Despite the upward-sloping yield curve, many banks are still hung over from bad credit and growth capital deficiencies. There are not a lot of banks out there that can be termed "strong" or "growth" banks that are on the offensive. There are even fewer that have been able to maintain or raise their dividends during the financial crisis.
First Niagara Financial Group (FNFG) is one such bank that is in position to grow, and is not sitting around waiting for economic activity to dictate their destiny. FNFG was conservative in its loan growth before the financial crisis, and as a result, has been able to manage its credit and capital quite well through the trough. It has emerged stronger than its peers, and in a position to take advantage of others' misfortunes and mismanagement. To this point, during the last two years, FNFG has made two strategic and opportunistic acquisitions (57 branches from Nat City in the western Pennsylvania market, and Harleysville Bank in Philadelphia) that increased and diversified their regional footprint at very cheap valuations relative to the risk they assumed from those transactions.
Yesterday, FNFG announced their intentions to make a third acquisition - NewAlliance Bancshares (NAL). Unlike Nat City and Harleysville, NAL is also dealing from a position of strength, is a larger deal size, and is more expensive on a valuation basis than either of the previous two deals for FNFG. As a result, traders crushed FNFG's stock on the announcement - indeed, FNFG's stock chart now looks like its namesake Niagara Falls. But I have had the privilege of having met the CEOs of both of these banks as well as sitting in presentation rooms with each on more than one occasion. They are both quality franchises, and people who know me understand that I don't praise banks easily. I therefore have confidence that FNFG is a stock that one should consider wading into now on weakness because the water is fine, and should get even better with time.
So why then did the market react so negatively to this deal? Investors had become accustomed to banks getting sweetheart deals in 2009 from the FDIC, which backed potential losses on acquired loan books. But the worst of the crisis period has passed, the too-big-to-fail banks (and many smaller ones too) have now been infused with more capital to help support their own future losses without the aid of the FDIC. To this point, the FDIC had no part in consummating this deal. Thus it would seem that this deal may signify that the FDIC match-making honeymoon is over for acquisitive banks like FNFG (at least in this region of the country), and some level of "normalcy" may be returning to bank M&A.
Another reason why the market may have reacted is the fear that FNFG would do a secondary offering to raise more capital. However, for this deal alone, a capital raise is not necessary. In fact, NAL's capital position is quite strong, and the combination of the two banks will keep FNFG in a strong enough position to do more deals if it so chooses.
Truth be told, NAL didn't need to be taken over. In fact, NAL didn't have a credit quality problem, had record revenues in the first half of 2010, and on some metrics was arguably an even stronger bank than FNFG. The fact that FNFG was able to buy this quality franchise in this region of the country at a discount to previous more normalized acquisition premiums for banks should be a positive, not a negative, for the stock. This combination will create the 4th largest bank in New England, with a balance sheet strong enough to grow the franchise faster than its peers - organically or through further acquisitions.
There are some low-hanging fruit that FNFG should be able to capture immediately upon consummation of the deal with NAL, which can be seen from this summary sheet of key metrics for each company. For example, NAL's net interest margin lags that of FNFG by nearly 70 basis points. All of that and more is the result of NAL's higher deposit costs, which should be easy enough for FNFG to bring down under its pricing umbrella. In addition, with both companies' efficiency ratios in the low 60s percent range, there is ample opportunity for cost reductions that will act as a tail wind for net interest margins. To this point, FNFG has already highlighted that they believe they can cut 20-25% of NAL's operating expenses.
Also attractive is that FNFG should continue to pay an above-average dividend yield after this deal is done. Even if we assume every outstanding share of NAL is converted to FNFG shares (which probably won't be the case), and if we assume the dollar amount of FNFG quarterly dividend payouts remains constant, the pro-forma dividend/share would be roughly $0.36, which at the new lower stock price still equates to a pro-forma 3% dividend yield. That's probably the worst case. Given FNFG's capital levels after the deal and the fact that NAL itself paid a dividend, there's no reason why FNFG couldn't maintain a similar pre-deal dividend yield closer to 4%. Either way, that's certainly better than what money markets and Treasury Bills pay these days, and you get paid to wait until the integration bears fruit.
FNFG's stock should bounce from this initial reaction, once investors have had a chance to digest this news and understand these two banks and the potential synergies here, It may take a few quarters for FNFG to prove it can manage integrating this heftier transaction along with the continued (and relatively early) integrations of Nat City and Harleysville. But a return to the premium valuation it deserves of 2x pro-forma tangible book value should translate into a $14 stock price. Add in your 3-4% dividend yield and you are looking at a 20%+ total return potential over the next 12 months, with most if not all of the near-term downside risk now behind you after today. I am fairly confident that such favorable risk/reward will be difficult to find among other smaller regional banks (if not the stock market as a whole) in that time frame.
Disclosure: Long FNFG; Long NAL