Pricing for profitable banks in strong regional economies has ranged between 1.50x and 2.00x tangible book (adjusted to an 8% level). In exceptional circumstances, we have seen prices go as high as 2.25x. Exhibit 1 is a recap of merger activity and trends in 2011 with a look toward what may develop in 2012.

Recap of 2011 Merger Activity and Trends

At the beginning of 2011, expectations abounded that it would be the breakout year for the next wave of industry consolidation. The second quarter surge in M&A transaction volume seemed confirmation of the year-end 2010 trend. But it proved the exception rather than the rule as volume ebbed in the final two quarters. Whole-bank transaction volume for 2011 totaled 157, down from 173 for 2010. Transaction volume in the second half of 2011 was no doubt affected by the continuing regulatory uncertainty and the tenuous nature of the U.S. economic recovery, exacerbated by the budget deficit debate and the deepening financial crisis in Europe.

An analysis of the types of buyers in 2011 reveals a marked shift from 2010. Transactions involving investor groups as buyers fell to 36 or 23% of total transactions in 2011, half the 73 (42%) posted for 2010. Banks reclaimed their naturally predominant position (versus investor groups) in bank M&A, acquiring 111 banks or 71% of the total sold during 2011 compared to just 83 or 48% in 2010.

Median pricing as measured by the price to tangible book trended downward in 2011. The 0.92x median tangible book multiple for the fourth quarter of 2011 was the lowest quarterly level recorded for at least the last eleven years. This trend in pricing seems counterintuitive since industry asset quality has found a bottom and profitability is trending up.

A review of fourth quarter transactions reveals nineteen transactions (51% of the quarterly total) involving a publicly-traded regional community bank buyer with assets over $1 billion, which explains the relatively large median size of the buyer. Thirteen of the selling banks were also publicly traded. Common stock accounted for some or all of the consideration in sixteen of the transactions compared to a total of twenty-four for the other three quarters combined. As noted in Exhibit 2, the median seller was experiencing some stress from asset quality issues.

Representative of recent transactions is $3.9 billion-asset SCBT Financial’s acquisition of Peoples Bancorp ($546 million), both South Carolina-based banks. The all-stock transaction also entailed the payoff of Peoples’ outstanding TARP in full at closing. For SCBT, the transaction deepened its upstate South Carolina footprint along the I-85 corridor and offered potential savings from charter consolidations and other synergies. The all-stock structure minimized goodwill, maintaining SCBT’s strong capital ratios. Peoples’s shareholders maintain their investment in the industry, but in the more liquid stock of a larger, stronger company.

Peoples Bancorp was well-capitalized and under no enforcement formal action. Its asset quality and earnings had improved over the last four quarters, indicating that the bank had ring-fenced its problem assets and was working through them. Yet its management realized that the shareholders would likely realize greater value at lower risk by merging with a larger partner with similar banking philosophy.

This scenario, with variations, was played out many times during 2011 (not just the fourth quarter), sometimes with the seller taking stock in a privately-held bank. This suggests that buyers are comfortable with their own financial position and are willing to take on some risk. Even though sellers may be confident of survival, they are recognizing that survival may not equate with success in the future banking environment. The path to success for many has been to merge with a partner at today’s prices and realize full shareholder value in the future.

The recovery in the banking industry progressed at a moderate pace during 2011 as profitability and asset quality improved at the nation’s largest banks. Industry profitability for the three quarters of 2011 as measured by the aggregate ROAA improved to 0.92% from 0.64% for the comparable 2010 period. Much of the improvement stemmed from lower provision expenses. Net charge-offs and non-current loans also fell from their 2010 levels, reducing the prospect of higher provisioning in future quarters.

Exhibit 3 shows the components of pre-tax, pre-provision net income (bars) and the resulting pre-tax, pre-provision net income (line) as a percent of average assets by size category for the median bank over the twelve-month period ending September 30, 2011. Note the direct correlation between size and profitability in this chart, a theme that pervades today’s banking environment and will fuel M&A activity.

Exhibit 4 shows the percent of total banks by last-twelve-months (LTM) ROAA since 2002 broken into four segments. Over the four quarters through the third quarter of 2011 (date of most recent industry data), the number of loss-making banks showed the greatest decline in number, falling from 2,166 or 28% of total banks for the comparable twelve-month 2010 period to 1,395 or just 19% in the 2011 period. Of the profitable banks, those earning 0.50% to 1.00% increased the most to 36% of the total or 2,654 in the 2011 period from 23% in the 2010 period. Overall, fifty-eight percent of total banks were profitable on an LTM basis at the end of the third quarter of 2011 compared to 47% for the LTM period ending the third quarter of 2010.

While the largest banks are far along in resolving problem assets, real improvement in asset quality is proving elusive at the community bank level. The total number of banks with NPAs+90s/ Total Assets greater than 2% fell by 270, just 7% to 3,605 over the twelve-month period ending September 30. While some banks are emerging from the tar pits, others have just become ensnared as evident in Exhibit 5.

The number of institutions with the most severe challenges (measured here as over 6% NPAs/ Total Assets) has steadily declined for the last five quarters. However, the reduction of 109 during that time was only slightly less than the number of failures – 119. Not all of the 109 were failures: some banks moved out of the category through successful resolution of some of their problem assets. But the message here is that while the level of problem assets has peaked, it appears the decline will have a long, fat tail.

Conclusion

As mentioned previously, there were sixteen transac­tions announced in January of 2012 versus three in January, 2011. As we see it, the fourth quarter of 2011 M&A activity signaled the beginning phase of the next consolidation wave spurred not by a desire for growth for its own sake, but for sustainibility in the face of an uncertain future. This applies to buyers as well as sellers.

It seems that the ingredients for more robust M&A ac­tivity are in place. Fourth quarter earnings announce­ments among the nation’s publicly-traded banks have been positive with a continuation of the trend in better profitability, lower provision­ing, and lower levels of problem assets. Loan volume, though anemic, seems to be stabilizing, with many publicly traded banks reporting higher loan levels and expectations for modest growth in 2012. While regulatory guidance regarding capi­tal remains unclear, there seems to be greater receptivity on the part of regu­lators to well-structured transactions.

There is pent-up demand on both sides of the negotiating table. Buyers are look­ing for loans and inexpensive deposits to boost net interest income and gain enough efficiency to offset lower non-interest income and higher non-interest expenses (driven largely by as-yet undeter­mined regulations). Many sellers have postponed en­tering the market in the last two years due to perceived low prices and uncertainty regarding their own finan­cial condition. The same issues driving buyers into the market, particularly margin compression and the need for size, are also driving sellers into the market.

Today, with the marked improvement of many larger community banks and the reemergence of these banks as the predominant acquirers, sellers have more poten­tial suitors which should lead to better clarity on pricing. Additionally, the recent flurry of merger activity points to better opportunities to find the right merger partner.

Contact us today for a complimentary discussion of the values and opportunities in your market.

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MBA CFO Presentation 2011

Looking at the broader picture presented in Exhibit 1, deal volume has been weaker in 2011. Announcements totaled 113 for the nine months ending September 30, 2011, down 9% from the 124 for the comparable 2010 period.

Over this same period, median deal pricing began a slow decline for four quarters before bottoming in the first quarter of 2011. Since then pricing has gradually improved. It should be noted that the overall median pricing tends to mask the two types of transactions occurring: healthy bank sales and distressed bank sales. ( See Exhibit 2).

The chart results, similar to past periods, show a near-equal number of healthy bank deals (<2% NPAs) at a median price/tangible book of 1.34x as distressed bank deals (>6% NPAs) at a median price/tangible book of 0.63x. Pricing for seller banks with NPAs/Total Assets between 2% and 4% is nearing the median pricing for healthy banks, indicating that more sellers and buyers are successfully negotiating the intricacies of asset quality and capital issues.

To better understand the causes behind weaker volume in 2011 versus 2010, we divided the buyers into two groups: investors and banks. An investor was defined as an entity with no current banking operations. An investor group making subsequent acquisitions was classified as a bank.

As Exhibit 3a shows, investors were prolific buyers during the first two quarters of 2010, accounting for 59% of total deal volume in those quarters. Investor participation has plummeted since that time to a low of 5 transactions in the third quarter of 2011 as targets that meet their profile prove elusive.

Factoring the investor group transactions out of the total reveals that transactions involving two banks has exhibited less volatility recently as shown in Exhibit 3b. In fact, merger transactions between banks totaled 91 for 2011 through September, up 44% from 63 for the comparable 2010 period. While total deal volume is down from 2010, banks, which are the universe of natural buyers, accounted for 81% of total deal volume so far in 2011 versus 51% in 2010. From this aspect, the M&A market today is a healthier, more viable market than that of 2010 which augurs well for the future.

A subset of this volume is made up of mergers of equals (MOEs), which have averaged about four each quarter for the last six quarters. (We defined MOEs for this analysis as transactions between (i) two banks one of which has no more than twice the assets as the other or both banks having $100 million or less in assets and (ii) the “seller” has NPAs/Total Assets less than 4%.) Three MOEs were announced in the month of September alone. Is this sudden surge in volume the result of Dodd-Frank going effective and fading economic prospects or just coincidence? Time will tell. But, we believe that an MOE represents an attractive means of gaining scale necessary to achieve sustainability while staying invested in the industry.

Exhibit 4 breaks down pricing data and buyer information by the three groups of buyers above (MOE, investor buyer, bank buyer). Pricing metrics for transactions in which investor groups are buyers are higher than metrics for the other two groups in both years. Investor groups typically pay a premium to entice sellers into a transaction due to a higher level of execution risk associated with non-bank buyers. They also are able to lay off much of the balance sheet risk onto the existing capital structure of the seller and have no legacy issues of their own. As expected, the book premium was lowest for MOEs; the 2011 median price/tangible book was 0.99x.

In the final analysis, as the moon’s gravity affects the tides, so investor groups have affected the M&A market over the last 18 months. As their interest has waned so have transaction volume and pricing.

But, as markets recover and the industry finds its footing, traditional bank mergers are replacing investor-led transactions. Questions still abound regarding the overall economic environment, the implementation of new legislation such as Dodd-Frank, and whether the industry’s performance can build upon its nascent signs of recovery. Local economies tend to dramatically affect bank performance and thus M&A pricing, but in many areas the stage is set for bank consolidation.

Such a consolidation involving healthy banks in stable regional economies will price out between 1.50x and 2.0x tangible book, or roughly 11x earnings – this appears to be the “new normal”. In the pockets of economic weakness that are inundated with poorly performing banks, deal prices will be at or near tangible book with many of the distressed assets carved out of the transaction. The government, through the FDIC resolution process, may lead the consolidation in some of these areas, but traditional unassisted transactions are set to increase as long as buyers maintain confidence in the overall economy and focus on leveraging their equity.

Contact us today for a complimentary discussion of the values and opportunities in your market.

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The early stages of a recovery are evident in Texas banking. Exhibits 1 and 2 chart the quarterly trend in nonperforming assets and provision expense as a percentage of average assets. While the level of nonperforming assets of Texas banks continued its
modest decline, the median level of provision expense in the second quarter continued its rapid decline to an annualized level of only 0.09% of assets. This implies that the earnings drag of nonperforming assets is lightening up as assets have been written down to the level needed to sell in the current market. South Texas and the DFW area clearly have more clean-up work to do but the state as a whole is well-positioned for a recovery in bank profits to begin taking hold.

One observation taken from the view of asset quality provided by the accompanying charts is that the credit cycle in Texas has peaked but the full recovery may have a long tail. Another take-away is that credit underwriting in Texas was strong in the years before the financial crisis and has been aided by a relatively strong state economy during the last three years. For the rest of the nation, the direction of the credit cycle is still in question given the steady rise of NPAs at banks in the large metropolitan areas. One caveat is that the improving trends are susceptible to any further weakening of the economy.

The continuing improvement in asset quality and the concomitant reduction in provisioning are reflected in the rising profitability in both the Texas and the national banking sectors. Led by the Non-Metro, El Paso and Austin banks, the median ROAA for Texas banks jumped to 0.79% in the second quarter, 32 basis points higher than the national metro median bank ROAA and 15 basis points higher than the national median. Also contributing to the Texas banks better performance are declining non-interest expenses. Non-interest expenses for the median bank in the nation have been essentially flat for the last year, likely reflecting the drag of losses on OREO sales and maintenance expenses of non-performing assets (see Exhibit 3).

Loan growth (or the lack of it) has been in the headlines as deleveraging in the private sector of the economy progresses. We decided to review the change in loans at Texas banks from the second quarter of 2009 through the second quarter of 2011. We aggregated total loans for each institution contained 2801 Via Fortuna n Suite 625 n Austin, TX 78746 (800) 279-2241 n www.SheshunoffIB.com The Texas Report Second Quarter 2011 in their quarterly regulatory reports. Loans for three institutions – Comerica, USAA, and Wells Fargo South Central, NA – were excluded from the analysis as significant portions of their loans are out of state. We calculated the percentage change in loans using the 2009 second quarter loan balance as a base and dividing the loan balance for each successive quarter by it.

The results in Exhibit 4 (Total Loans, above) show that loans in Texas as a whole remained above the 2009 second quarter benchmark in all quarters and were 103% of the base level in the 2011 second quarter. (The change in loans at the rest of the nation’s banks over the same period was about 1%.) Loan demand at Non-Metro, Austin and El Paso banks has been the source of strength over the last two years, contributing to the state’s resilience. Given its relatively high level of NPAs over the last two years, it is interesting to note that loans at DFW banks have also been strong. Loans at banks in Houston and San Antonio fell steadily until about the 2010 second quarter before stablizing. Banks in both MSAs reported higher levels of loans in the 2011 second quarter. Banks in South Texas have shed loans in each quarter for the last two years. Balances at these banks in the 2011 second quarter were 92% of the level in the 2009 second quarter. To some degree, the “stability” of loans over the last two years at both the state and national level is remarkable considering the large amount in dollar terms of loans that have been charged off, sold, or transferred to OREO in addition to the paydowns on performing loans.

Pricing for Texas’ publicly-traded banks in the second quarter shows that others are noticing the improving climate for Texas banks. Pricing rebounded sharply for the median Texas bank with the price to tangible book rising to 1.43x as of June 30, 2011 compared to 1.00x for the national median. Of note, this was the last quarter for Sterling Bancshares to report as its merger with Comerica closed on July 28. See Exhibit 5, previous page.

Texas is one of the leading states in merger volume and pricing, although in this weak market, the volume and pricing are not what Texans are used to seeing. Community banks or investor groups were the buyers in five of the Texas transactions so far this year. It’s difficult to draw much guidance from the pricing multiples with so few deals and with each having unique characteristics. Based on our experience in the market, a relatively clean bank in a decent market would fetch between 1.4x to 1.8x tangible book (assuming a capital level around 8%).

With the solid capital base and strong stock prices of the publicly traded banks in Texas, one would expect to see robust M&A volume. But the fact is that only one publicly traded bank in Texas has made an acquisition so far in 2011 and that was Comerica buying Sterling in January. One factor cited by executives at several leading publicly traded Texas banks is a lack of sellers in their target markets. On the other hand, given the strengthening financial condition of Texas banks, potential sellers aren’t under the pressure from regulators or shareholders that others around the nation may be feeling.

From our discussions with prospective buyers and sellers, we sense the M&A market is hostage to several short-term tensions. While regulatory pressure is driving some sellers to market, potential buyers are fearful of the regulatory consequences of fair value accounting and NPAs on capital. In some areas, there is an insufficient number of strong buyers with capital and management to handle the backlog of sellers, many of which are profitable with few asset quality problems. Although there is some convergence between buyers and sellers on the concept of a “fair” price, some buyers suffer from a low stock price or the seller’s reluctance to accept privately-held stock in a trade.

Certainly, greater clarity from regulators regarding “adequate” post-acquisition capital and the treatment of NPAs acquired is required to resolve the first dilemma. As to the second, only time and sustained efforts by potential buyers afflicted with problems can bring about a better balance. An informed understanding of value in today’s market and receptivity to alternative structures by both parties are essential to resolving the last issue.

What Opportunities Exist in Your Market?

Buyers and sellers are beginning to explore mutually beneficial transactions, a trend that is likely to accelerate throughout 2011. As the burden of regulatory costs becomes clear, many institutions realize the need for more economies of scale.

Call Curtis Carpenter or John Adams today to discuss how our recent transactions represent win-win situations and what can be done to create one for your institution. We would enjoy visitingwith you about current pricing trends as well as common obstacles in today’s negotiations.

Contact us at (800) 279-2241 or visit us online at www.SheshunoffIB.com.

Q2 2011 Texas Report

As Exhibit 1 (above) shows, median pricing has been flat-lined at about 1.08x book for the last three quarters, held in check by the very low prices for the most highly stressed banks. An analysis of deals announced during the first half of 2011 reveals that asset quality guides pricing as it has for the last two years.
(See Exhibit 2 below)

One interesting note is the superior pricing for the seven institutions with NPAs / Total Assets between 2% and 4%. Four of the seven sellers in this 2-4% NPA group were large community banks with assets between $1 billion and $5 billion. In each case, the buyer’s motivation was the strategic value attached to the seller. For F.N.B., the acquisition of Parkvale Financial moved it from seventh to third in deposits in Pittsburgh, while Valley National doubled its deposits in New York and expanded into Long Island with its acquisition of State Bancorp. Abington proved a perfect fill-in for Susquehanna in the Philadelphia market with no overlap, while picking up $95 million of excess capital (which it will deploy in its follow-on acquisition of Tower Bancorp).

Scarcity value was a big part of Comerica’s purchase of Sterling Bancshares as there are few large banks domiciled in Texas. The deal moved Comerica’s deposit share in Houston up to sixth from twelvth and gave it a presence in San Antonio, which it was lacking.
(See Exhibit 3, below.)

In what may be one of the few bright spots in California these days, M&A volume soared to eleven deals during the first half of 2011, eclipsing the full-year 2010 volume of nine. The median asset size of California sellers was $153 million, similar to the median asset size of $146 million for all transactions in the nation. While the median California seller was better capitalized, its asset quality was weaker with median NPAs/ Total Assets of 5.98%. Four of the transactions involved investor groups, three of which made their initial acquisition in 2010. Contingent payments comprised a part of the consideration in two of the transactions. Median prices to book and tangible book of 0.92x were below the national medians as were other pricing metrics. Indicative of the weaker pricing, the median premium to core deposits was a negative 1.85% versus a positive 0.85% for the nation.

The two largest transactions announced so far this year were divestitures. Capital One won the battle for ING Bank FSB, the on-line U.S. subsidiary of ING Groep N.V.(Netherlands). Capital One is paying $9 billion in cash and stock or roughly book value for the $92-billion bank. The deal significantly broadens its funding base and catapults Capital One into the number five spot domestically in terms of deposits. With the deal, ING will be exiting the U.S. depository market, but the proceeds will boost its Tier 1 Capital ratio while reducing the Dutch government’s exposure to a toxic asset pool. The second largest transaction involved PNC Financial’s purchase of the Royal Bank of Canada’s (RBC) U.S. banking operations The deal represents a very strategic extension of PNC’s footprint into the Southeast, especially North Carolina, Georgia and Alabama and augments PNC’s existing presence in Florida. The price was approximately 97% of tangible book for the $27-billion bank and will be paid in a combination of cash and stock. For RBC, the deal is expected to be accretive to its 2012 earnings and raise its Tier 1 capital by 1.4%. RBC will refocus its efforts in the U.S. on wealth management and capital markets.

The common threads running through these three facets of the bank M&A market in the first half of 2011 are: a perception of a tipping point in the credit cycle, easy access to capital, and a continuance of the first-mover advantage theme. While it does appear that asset quality has bottomed at the industry level, in the merger arena, it may be better said that clarity is now sufficient for potential buyers to venture out. Capital appears to be abundant either on buyers’ balance sheets or in the market as almost $7 billion of common equity and $3.5 billion of preferred equity has been raised thus far in 2011. Further, buyers are increasingly comfortable using their stock as currency even though the public markets are off from year-end 2010 levels. Finally, in many of the deals highlighted above, the seller represented a unique opportunity for the buyer to acquire a scarce resource relevant to the buyer at an acceptable price.

CONCLUSION

In spite of industry and market uncertainties, M&A activity is almost at the peak levels (post-crisis) of the last half of 2010 while pricing closely follows the contours of asset quality. There seems to be a greater willingness on the part of buyers to act decisively in the face of organic growth challenges, especially if the target fulfills a strategic goal. In addition, more sellers are realizing the importance of joining forces to create a larger pool of resources even though the price may be perceived as “low” by some.

Deal pricing is still rooted in the fundamentals of regional economic growth and institutional profitability. Said another way, the value of a bank is based upon its projected growth rate and ROA. Banks that have been receiving premium pricing (at or near 2.0x tangible book) are those that are in healthy, growing regional economies and that have relatively strong net interest margins. Banks with these factors, which also present an opportunity for economies of scale for a buyer, are fetching the industry’s highest prices.

Contact us today at 800.279.2241 for a complimentary discussion of the values and opportunities in your market.

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