis is intact. I think not all the growth banks in the group of growth banks I mentioned in my October letter have moved up to the same extent, I think there’s a little bit of differentiation by credit quality and loan growth. I still think these banks as a whole are cheap relative to their organic growth, so I think the thesis is still intact, I think there’s some dispersion of whether they’re all working or not. I also don’t think this investment thesis will persist forever, I think the opportunity’s here right now, I don’t think that all these banks will trade this cheap for a long time. I think as they continue to grow, the market will place higher multiples on them, and the opportunity will shrink.

Alexis Sayers:
Okay, great. Thank you. Thank you to everyone who’s listening. Please save the date for our next webinar, it is on May 12th at 11:00 AM. Thank you Derek for taking the time to speak with us today, and thank you to everyone who listened in on this webinar. If you’re interested, we look forward to continuing this conversation with you.

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