The US banking sector has seen a tremendous amount of M&A activity. Since the beginning of 1991, over 5,700 bank and thrift acquisitions, comprising about $1.3 trillion in aggregate value, have been announced. With the exception of Citigroup (C), the largest banks are large specifically because they were acquisitive.
The reasons for all this M&A activity are straightforward. First, there are way too many banks in the US (still more than 6,800). Second, organic growth opportunities are modest, and smart deals can enhance growth. Third, banks believe in the existence of economies of scale, and deals provide scale.
The better a bank is at acquiring other banks, the faster it will grow and the higher the valuation investors will give it. So which banks are good acquirers? Answering this question is complicated. If a bank completes an acquisition, and then its EPS stagnates, was that because of problems with the target, problems with the acquirer, or macro problems? Was the deal priced badly, or did merger integration fail to meet expectations? However, there is one clear indicator of a failed deal: goodwill impairment charges.
Large bank deals are almost always stock-for-stock. Banks once had the opportunity to use pooling-of-interests accounting in stock-for-stock deals. If pooling were used, the acquirer and target balance sheets were basically added together, with no acquisition goodwill created. No goodwill meant no goodwill amortization expense and therefore higher pro forma GAAP earnings. However, pooling could only be used if certain conditions were met, and some banks spent considerable time and money to meet them. Most big bank deals were accounted for as poolings until pooling was abolished at the end of 2000. Thereafter, banks had to book goodwill in deals, but they were not required to amortize it. They did need to test it periodically for "impairment", and if it was decided that the goodwill was impaired (if the target's value had deteriorated), the goodwill would have to be written off.
The elimination of pooling led to a ballooning of goodwill on the largest banks' balance sheets. Wells Fargo's (WFC) Q2 2012 goodwill was $25 billion, or 18% of common equity. JP Morgan Chase's (JPM) was $48 billion, or 26% of common equity. Neither bank has written off any goodwill as impaired, not surprising given each bank's strong operating performance. Citigroup and Bank of America (BAC), both much more erratic performers of late, had Q2 2012 goodwill of $25 and $70 billion, respectively, and have written off as impaired $10 and $16 billion, respectively. Both writeoffs are relatively low in percentage terms. C's and BAC's goodwill to common equity stand at 14% and 32%, respectively.
In isolation, the magnitude of the intangible asset figure shouldn't scare investors. Intangible assets clearly have value; if investors didn't think so, then no bank stock would ever trade above tangible book value per share ("TBV-PS"). Economics trumps accounting. However, if a bank charged off of lots of goodwill, that would be an admission that it had made one or more bad acquisitions. And if its intangible assets had grown especially large relative to common equity, such growth might imply that the bank had been betting the ranch on acquisitions. Do any banks meet both criteria?
Two relatively large ones do. Birmingham, Alabama based Regions Financial Corporation (RF) is the larger of the two. RF, which has a current market cap of $10.6 billion, is an amalgam of more than 130 depository acquisitions. In January 2004, RF and Union Planters Corporation announced a $6 billion merger-of-equals. RF had previously completed 55 acquisitions comprising $5.6 billion in aggregate value, and Union Planters had completed 65 deals comprising $6.7 billion in aggregate value. The merged entity subsequently announced an acquisition of AmSouth Bancorporation for $10 billion in May 2006. AmSouth had completed 14 deals of its own, comprising about $7.2 billion in aggregate transaction value. And some of the targets had done deals of their own.
RF's assets had been growing steadily, but the Union Planters and AmSouth deals catapulted RF to a much higher level. The Union Planters deal increased RF's assets from $50 billion to $84 billion, and the AmSouth deal increased RF's assets to $143 billion. Intangible assets as a percentage of common equity rose from 25% to 47% after the Union Planters deal closed and to 54% after the AmSouth deal closed. And then in Q4 2008, RF wrote off $6 billion of goodwill as impaired, or about half of its total goodwill and an amount equal to 60% of the $10 billion in goodwill created in the Union Planters and AmSouth deals.
If any bank had the credentials to prove that it was a sophisticated acquirer, RF did. And yet its biggest deals appear to have been disastrous. RF ended up having to undertake subsequent common equity issuance that diluted TBV-PS. At Q2 2012, RF's Q2 2012 TBV-PS was $6.65, a level it had cracked back in 1992. Let's assume we don't even penalize RF for the dilution from the equity issuances. At Q4 2000, the last quarter before pooling was prohibited, RF's TBV-PS was $11.00 and intangible assets per share were $1.75, giving a stated book value per share ("BV-PS") of $12.74. At Q3 2008, nearly eight years later and the last quarter before RF wrote down the $6 billion in goodwill, TBV-PS was $10.84 (lower than the year-end 2000 figure!) and intangibles per share had risen to $17.64 per share, giving BV-PS of $28.48.
I believe that intangible assets have value, but more importantly I believe that growth in TBV-PS is perhaps the best gauge of how well a bank's management team is building value for its shareholders. Acquisitions should increase TBV-PS in the long run, not reduce it. Perversely, as long as an acquiring bank trades above 1.0x BV-PS, the higher the price it pays in an acquisition, the higher its pro forma BV-PS will be. In contrast, TBV-PS falls as deal price rises. So if you see a bank's BV-PS keep growing but not its TBV-PS, that bank is a serial acquirer that prices its deals too richly and/or integrates them poorly.
The damage done at RF is now well in the past. What's the relevance of my analysis to investors today?
With all the bank deals that haven't worked out well for acquirers, it's reasonable if not imperative for shareholders to require that a bank prove it is an astute acquirer. As long as a bank doesn't keep doing big deals in rapid succession and muddying the waters, the truth about their acquisition prowess, reflected in TBV-PS over time, will emerge, good or bad. I'm not sympathetic to the argument that swearing off frenetic deal activity ties the hands of management, perhaps keeping them from the deal of the century. I'm more sympathetic to the idea that low-growth banks may chase acquisitions in the hope of enhancing growth (or to hide the fact that they are low growth), and end up overpaying in the process, when selling might be a better idea.
If you're thinking about owning stocks that look like they might be new RFs in the making, banks like Susquehanna Bancshares, Inc. (SUSQ) and First Niagara Financial Group, Inc. (FNFG) (there are others - contact me for a full discussion of them, at WintersReport@gmail.com), assessing expertise with respect to acquisitions may be the most important part of your analysis.
Because RF showed investors how this story can end. It can end badly.