Banks and the Clustering of Mergers and Acquisitions Activity

Industry structural changes are a major M&A catalyst. The changes inhibit incumbent firms’ ability to create shareholder value. This is reflected in the current clustering of M&A activity in the healthcare, technology and oil and gas industries. Banking has also seen increased activity in the number of deals. The deals have been primarily in the smaller community and regional bank segments. Hence, dollar volume is still off pre crisis levels. Larger Too-Big-To-Fail banks are still reluctant to seek regulatory approval. Nonetheless, banking has structurally changed since the financial crisis as reflected in weaker operating performance. Many bank, however, have yet to adjust to the changes.

This is reflected in lower economic returns, ROE less cost of equity, and consequently lower pricing multiples like price to book.  Pricing multiples reflect underlying operating performance. Pressure is building, primarily from activists, to improve returns. Banks who “get it” will enjoy improved returns and values e.g. Warren Buffet’s favorite bank Wells Fargo. They will likely force changes upon weaker banks that “don’t get it” like Bank of America which trades below book value. This will spur increased banking M&A-initially smaller transactions until a larger deal is pushed thru the regulatory log jam. My thoughts on this matter are outlined in my attached American Banker BankThink comment.

J

An Inch by Any Other Name Is Still 25 Millimeters

Banks post the 2008 financial crisis, have been priced primarily upon a book or tangible book basis instead of the pre crisis earnings basis Metrics. This was largely due to a lack of earnings and uncertainty over asset quality. A common pricing metric used is P/B (price-to-book) =ROE-growth (g)/Ke (cost of equity)-g.

Asset quality and earnings issues have been largely resolved as banks have recovered. Thus, Price-Earnings (P/E) ratios have returned. Some mistakenly believe that using P/Es will lead to higher M&A  pricing than P/B ratios. Higher pricing may occur, but not because of a switch in pricing metrics. The higher pricing reflects improved fundamentals.

A bank is worth what someone will pay for it. What someone will pay for it is driven by the underlying fundamentals-how much cash is produced, for what period of time and how sure we are about our estimates. The different metrics-P/E and P/B must be equivalent just like an inch must be 25mm (rounding error excepted). Consider:

1)     P/B= ROE-g/Ke-g

2)     P/E=P/B divided by ROE

Thus, for a bank with a 12% ROE, 2% growth and 10% Ke the P/B is 1.25X and its P/E is 1.25/12% is 10.4X. An improving bank with a 15% ROE, 3% growth and 10Ke will generate a P/B of 1.7X and a P/E of 11.3X.Of course there can be divergences of opinion regarding future operating performance especially concerning expected synergies. Nonetheless, large differences need to be reconciled against more detailed discounted cash flow analysis.

For me, the biggest issues in bank M&A pricing is not P/B or P/E, but rather the premium over the pre-bid target trading price. Premiums less than 20% have a much greater chance of adding value for the buyer’s shareholders than those exceeding 40%. If you over pay relative to the cash flow acquired, regardless if expressed in P/E or P/B terms, your shareholders lose.

Ralph and I are on our way to Amsterdam to hold our annual acquisition financing class. Thus, posts next week may be suspended. I always learn something new from the interchange with the attendees, and will share those insights with you.

I hope everyone had a great Thanksgiving Day holiday. As usual, I over ate and watched too much football.

J

Repurchases: Part 2 The Positive Side

On our last post, Repurchases: Part 1 Shareholders Beware Joe pointed out some concerns about repurchases.  These are good cautions, but I'm an empiricist and I need to point out that the empirical evidence on repurchases is much more positive.  In the paragraphs below,  I'll first outline some theories about share repurchase and then discuss some empirical evidence.  

We generally assume one of six things is going on with a share repurchase.  First, a firm could feel that its stock is undervalued and the repurchase signals positive news to the market about this inside view.  In this case, we'd expect to see the stock price rise on the announcement of a repurchase.  Second, the firm could use repurchases as an efficient tax-advantaged way to return excess cash to shareholders.  It is efficient and tax advantaged since capital gains are taxed at a lower rate than dividends.  Third, the repurchase signals that management is not going to squander excess cash on things like unproductive acquisitions.  Both of these are positive effects and the stock price should rise upon announcement of a repurchase.  Fourth, an in contrast to the previous item the repurchase could signal a lack of growth opportunities for the firm.  In this case, we'd expect the stock price to decline at the announcement of a repurchase.  Fifth, since repurchases reduce the equity position in a firm, they change the capital structure producing less cushion for debt holders.  If true, debt holders would lose upon announcement of a repurchase; equity holders would gain.  Sixth, firms sometimes repurchase shares to fund executive options. One can imagine other motives, some of which Joe outlined in his post.  I'll return to that in a moment.  

The empirical evidence on repurchases is strongly consistent with a positive impact to shareholders and generally supportive of the first three hypotheses mentioned above: signaling, tax efficiency, and the return  (rather than squandering)  of excess cash.  The fourth and fifth hypotheses ( a lack of growth opportunities and wealth transfers from bondholders)  find less support.  On the sixth hypothesis, Kahle (2002) also provides compelling evidence on the use of repurchases to fund executive options.  This is not, by itself detrimental, but has clouded some empirical tests of the other hypotheses.  (For an elaboration on this see Share Repurchases see our article in the Journal of Corporate Finance, Share Repurchases Executive Options and Wealth Changes to Stockholders and Bondholders.) 

So the empirical evidence is overwhelmingly positive and I find myself more optimistic about repurchases than Joe.  This does not mean that shareholders shouldn't be concerned with the cautions that Joe notes.   The empirical results we discuss in this post are statistically significant tendencies.  Individual firms could still be using repurchases for less than desirable reasons.  Indeed, some of the items Joe notes (use of repurchases to mechanically raise earnings per share, for example), have no empirical justification.  Concerns about firms overpaying shareholders who tender make sense.    Other items like repurchases to alter option values suggest fruitful additional ideas for additional analysis.    These things may exist in a subset of the data.  The wise investor or board member can take comfort from the positive evidence about repurchases, but should sprinkle this with healthy skepticism for possible abuse.  

Ralph

Share Repurchases: Part 1 Shareholders Beware

Happy 2013 to All!

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A strength of our blog is the combined and sometimes differing viewpoints on topics.  Today, Joe warns of the dangers of repurchases.  On Monday, I'll talk about some positive elements of repurchases.

Ralph

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Slow organic growth and a tepid M&A environment have caused an embarrassment of riches at many firms with increasing capital and cash levels. Managers are concerned about falling ROEs , stagnant earnings per share (EPS) and their incentive compensations plans which are tied to those measures. Shareholders are also expressing concern over raising capital levels. Their concern is it may be reinvested in over- priced acquisitions among other things. Thus, they are putting pressure on management to return excess capital. This in turn raises the question of how best to return capital. The focus of this post is on excess cash funded repurchases-not debt financed repurchases -which involve capital structure considerations.

Share repurchases, aside from technical tax differences depending on the tax status of the firm’s investor clientele, have similarities with dividends as a cash distribution mechanism. For example, a dividend combined with a reverse stock split yields the same result as share repurchase of the same amount. Dividends and repurchases differ, however, in certain important respects. For example, EPS will be higher with a repurchase compared with a dividend absent a reverse split because of a reduced number of shares. This is true even though the ROE is same under both distribution alternatives. Thus, repurchases can be used to disguise poor earnings growth through manufactured EPS growth by reducing the denominator of the calculation instead of improving the numerator.

Another difference concerns the allocation of value between the selling and remaining shareholders. All shareholders receive dividends. Only the selling shareholders receive cash in a share repurchase. Remaining shareholders are penalized when shares are repurchased at a price above their intrinsic value. In that case value is transferred from the remaining shareholders to the selling shareholders. Managing this risk is difficult as it can only be assessed after the fact. Historically firms are poor at timing share repurchases at the appropriate price-i.e. they overpay.

A simple discount to a target is insufficient to justify a repurchase.  The discount may be warranted due to poor earnings prospects. Management over-optimism frequently results in over-paying departing shareholders at the expense of those who remain.  Particular attention is needed to guard against repurchases that are overpriced to influence stock prices by increasing EPS. Managers seeking to game incentive compensation systems tied to these measures will propose repurchases. EPS improvements following a repurchase are, however, offset by falling price-to-earnings ratio without necessarily increasing long term value. Repurchases affect the distribution of value, not the creation of value as operating results remaining unchanged.

Boards reviewing a repurchase proposal should follow a three-step process. First, they need to understand and approve the motive for the repurchase. Motives other than the efficient return of excess cash should be challenged. Next directors must understand the firm’s conservatively calculated intrinsic value. They should approve stock repurchases only below that value. Thus, managers should justify repurchase prices based on credible intrinsic value estimates.

Boards should be skeptical of managerial undervaluation claims. This may reflect a poor investor communications that should correct over time. Alternatively, investors may not believe management value estimates. When in doubt a special dividend may be better than a potentially overpriced repurchase. Finally, the distribution should be part of an overall capital plan that is tested under adverse macroeconomic scenarios.

The repurchase decision involves complex valuation and governance considerations. Investors are not and should not be indifferent to these factors. This requires clear thinking by the board to protect the interests of non-selling shareholders against potentially conflicting management motivations. Capital management assumes Uheightened importance in a low growth environment. This includes selecting the best means to return capital to shareholders when it cannot be profitably reinvested in organic or acquisition opportunities. Repurchases are not necessarily bad, but when misused they can reduce shareholder value. So, shareholders beware.

Joe