PacWest And CapitalSource Are Merging, Investors Are Overreacting

| About: PacWest Bancorp (PACW)

On Monday after the close PacWest (NASDAQ:PACW) announced that the company will merge its operations with CapitalSource (NYSE:CSE).

As the market is reacting with great enthusiasm towards the deal, on the back of sizable synergy estimates, I think investors are overreacting. The pro-forma valuation, after accounting for synergy estimates, is quite generous for a regional bank. And frankly, this is a bit too generous for me.

The Deal

PacWest announced that it has signed a definitive merger agreement under which it would merge with CapitalSource in a $2.3 billion deal.

Shareholders in CapitalSource will receive $2.47 per share in cash and 0.2837 shares in PacWest for each share they currently hold. Based on Friday's closing prices, the offer comes down to $11.64 per share.

For tax purposes, the deal has been structured to qualify as a tax free reorganization. Shareholders in PacWest should hold about 45% of the shares of the new, while shareholders in CapitalSource would hold the remaining 55%.

The new company will be names PacWest Bancorp, while the national lending operations of CapitalSource will continue to do business under its current name.

CapitalSource is a California-based bank with $8.7 billion in assets and 21 branches. The Pacific Western Bank has $6.7 billion in assets across 75 branches within California. The combination will have assets of over $15 billion making it the sixth largest publicly traded bank in California. Still, the asset base will only be about 1% of Wells Fargo's (NYSE:WFC) massive balance sheet.

CEO and Chairman of PacWest Matt Wagner commented on the rationale behind the deal, "This transaction represents the combination of two outstanding organizations. CapitalSource has built an enviable lending platform and growth engine. PacWest has a valuable community banking franchise and a low cost deposit base driven by our high percentage of non-interest bearing demand deposits. The combination of these two franchises will create a formidable company going forward, with a strong balance sheet and capital base, attractive margins and good earnings momentum."

With the deal PacWest can provide CapitalSource with a stable and low cost deposit base, while CapitalSource has a robust lending presence. The combination expects to take $80 million in pre-tax charges related to the merger. Yet the deal should result in $47 million in pre-tax annual synergies by 2015.

This implies that combined non-interest expenses would be cut by roughly 12%. Consequently, PacWest sees a 18% increase to 2015's expected earnings per share based on current consensus estimates.

The deal is expected to close in the first quarter of 2014 and is subject to normal closing conditions including regulatory approval. Shareholders of both firm's still have to vote on the deal while the board of directors of both companies have already unanimously approved the deal.


PacWest ended its second quarter of its fiscal 2013 with $6.71 billion in total assets. A total deposit base of $5.52 billion supports the total loan book of $4.33 billion. The company is conservatively financed with a 12.8% Tier-1 leverage capital ratio and a 15.0% Tier-1 risk-based capital ratio.

For the first six months of the year, PacWest generated net interest income of $132.9 million, down slightly on the year before. Net earnings fell by 15% to $17.8 million. The company took $18 million in acquisition and integration charges during the second quarter.

On a stand-alone basis, the company could generate annual net interest income of around $265 million on which it could earn roughly $50-60 million.

Factoring in gains of 7% following the announcement of the deal and the second quarter results, the market values PacWest at $1.25 billion. This values the company at around 4.7 times annual revenues and 22-23 times earnings.

PacWest pays a quarterly dividend of $0.25 per share, for an annual dividend yield of 2.9%.

Some Historical Perspective

Investors in PacWest have seen no capital gains over the past decade while they have witnessed quite some volatility. Shares rose from $35 in 2003 to highs of $60 in 2006 on the back of the housing boom.

Shares fell to lows of $10 in 2009 in the midst of the financial crisis and have steadily recovered to current levels at $35 per share. So far in 2013, shares have already returned some 40%.

Investment Thesis

Investors are enthusiastic about the deal. Combining regional banking players in this heightened regulatory environment promises high synergies. The combination hopes to achieve $47 million in pre-tax synergies per annum by 2015 which could boost net earnings by some $30 million, assuming statutory tax rates.

On the back of the news, shares of PacWest rose some 7% towards $35 per share which boosted the market capitalization of the bank by some $80 million. This excludes the roughly 55 million shares to be issued to CapitalSource's shareholders which increased by roughly $120 million in value. As such the company saw its value increase by $200 million, or roughly 7 times after-tax synergies.

Shares of CapitalSource rose by more than 20% towards $12 per share, largely reflecting the $2.47 per share in additional cash they receive.

PacWest's shareholders will hold a 45% stake in the combined business. At a current valuation of $1.25 billion, this values the operations at roughly 4.7 times net interest income and roughly 18 times normalized earnings of $70 million which are achieved on a $6.7 billion balance sheet.

Shareholders in CapitalSource stand to hold a 55% stake in the combination while its balance sheet of $6.4 billion is actually a tiny bit smaller than that of PacWest.

After the massive gains on Tuesday, investors value the bank at $2.35 billion or little over 7 time net interest income, estimated at $330 million. Note that the bank generates higher non-interest revenues compared to PacWest. The bank is a bit more profitable as well, on track to generate full year earnings of around $110 million, which values the business at 21-22 times normalized earnings. Note that this excludes the $2.47 cash component shareholders stand to receive under terms of the deal.

All in all the new bank will hold total assets of roughly $15 billion on which it could generate net-interest income of around $600 million. The combination could earn net income of roughly $180 million per annum. This excludes annual synergy estimates of $47 million by 2015, which could boost after-tax earnings above the $200 million mark.

As PacWest might have to issue some 55 million new shares to investors in CapitalSource, the outstanding share base will increase toward 91 million shares, valuing the combined entity at $3.2 billion. This values the pro-forma activities at 5.3 times net-interest revenues and roughly 16 times earnings after accounting for synergies.

Overall, the market has already priced in the positive effects from the deal. Trading at 16 times earnings, after accounting for synergies and assuming a smooth integration, the market is a bit too enthusiastic too my taste.

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.

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