Wednesday, February 28, 2018

A Bank Consultant Is a Road Warrior: So Here Are My 3 Driving Pet Peeves!

To the followers that spend a lot of time in your car, I'm with you! Most times it can be a relaxing time to listen to podcasts, sports, or relaxing music. Sometimes, though, it's blow-your-top nerve wracking!

In the below video blog, I highlight my Top Three Road Warrior Pet Peeves! Not a banking post. But, hey, it's my blog, and perhaps you would be interested to peel back the onion on what makes me tick, even if it's about my pet peeves.

What are your Road Warrior Pet Peeves? Leave me and the rest of the readers a comment!

~ Jeff

Note: If you like podcasts and banking, try my firm's podcast, This Month In Banking!

Saturday, February 10, 2018

For Banks, Acquire or Be Acquired Is a Hobson's Choice

Bank Director recently held their Acquire or Be Acquired (AOBA) conference in the Arizona desert. It is a well run, well attended conference. When not there, which I wasn't this year, I follow the hashtag on Twitter. But the title of the conference bugs me. It's a Hobson's Choice.

According to Wikipedia, which is how I might have written college papers had it been available, Thomas Hobson was an English horse stable owner that gave buyers the choice of taking the horse in the closest stall or none at all. Translated to AOBA, merge or die.

But is that your choice: acquire or be acquired? What if, I don't know, you want to execute your strategic plan without merging?

I often say that "it all comes down to a spreadsheet". It doesn't mean that I wish it so. I want financial institutions to build an enduring and independent future. For the benefit of their customers, communities, and employees. If you have accepted shareholder money, i.e. you are owned by stockholders, you must also function for their benefit. One reason for the continued decline in the number of financial institutions, in my opinion, is the lack of balance in serving constituencies. 

Ignore one constituency to focus on another leads to problems, or the lack of alternatives, i.e. Hobson's Choice. AOBA.

So here is how I propose you work your strategy for the benefit of constituencies while keeping your eye on shareholders at the same time.

Strategy and The Option to Sell

Build a strategic plan that is aspirational. Shoot to become the financial institution you want to be. Identify it, and set strategy to achieve it. When you target such a future, which should benefit all constituencies, develop financial projections on what success would look like, in financial terms, if you nailed it! 

How far out should you project? As far out as you estimate it would take for the full economic value of your plan to play out. This could be three, four, five or even more years. Long term projections allow management teams to make strategic investments to build an enduring future. Budgets allow management teams to think short term, and delay strategic investments.

Naturally, I have a spreadsheet for you from our hypothetical banking company, Schmidlap Bancorp. 

Full disclosure, I used Evans Bancorp in Hamburg, NY. A well run, $1.3 billion in assets financial institution near Buffalo. They are not a client, so I know no inside information about the bank. Although the base period are their 2017 numbers, the projections are my own, not theirs. But I will refer to them as my hypothetical bank name.

Schmidlap's strategic plan includes near-term strategic investments that will adversely impact their earnings in Years 1 and 2. Their strategy is to achieve a 1%+ ROA in four years. Their plan has them achieving their aspiration.

The board and management team, in balancing their duty to shareholders, developed the present value per share of implementing this strategy. The table above shows the per share results. Schmidlap currently trades at 18x earnings, and their per share price was $40.70 at last close. If they execute this plan, and maintain an 18x earnings multiple, then the present value of executing this plan is $42.97 using a 10% discount rate. Perhaps you think this is uninspiring. But we are discounting results by 10%. So this plan should result in a 10% plus compound annual growth rate in their stock price if they succeed. Note that Schmidlap pays a 2% dividend yield. So the annual total return of this plan would be 12%+, all things being equal.

Not too shabby. 

But wait. An investment banker presents to the board that Schmidlap could reasonably achieve $46 per share in a sale. A 13% premium to their current stock price of $40.70, and a 7% premium to the present value of their strategy. This is termed the "strategy gap". If the gap is beyond board tolerance levels, management could revisit their strategy and sharpen their pencils, seek a downsteam merger partner to stoke earnings growth, or some combination. If they can't bridge the strategy gap, then perhaps a sale is in their future. And the investment banker smiles.

Hold on though. By remaining independent, and assuming management does not do wild things to materially elevate risk, Schmidlap maintains the option to sell into the future if they are not successful in executing their strategic plan. In most instances you can achieve a premium in a sale due to the synergies of the combination with a buyer. The oft-cited "cost savings". 

But what is the value of that "option to sell". I have ideas, and they are in the spreadsheet below.

If, in year 4, Schmidlap was not able to achieve their strategy, and they decide to sell, the buyer and Schmidlap would split the benefit of "synergies". In the accompanying table, by 50% although merger negotiations may be more or less. In addition, those added earnings are tax effected, and a terminal multiple applied equal to the difference of Schmidlap's trading multiple, and the multiple currently prevailing if Schmidlap were to sell (23x minus 18x). This yields a per share value of Schmidlap's option to sell at $3.82.

So, the present value of Schmidlap's plan, if including their option to sell, is $46.79 ($42.97 + $3.82). And exceeds what they can reasonably achieve in a sale. 

Since strategic plans and merger multiples will always be estimates when a board makes a decision, I do believe there ought to be reasonable tolerance levels of the strategy gap. For example, if the above math resulted in less than $46, should Schmidlap sell? Probably not if within a board specified strategy gap tolerance level, such as 5% to 10%. There is so much uncertainty in predicting the future, and the bank is operating for customers, employees, and communities in addition to shareholders. 

But ignoring shareholder value... as one of my Navy captains once said, bad news doesn't get better with age.

And the AOBA false choice will be your only choice.

Do you apply these principles in strategic planning?

~ Jeff

Saturday, February 03, 2018

The State of Banking

Where are we and where have we been? Trends are telling. In 2013, there were 6,812 FDIC-insured financial institutions. At September 30, 2017 there were 5,737, a 16% decline. There were 166 mergers, and four new charters in the first three quarters of 2017. As an industry, the trend is down. Ski slope down.

What about the financial performance and condition of our industry? The Presidential State of the Union address was supposed to report to Congress the Administration's view of the condition and performance of our country. It has turned into a sea of words amounting to nothing more than a wish list and priorities. Because the nation's balance sheet and income statement is not improving.

But what of banking? 

I broke down banking's financial condition, performance, and trading multiples into thirteen charts, seen below. Charts 1-6 are financial condition trends, 7-10 are financial performance, and 11-13 are trading multiples.

The numbers are medians from all publicly traded financial institutions between $1 billion and $10 billion in total assets. That yielded 291 total institutions, broken down by region. 

Financial condition ratios are promising. So I will say to you that the condition of the industry is strong. Assets, Loans, and Deposits continue to grow, although at a more moderate pace. And capital ratios have held steady and strong. In fact, if you listen to some institutional investors, the industry is over-capitalized. Many view an 8% leverage ratio as the "right" number. Although this should depend on an institution's risk profile and growth trajectory. And I have never heard a regulator say the phrase "over capitalized".

Non-performing asset ratios are in a long term downward trend. They have leveled off in the 60-80 basis point range. Some regions are experiencing slightly elevated non-performers from the previous year. A trend to watch.

The challenge with industry balance sheets is that loans have grown faster than deposits over the past few years. And loan/deposit ratios are steadily increasing as liquidity positions steadily decrease. Many bankers are less concerned about this citing their access to wholesale funding to bridge any shortfalls, or that they have been mopping up excess liquidity.

But rates have been rising slowly, and I believe Fed rate increases will accelerate this year, perhaps crossing the rate threshold where depositors now care what you pay them, and dooming those Betas in your ALCO assumptions to irrelevance. My opinion is that one or two more rate increases will trigger more skirmishes on the deposit battlefield. Those that have not positioned their bank to have strong liquidity will have to compete, giving back deposit mix gains they have worked so hard to achieve.

Net interest margins have leveled off from long-term industry declines. Good news! In 2017, NIMs ranged from a high of 3.8% in the West and Southwest, to a low of 3.1% in the Northeast. Are these anomalies due to region, competition, or business models? I would argue a mix of all three. But if I were a Northeast bank, I would ask why other regions achieved between 3.5%-3.8% NIMs and we're at 3.1%. That's a tidy sum to leave on the table.

Efficiency ratio trends look fantastic! And since NIMs are holding steady, it leaves me to think that operating expense control or increased profitability in fee-based businesses are at work. Based on my firm's experience with the profitability of fee lines of business, I am guessing the former. As balance sheets grow, operating expenses grow less, creating greater efficiency. Positive operating leverage!

Both ROAA and ROAE declined 2016-17, although efficiency is better. So what doesn't the Efficiency Ratio measure? Provision, and income taxes. Most of the institutions, if not all of them, probably took a Deferred Tax Asset (DTA) writedown in the income tax line item, impacting these bottom line ratios. But this probably doesn't account for all of the decline. Are assets growing faster than profits, therefore reducing ROAA? Is equity accumulating faster than an institution's ability to deploy it, therefore reducing ROAE? Or, is provision expense up throughout the industry. I believe a combination of the three. But if provision expenses are rising, credits could be moving from pass, to watch, to substandard, and onward. Take note.

Trading mutliple trends are jolting. Banking is not a long-term growth industry. In a past blog post I wrote about the PEG ratio (P/E divided by EPS growth), and to keep an eye out for anything that moves too far from 1. I further deconstructed a bank's p/e ratio because the industry is more capital dependent than most, if not all industries. I estimate that a bank's p/e can be reduced by 5-7 times to calculate PEG due to high capitalization. If I took 7x, and applied it to the Mid Atlantic's 22.1x p/e (the lowest of the six regions), then those banks would have to achieve earnings growth rates of 15% to earn that valuation. Note that p/e measurements for the below charts were done on 12/31, after the new tax law passed, and after most bank's announced their DTA writedowns. But prior to their earnings releases, so the reduced earnings were not yet baked in the cake.

Banks might earn that valuation depending on how they take advantage of the new tax law. Do they take the one-time earnings injection, or make strategic investments for longer term earnings growth. If the former, I do not believe the p/e's will last long term. And therefore I believe, as an industry, bank stocks are likely at peak valuations.

Or as industry stock analysts put it: Neutral.

What are your thoughts on the state of banking?

~ Jeff

Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.

Source for all charts: S&P Global Market Intelligence