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  1. Home
  2. / Investing
  3. / Financial Services

Bank M&A Activity Is Heating Up

This bodes well for investors in community banks.
By TIM MELVIN Apr 29, 2015 | 12:00 PM EDT
Stocks quotes in this article: RY, CYN

I have been paying even more attention than usual to the news this week. Not only is Baltimore a place I called home for many years, my daughter lives downtown, near the ballpark. As things calmed a bit last night, I caught up on some reading I had neglected -- although CNN and the streaming news feed form local Baltimore channels were on in the background.

I was delighted to see that I had the newest white paper on bank Mergers and Acquisitions from my friends at FJ Capital in my inbox. Andrew Jose and the rest of the team at the firm are fantastic bank stock investors, and have been generous about sharing information and ideas over the past few years.

The report covered M&A activity in the first quarter of 2015. Deal-making has picked up once again, with 66 deals done in the fourth quarter of 2015. Larger deals are getting done, as total volume in the quarter was $8 billion compared to just $2.7 billion a year ago and $6.7 billion in the final three months of 2014. As predicted, deal multiples are starting to climb as well, with the average price-to-book value ratio of announced deals at 1.41 compared to 1.28 last year. The numbers are skewed a bit by the Royal Bank of Canada (RY) buying City National (CYN) in the biggest deal since 2011 at a premium price of 262% of book value.

The Midwest is seeing the most M&A action with 24 deals followed by the Southeast region of the US with 14 deals. The pace in the Northeast has slowed, with just two deals in the quarter. The Mid-Atlantic region had seven deals and the Southwest had 10. The West region saw just nine deals, but because of the City national deal, it was the dollar volume leader by a wide margin.

There continues to be a discrepancy between the prices paid for higher-performing banks over competitors who might be struggling a bit. The high-performing banks were defined as those with a return on average assets over 1% and returns on equity and over 10%. Buyers were willing to pay quite a bit more for the 11 high performers purchased in the quarter, and on average paid 196.8% of book value.

The more pedestrian banks were purchased for 135.7% of book value. This suggests that if I am willing to pay 85% for low-performing banks, I might consider paying up to 130% of those very rare high performers. I need to spend a little time pondering and testing that conclusion, but at first glance that appears to have merit.

FJ Capital also broke out some common characteristics of sellers in the quarter. Most target banks were small, with 50% of them having less than $500 million in assets and 75% of sellers having less than $1 billion in total assets. It is these smaller banks that are having the most problem with compliance costs and the huge need for technology spending that are making it difficult to generate consistent profits.

Most of the banks going on the block are having problems generating earnings, and have returns on average assets on an average of 0.49% and returns on average equity of just 4.28%. The costs I mentioned are a big reason for the earnings and profit drags, and these small low performers are in a position where they almost have to sell.

I was not surprised to see that the banks being bought tended to have higher equity-to-assets ratios. According to the paper, 80% of the banks purchased in the past three years had equity-to-assets ratios greater than 8, and 40% were in the 10 to 15 range that has been my hunting ground.

Credit quality for target banks is improving, as on average non-performing assets as a percentage of total assets for sellers was 2.1% over the past three years. Only 20% have been those high-quality little banks that have less than 1% NPAs, but that is changing. The average NPAs of selling banks in the first three months of 2015 was 0.94%.

According to Andrew and his team at FJ Capital, banks with high core deposit ratios are attracting buyers' attention as well. They say in the report that "more than 80% of sellers in the past three years have core deposit ratios higher than 75%. When the Fed likely begins to increase interest rates in the near future, banks with strong core deposit bases could be more valuable to buyers."

They conclude that they expect the pace of deals to pick up, as I do. Multiples are going to continue to rise during the year, as buyer currency and seller credit quality continue to improve as well. The Trade of the Decade is alive and well, and 2015 is shaping up as a great year for community bank investors.

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At the time of publication, Tim Melvin had no positions in any of the securities mentioned.

TAGS: Investing | U.S. Equity | Financial Services | Stocks

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