PacWest-CapitalSource Deal: Jumping On The Bandwagon Doesn't Make Sense

Jul.28.13 | About: PacWest Bancorp (PACW)

Independent directors of PacWest Bankcorp (NASDAQ:PACW) approved a tentative deal on July 22 that will allow the company to acquire CapitalSource (NYSE:CSE) and enable PacWest to enhance its presence in Southern California. PacWest's primary business involves commercial banking via its wholly owned subsidiary Pacific Western Bank. Its operations include consumer deposit and loans, money market operations and issuing commercial loans to SMEs. The proposed acquisition will consolidate PacWest's presence in middle market lending.

When the acquisition takes effect in first quarter of 2014, the combined new bank will be operated by 13 directors, 8 of whom will be chosen by PacWest, while the remaining 5 directors will be selected by CapitalSource. It is anticipated that Matt Wagner, the current CEO of PacWest, will lead the new company. This $2.3 billion deal will put 28% shares of PacWest to the stakeholders of CapitalSource. However, creative lawyers have structured the deal in a tax-effective way and it is labeled as reorganization.

When the deal was announced after the market closed on July 22, 2013, PacWest was trading at $32.48 a share. The next day the stock climbed to $35.06, constituting a 7.94% gain, and PacWest's market capitalization increased by almost $80 million on July 23. Similarly, CapitalSource gained 22.28% as its stock price also headed north from $9.83 per share on July 22 to $12.02 the next day.

Investor enthusiasm is well justified-the combined new bank will be worth $15 billion. With 75 operational branches of Pacific Western Bank and 21 of CapitalSource, the new bank will become the 6th largest bank in California. However, the underlying fact is that these two banks are small regional providers and in contrast to nationwide banks such as Wells Fargo (NYSE:WFC), the combined PacWest-CapitalSource entity will have only 1% of WFC's asset base. Also, the 7.94% and 22.28% gains in stock prices for PacWest and CapitalSource seem exuberant, as P/E ratios of these two companies are currently at 24.01 and 19.95 respectively, compared to the industry average of 12.52.

Investors are particularly bullish because the combined company will save almost $47 million pre-tax annually by 2015 fiscal year. So the market is looking at medium-term gains from this deal. One of the factors that drew the bulls on July 23 is the fact that new shares PacWest will be issuing are estimated at 55 million. Once that happens, PacWest's total share base will reach 91 million and it will pick up the valuation of PacWest-CapitalSource at $3.2 billion, along with net earnings of $227 million per year (including $47 million pre-tax synergy) by 2015.

Should you jump on the bandwagon? I believe the boat has already sailed and the market has already priced future earnings potential, since PacWest's stock is trading at 16 fold of its current annual earnings. The banking sector in the United States saw a huge bull run in 2013 as the housing sector rebounded. Currently most of the banking stocks are overvalued and trading at a range where P/E ratios are off the chart. Betting on the PacWest deal would have been OK before the announcement, but not so much today. The stock price has stagnated since the July 23 spike for both PacWest and CapitalSource-they are trading at $35.47 and $12.15, respectively, as of July 25, 2013.

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.