Shrinking net interest margins and regulatory oversight are making for a tough environment at regional banks. The larger banks have enough volume and diversified revenue sources to survive but smaller banks are feeling the pinch. While analysts have been calling for the next big wave in M&A for the last few years, the rebound in the housing market could provide the last push to increase activity. Investors should look for profitable banks with high insider and institutional ownership and less than $500 million in assets.
Throwing out the Money Changers
The Federal Reserve's quantitative easing programs have led to shrinking net interest margins and are likely to continue well into 2014 or beyond. Low rates and the weak environment for loans means deposits are building up and banks are paying more in interest. As loans mature, banks are lending out at extremely low rates and net interest income is constrained.
The regulatory environment looks to be the biggest hurdle for many small banks. As more of Dodd-Frank is enacted, small banks could see fees limited and costs increase. The implementation of Basel III also means increased capital reserves leading to lowered ability to leverage the low rate spread.
Some banks have managed to stay profitable though performance is uneven. SNL data shows a growing disparity between performance at the best and worst firms with stronger banks reaching a return of 1.03% on assets while weaker banks post negative returns. The rate environment and increased fees due to regulation are making it hard to grow so larger banks may choose to grow by acquisition, finding banks with stronger earnings growth and return on assets.
Banks looking for acquisition targets should find plenty of friendly boards. Many banks were started between 2002 and 2005, when prices were around three times book value, with the intent to build a book of business for a few years and then sell. Now that prices have come down to an average of just 1.25 times book, many boards will be eager to sell for what they can get. Sonny MacArthur, audit partner of Atlanta-based Porter Keadle Moore LLC, commented in a recent interview that banks under $500 million in assets could struggle.
While many have been calling for a wave in mergers since 2011, the rebound in housing may give new impetus to activity and the first half of 2013 could see a pickup in deals. As residential prices increase and the market improves, many banks could see stronger earnings on fewer loan loss provisions. This could make them targets of larger banks looking for earnings growth in a rate environment that is not allowing for much organic growth.
A report in 2010 from the Federal Reserve Bank of Philadelphia found the average price to book premium for takeover targets received 1.14 times book value with intrastate targets receiving a slightly lower premium. Premiums also differed on the size of the target with banks under $1 billion in assets receiving almost 16% more than larger banks.
Two Strong Candidates and Two with Potential
Provident Bank of New York (PBNY) trades at just 0.81 times book value but returns 5.5% on equity. Institutional investors own 42% of the $400 million New York lender with insiders holding 12% of the shares. At a premium of 1.14 times book, the bank could go for around $12.88 per share or 40.7% higher than current levels.
The bank recently hired a team from rival Signature (NASDAQ:SBNY) specializing in middle-market lending to run a new office in Long Island. The bank's strategy of recruiting experienced lending teams could help to make it a target from another bank looking to expand in the area with an acquisition.
Republic Bancorp (NASDAQ:RBCAA) trades at just 0.87 times book value but returns 22.0% on equity. Institutional investors own 30% of the $466 regional lender with insiders holding 50% of the shares. Between direct holdings by CEO Steven Trager, Vice Chairman Scott Trager and shares held in trusts, the Trager family controls approximately 44% of the shares. At a premium of 1.14 times book, the bank could go for around $28.38 per share or 31.0% higher than current levels.
The bank beat expectations for the fourth quarter on gains to the purchase of failed banks in Tennessee and Minnesota. Net income increased 27% for the year on an additional $55.4 million from the acquired banks as well as gains in mortgage banking. While a more geographically-diverse bank portfolio may make the company less of a target, Republic Bancorp is still performing well and the low price could bring bids.
Park Sterling (NASDAQ:PSTB) trades at just 0.96 times book value but returns 2.9% on equity. Institutional investors own 72% of the $257 million Mid-Atlantic lender with insiders holding 4% of the shares. At a premium of 1.14 times book, the bank could go for around $6.82 per share or 18.8% higher than current levels.
Park Sterling saw its net interest income triple to $19.5 million and its net interest margin widen to 4.36% after its acquisition of Citizens South completed last quarter. Provisions for loan losses also came down by 10% as the bank expanded its footprint in the Carolinas and Virginia.
First Busey Corporation (NASDAQ:BUSE) trades at just 0.96 times book value but returns 5.9% on equity. Institutional investors own 45% of the $396 million Illinois lender with insiders holding 14% of the shares. At a premium of 1.14 times book, the bank could go for around $5.44 per share or 18.8% higher than current levels.
Risks to Consider: While these shares could see a huge bounce on a buyout or M&A activity in the sector, the interest rate environment is not optimal. A strong history of profit and earnings growth should support the share prices but be ready for volatility and possibly losses, especially around earnings.
Investors may want to stagger their position into the shares with half now and the rest through the year to see how rates and the regulatory environment evolves.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.