Going It Alone Could Be A Tough Road For Synovus Investors

| About: Synovus Financial (SNV)
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If I'm brutally honest, following bank stocks on a week to week basis is a challenging (and not particularly exciting) pursuit. While we all got a vivid lesson in just how badly wrong these business models can go, even on a quarter to quarter basis we're pretty much talking about submarine races - there's a lot going on below the surface, but you'll never see it.

That is relevant to Synovus (NYSE:SNV) as these shares have enjoyed quite a run - up 35% over the past year, about 66% from the summer 2012 lows, and near a 52-week high on optimism about the prospects for improved performance, a TARP repayment, and a possible acquisition. That long-held expectation of a deal could actually be the biggest risk factor for these shares today. While the company could indeed hold value for an acquirer, it's much harder to find an attractive target price on its own operating credentials and a failure to see a bid materialize after the TARP repayment could set shareholders up for some depressing performance.

Destruction Is Easy, Rebuilding Takes Time And Work

Prior to the collapse of the housing bubble and the banking crisis, Synovus was an aggressive growth-by-acquisition Southeastern banking story. The company eventually built up a #5 deposit base in Georgia and Alabama (and the #6 share in South Carolina), but Synovus was operating under 40 different charters as a result of the deals.

What went wrong at Synovus was not all that different than what went wrong for many banks. Areas like Atlanta and Florida were hit hard by the collapse in housing prices (and mortgage foreclosures), and businesses suffered as well. With a large exposure to both commercial lending and commercial real estate, Synovus saw its non-performing loans soar and its credit quality plummet.

That Synovus made it through at all is frankly a bit of a surprise, and the company continues to suffer from the wounds inflicted by the crisis. Survival demanded tremendous dilution (the share count is up over 175% from 2008) and a serious retrenchment around its core competencies. Unfortunately, management has had to focus most of its attention on liquidity, capital, and managing bad debt as opposed to repositioning the bank for the new realities of the financial industry. That has left it with high expenses, weak profitability, and a credit quality profile that is still not that great.

What It Is Today

Even with that negative introduction, Synovus is still a viable and significant bank. Synovus operates approximately 300 branches in five states. The bank is a leading deposit share holder in Georgia (#4, with about 6% share), Alabama (#5 with 4% share), and South Carolina (#6 with 4% share), and has a toehold in both Florida and Tennessee.

Synovus is also still largely focused on non-retail lending. About 80% of the bank's lending is commercial and commercial real estate (CRE), which puts it up there with the likes of Comerica (NYSE:CMA), M&T Bank (NYSE:MTB), and Zions (NASDAQ:ZION) in terms of its reliance on commercial lending. Although I believe commercial lending gets a bad rap from a lot of analysts and investors, it is just as profitable and "safe" if a bank's underwriting standards are strong.

That said, Synovus is looking to adapt to the new realities of the sector. Commercial lending is likely always going to feature prominently in its loan book, but management has been shifting towards C&I lending (instead of CRE lending) and looking to enter into markets like healthcare lending and equipment leasing. Regional rivals like BB&T (NYSE:BBT), Wells Fargo (NYSE:WFC), and SunTrust (NYSE:STI) have similar plans, though, so Synovus will have its work cut out building share in these new markets.

Due in part to the corporate structure that resulted from its acquisitiveness, Synovus has an inefficient cost structure. While most well-respected banks like U.S. Bancorp (NYSE:USB), Wells Fargo, and BB&T have efficiency ratios in the 50%'s, Synovus is still north of 60%. With the bank looking to hire employees that can help it grow the business and improve its performance in areas like cross-selling, it will be challenging to simultaneously drive costs lower.

Credit quality is still something of an issue. While the bank sold over $500 million in problem loans back in December of 2012, the company's 2.6%-plus NPA ratio is still not great (Comerica was at 1.3% for the fourth quarter of 2012, while BB&T came in at 1.4%).

Repay TARP, Then Improve Operations?

The biggest issue remaining on the to-do list of Synovus management is repaying its TARP funds. Synovus is one of the final well-known banks with outstanding TARP commitments, and these total close to $1 billion. Luckily for shareholders, it doesn't look like the company will have to resort to a common equity raise to repay the government's loan. By kicking up dividends to the holding company and using cash on hand and a sizable preferred stock issuance, Synovus should be able to put together the capital it needs and still meet the Fed's capital ratio requirements. That said, I wouldn't completely rule out the possibility of a common equity and/or debt raise as part of the process, and that would be a material negative for perception on the stock.

Once the TARP funds get repaid, Synovus will be faced with the reality that it is a banking franchise with an attractive footprint, but an ample number of warts, bunions, and toe fungus. As I mentioned before, the bank still has work to do getting its expenses in line with peers and improving its credit quality.

But there's more work to do beyond that. Synovus needs to focus on lowering its cost of funds (preferably by taking advantage of low-cost deposits), improving its cross-selling, and reigniting loan growth. While Synovus did finally show some loan growth (average loans were up 1% on an annualized basis, the first growth in more than three years), it's tough to repair a banking business with such weak lending growth.

Is Independence The Way To Go?

Synovus management has been pretty adamant that it is not looking to sell. I wouldn't expect them to say anything else, though, as publicly acknowledging their hopes of getting taken out wouldn't help in the negotiating process.

Even so, analysts and investors continue to highlight Synovus as one of the most likely take-out stories in the banking space. Clearly that makes sense - this is a wounded franchise, but it has attractive market share in a very attractive market (Atlanta, and Georgia as a whole). BB&T has explicitly said that it would like to get bigger in Georgia, and companies like Fifth Third (NASDAQ:FITB), PNC (NYSE:PNC), and maybe even U.S. Bancorp could share that sentiment.

On the other hand, there are reasons why Synovus may be a tricky sell. That convoluted and high-cost operating structure offers a lot of upside to a buyer who can slim it down, but that's a lot to bite off - even for companies like BB&T with substantial acquisition/integration experience. The company's commercial lending focus could also be problematic, as the market may punish a buyer for adding this sort of exposure (particularly a bank like BB&T where its C&I/CRE lending is already a frequent talking point).

Don't forget, too, that the Fed has gotten more stringent with its capital requirements for banks, and it's unclear to me that the regulators would cut a large acquirer any breaks in approving a deal. With capital costs still pretty high for many banks, it won't surprise me if many potential/theoretical acquirers decide to try growing organically (building branches) in markets like Georgia or target smaller, more easily digestible banks for M&A.

A Slow Road Back To Growth

I think it's going to be hard for Synovus to log impressive growth over the next few years. The effective "zero interest rate" policy has seriously compressed net interest margins across the sector, and I don't see Synovus growing its loan book and/or cutting expenses fast enough to generate substantial earnings growth or attractive returns on tangible common equity.

On a longer term basis, I do believe Synovus could generate returns on equity in the 9% to 12% range. Once again, though, that doesn't point to dramatic underlying earnings growth, and Synovus could well lag larger, better-capitalized banks like U.S. Bancorp and BB&T.

That leads me to suspect that a lot of Synovus's valuation is predicated on selling out. On an excess returns model that incorporates a long-term 12% return on equity assumption, it's hard to generate a fair value on Synovus beyond the $2.50 to $2.70 per share range. Using a multi-factor M&A model and assuming relatively favorable marks on the bank's loan book, though, produces a target range from $2.50 to as much as $4.00, with $3.00 to $3.50 as the most likely range (depending on the buyer).

The Bottom Line

If you split the difference and estimate a 50/50 chance that Synovus gets a bid (almost certainly after the TARP repayment is done), that suggests a fair value of about $2.90 on Synovus. Given that I think a 50/50 chance likely overstates the odds of a takeout, I think these shares offer more risk than reward at these prices.

Synovus does have a valuable banking footprint and the potential to perform substantially better. I feel like a lot of that potential is already in the shares, though, and I think you have to have a pretty optimistic outlook to see real upside here. As a result, I'd be more inclined to stick with names like U.S. Bancorp or BB&T, or maybe take a chance on Bank of America or Citigroup (NYSE:C) before making a huge commitment to Synovus at this price.

Disclosure: I am long BBT. 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.