The State of Bank M&A with Brady Gailey from KBW
This week we sit down with Brady Gailey, Managing Director of Equity Research at KBW. We discuss how COVID has impacted the world of bank M&A, the impact of the new CECL regulations, and the M&A trends he anticipates in the next couple years.
The views, information, or opinions expressed during this show are solely those of the participants involved and do not necessarily represent those of CenterState Bank and its employees.
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[Intro] Helping community bankers grow themselves, their team and their profits. This is the Community Bank Podcasts. Now, here are your hosts, Eric Bagwell and Tom Fitzgerald.
Eric: Welcome to the community bank podcast. I’m Eric Bagwell, director of sales and marketing with the correspondent division at CenterState Bank. Joining me as always Tom Fitzgerald. Tom is director of strategy and research in our capital markets area. Tom, what’s going on?
Tom: Eric, I am doing fine. I hope you are well.
Eric: I’m good. It’s cloudy and humid and…
Tom: And not so hot.
Eric: Not so hot, but football is around the corner we think and so maybe some cool weather is coming as well. So today on today’s show, we’re going to talk about a topic that you hear pretty much everywhere you go, probably within a bank meeting, but it’s M&A and we’ve got Brady Gailey joining us. Brady’s managing director of equity research at KBW Brady’s it’s a great interview. We’re going to play it for you in a minute. Brady, actually used to work with us in a past life and Brady. I think he’s been with KBW; he’ll say it in the interview. I think he’s been there probably 13 years or so, so he’ll have some great information, but before we get to that, we want to talk about an event we have coming up. You know, we’ve delved into the world of podcasts now. I think this is our 12th or 13th show. We’re going to try to hit like a little TV type deal now. On October the 15th, we have a capital markets forum. It’s going to be a live stream event. It will be I guess myself; you and four other people will join us from our capital markets area. Why don’t you talk briefly about what that’s going to look and sound like?
Tom: The faces of radio are going on the big screen, so we’re not sure how that’s going to work. Anyway, some of the listeners may have recall, I guess the last couple of years we were doing series of bond schools. And so, we traveled around and got 15, 20 banks together and spent about five hours going through kind of just an overview of the economy and where rates are going and kind of from that, you know, what makes sense in the investment portfolio as far as investments. The good news is we’re going to condense that five hours down to about two and give you sort of the best of, of those bonds’ schools. So, if you’ve seen them before, certainly, you know, you’ll want to see them again, we’re going to update our economic forecast. We’re going to kind of give you a rate outlook. And then from that kind of delve into what makes sense in this environment from an investment perspective. It’s, you know, nothing looks good from an outright yield perspective, but you know, we’re in a spread business and you want to try to keep those spreads as wide as you can to help your margins. And so, we hope this this event we’ll give you some nuggets to take back with you to be able to do that.
Eric: Yeah. And we’re excited. CPE credits will be available. It’s going to be interactive. We want questions coming in from you guys and we want you guys to take part in it as well. So, we’re excited about it. We are sending out a save the date. It should be first of next week as this podcast is coming out. So, if you’re listening to this, probably expect an email but we’ll also tell you how to register probably next week on the podcast as well. So, we want as many folks to join us for that as we can. So, let’s get to the interview with Brady. Brady, Gailey, managing director of equity research with KBW. We’ll go to that interview now.
Joining us now is Brady Gailey, managing director of equity research at KBW. Brady, thanks for coming on the community bank podcast with us today.
Brady: Thanks for having me.
Eric: Alright, so we want to hear about your background and quickly I’ll just throw in that we all used to work together and it seems like especially after this year, an eternity a lifetime ago, but give us some of your background and for those people that are listening.
Brady: Yeah. Thanks Eric. So, I graduated from Ole Mess in 2003, and actually my first job out of school was working for the Bankers Bank. I spent the first couple years doing after consulting and then I worked with Frank Brown on the M&A side. In 2007 I joined Keith Bruyette and Woods KBW in their equity research department. And I now cover in between 30 to 35 publicly traded community and regional banks all in the Southeast or Southwest. My territory is really kind of North Carolina, Georgia, Florida and then I hop over and do Texas and Oklahoma and then I have one in Denver and one in Tennessee, but they’re mostly Southeast and Southwest focused analysts.
Eric: Gotcha. Let’s jump right in and here talking about M&A this year and given the pandemic how it’s changed everything about banking it seems this year. Tell us how it’s impacted the world of M&A ready?
Brady: Yeah. So, once COVID hit, you know, it really feels like in a conversation, mostly I just stopped. You know, the banks have really been busier in the last six months trying to figure out the risks embedded in their own balance sheet. Like, you know, hospitality and restaurant and retail and energy. They’re really trying to ring fence their own risks and not really, you know, assess the risks of others in a potential transaction or other risks of a target. There are many banks have been very active in the loan modification and a deferral space and we’ve seen a lot of banks, you know, defer or modify 20 to 30% of the loan book. Yeah, which is just a big number. The banks have been very busy with the PPP program and now the forgiveness process associated with that. You know, we’ve seen rates go to zero, go back to zero pretty much overnight and we saw the 10-year bond yield, the lowest it’s ever been. So, you know a lot of new risks came with COVID which has really pushed M&A conversations to the back burner. M&A has really been almost dead for the last couple quarters. You know, it’s just hard for a bank buyer to assess, you know, the core earnings power of the target and really the underlying credit quality of the target. You know, and to the extent that the buyer has a publicly traded stock price, stock prices you know, have been impacted significantly, especially bank stock prices since COVID. So, you know, it’s hard for a buyer to use his currency with a lot of these buyers here, their stock is trading below tangible book value. It’s hard to use that currency to do a deal.
Tom: And Brady, we all know that you know, before COVID arrived on the scene, there was the issue of CSO, which is the new loan loss, accounting standard, which kind of put a probably a little bit of a headwind on M&A as well. Can you kind of talk without getting too much in the accounting weeds of its kind of how CSO has impacted the M&A business and valuations in that regard?
Brady: Yeah. So CSO became effective on January the first of this year. Although the cares act did allow for a delay of CSO which led some banks to delay season, they got to push it back to the last day of the year, December 31st. You know, most of mine went ahead and adopted CSO. And CSO I’m sure you guys noticed just a new way of calculating a new reserve that’s really more forward-looking versus the prior methodology, looking at more backward looking. You know, CSO does have a real impact on M&A. You know, in most transactions you always take a loan mark. Now with CSO in addition to your loan mark, you also take a day to reserve build. So basically a, you know, double loan mark, you know, which would you be burdens, tangible book value per share, you know, it helps forward EPS, it helps forward earnings accretion to the extent that you can capture those excess reserves, but, you know, it does burden, tangible book value per share. You know, investors do not like tangible book value per share dilution. So CSO, you know, has made M&A more problematic on the accounting side.
Tom: Brady in the most recent transactions that we’ve seen. What are the value ranges that are being received and how do these valuations compare to deals that were done in the past?
Brady: Yeah, so, you know, M&A pricing has changed dramatically over the last 15 years. And back in 2005 and 2006, it was not uncommon to see bank selling for three to four times tangible book value. You know, some, even five times tangible book value. You really never see those multiples anymore. You know, bank stocks trade at a greatly reduced valuation now versus then. So, the buyer’s ability to pay is greatly reduced as well. And, you know, I feel like the stock for those buyers that have a publicly traded currency. You know, I feel like the stock market nowadays is really holding the bank buyers to a more conservative standard. You know, investors and shareholders are very focused on not allowing bank buyers to overpay. You know if the bank does overpay in a transaction, their stock price can be negatively impacted for years. You know what one metric that is very much in focus today when investors and shareholders help look at M&A is this idea of the earn back period, which is basically the earn back on your tangible book value per share dilution. Is basically a calculation in the States, how much time it’ll take the buyer you know, to earn back the dilution and realized from the transaction? Investors really want to see that earn back period around the two or three years or less but you have a buyer announces a transaction that has, you know, a five to six year earn back, and that stock price can take a hit, you know, which isn’t good for anybody, but the buyer or the seller.
Tom: And Brady everybody’s crystal ball is a little bit crack these days. But do you have a feel kind of where the trend is going to go in the next year or two as far as activity in M&A and valuations as well?
Brady: Yeah. You know, I think near term, you know, M&A will continue to be pretty quiet and maybe you’ll see a pick up late this year. But I do think that one thing that COVID will do longer-term is drive even a greater need for M&A and if you look at you know, technology and that it’s more important now than ever and, you know, having a larger base to spread those technology costs over is very important. And with lower rates, with lower interest rates and a flat curve, I mean, your net interest margins are under pressure. We saw significant net interest margin compression back in the second quarter and we’re likely to see it continue. So, with NIMS under pressure you know, that obviously will impact the profitability of the bank. So, you know, again, you know, having scale and having opportunities to get cost saves are very important to achieving your higher ROE levels. So, you know, I do think we’ll see a lot more kind of low to no premium merger where it’s really kind of a merger of equals or a partnership.
Tom: Well, let’s step back a year or two when the transactions were a little bit more active and valuations where, you know, it was a little more attractive as far as getting people involved and getting, you know, buyers and sellers to come together. Everybody enjoys a good anecdote. Do you have some kind of, some tales from transactions in the recent past that you could share with us?
Brady: Yeah, so we, you know, last year in 2019, and that was really the year of some pretty big bank mergers, and it was in the year of the merger of equals. You know, we saw five substantials in a reason announced of the largest Obsidian Southeast where SunTrust and BB&T came together to create tourist. You’re looking more at the community bank and regional bank space. You know, we saw TCF and chemical get together up in Detroit, in Chicago. You know, in the Southeast we saw First Horizon an Iberia Bank complete a nice NOE. You guys obviously well aware of this interstate, South State merger of equals. And then we had one in Texas, Texas Capitol announcing NOE with independent bank, which that Texas transaction was actually later been terminated. I didn’t cover backdrop it up. I do think we’ll see a lot more of these strategic interviews where it’s not really about going to day one premium, but instead it’s about putting together, you know, two like-minded companies that, you know, together can expand their scale and profitability, which over time will we do a higher valuation in the banking space is consolidated because it needs to. You know COVID has definitely temporarily paused that, but I do think it will come back and when it comes back, I think they will be, you know, very active.
Tom: Finishing up with Brady Gailey. Quickly, Brady, if there’s a listener out there that’s thinking of selling, what are some things that you can advise them of to prepare, or maybe even clean up before they maybe start soliciting bids? And are there some things that they can expect in the process that they may not be aware of on the front end?
Brady: Yeah, I would say the transactions that are, you know well received by the market, or really transactions where you have, you know, two very like-minded strategic companies that are very similar. So, you know, sometimes you see banks that are built to sell, and sometimes those can be lower quality and your banks. I would really build your bank like you’re going to only forever, you know, definitely focus on core deposits, that’s a big focus nowadays. And, you know, I would focus a lot on the currency that you’re getting, especially if it’s an all-stock transaction and I think the currency that you’re receiving is a lot more important than, you know, the day one premium or the price to tangible that you get. And sometimes even, you know, accepting a lower price that leads to a transaction that’s better received. You know, they, the buyer stock price will go higher and you have a better deal over time versus a takeout where you’re getting every penny that you can get, but the market doesn’t like the deal and the buyer stock price, you know, it can be down 20% from announcement, which is not great. You know, you want to keep asset quality as clean as you can. You know, another thing to consider is just, you know, trying to find a buyer that does have some nice overlap. So, there are ample cost saving opportunities. The more cost saves opportunities that the buyer has, will really allow for a better transaction for them at the end of it to pay a higher price and hiring a good investment banker that knows the market and knows your likely buyers as well.
Tom: Brady, we appreciate you coming on today with us. This has been some great information and obviously this is a topic that you hear a lot about any convention you go to a lot of meetings. It seems like you always talk about M&A. And so, we probably want to have you on as a regular guest, but we appreciate your time today, man.
Brady: Yeah. Thanks for having me guys.
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