First Midwest Bancorp Undervalued, But Without Much Agency To Create Value
- First Midwest had a better second quarter performance than its merger partner Old National, with better performance on a pre-provision basis, though with a bit less loan growth improvement.
- First Midwest has built an arguably underrated commercial lending platform, and Old National should have some attractive opportunities to leverage that across a wider footprint and with underused deposits.
- The fates of FMBI and ONB are tied together now, but FMBI looks very slightly cheaper and would be the bank I'd rather own if the deal falls apart.
The announcement of the merger of equals between Old National (ONB) and First Midwest Bancorp (NASDAQ:FMBI) took a lot of analysts and investors by surprise, as most expected these two banks to remain independent consolidators of other Midwestern banks. Given that the market doesn’t really like whole bank M&A all that much, and definitely has its doubts about mergers of equals, it’s not altogether surprising then that these shares have lagged the regional bank index since the deal was announced.
I think both Old National and First Midwest are undervalued today, but I’m slightly more favorable on First Midwest. First, this is the bank I’d rather own between the two, so if the deal were to fall apart, this is the one I’d rather hold for the longer term. Second, with the shares trading very slightly below the implied deal ratio (at least as of this writing), it’s the incrementally cheaper of the two relative to my post-merger assumptions.
Better Core Results In The Second Quarter
In comparison to Old National, which posted a second quarter result that included a very modest pre-provision miss and a provisions-driven beat, First Midwest had a more positive, more balanced quarter, with both pre-provision profits and provision expense contributing equally to the beat.
Revenue rose almost 7% year over year and 2% quarter over quarter, beating expectations by close to 2% or around $0.02/share. Net interest income declined 1% yoy and rose 2% qoq, slightly beating expectations as greater growth in earning assets (up about 3.5% qoq) helped offset a weaker net interest margin (down 7bp qoq to 2.96%, 18bp below the Street).
Non-interest income was also a big help, rising 40% yoy and 1%, beating by more than 5% with strong yoy improvements in wealth management, deposit charges, and mortgage banking (though this declined a third on a qoq basis).
Operating expenses declined 1% yoy and 3% qoq, coming in below expectations despite the higher revenue level, leading to a 250bp outperformance in terms of efficiency ratio. Pre-provision profits rose 21% yoy and 9% qoq on an adjusted basis, beating expectations by about 9% or around $0.04/share. The rest of $0.08/share core EPS beat was driven by a lower provision expense ($0M versus an expectation closer to $8M).
Tangible book value per share rose 4% qoq and beat expectations by about 4%.
Improving Loan Demand And Credit Improvement In Sight
While reported loan performance wasn’t so exciting, with loans down slightly on an end-of-period basis, growth was more like 2% qoq when PPP loans are excluded. Improving credit line utilization and some middle-market activity is helping to drive commercial loans, were adjusted growth was a more lackluster 1%. In the consumer business, growth was stronger (up 4%) with improving demand and loan purchase activity – First Midwest has historically used excess liquidity to purchase prime floating-rate home equity loans.
Loan yields declined 7bp qoq to 3.56% and new originations are still below trailing rates, but First Midwest does have leverage to variable-rate loans and loan yields are likely at or near the bottom for the cycle. First Midwest has also likely come close to maximizing its deposit remixing and repricing, as deposit costs fell another 2bp qoq to 0.07%.
Credit was somewhat mixed in the quarter. Some larger write-offs pushed up the reported charge-off ratio this quarter (up 29bp qoq to 0.55%), but management guided to the low end of the prior 25-40bp range for the remainder of the year. Past-due loans dropped by about a third from the prior quarter, while criticized loans (substandard and special mention) declined 4% qoq and a lot of those are still made up of loans to COVID-19-stressed sectors that are likely to see some improvement in underlying business trends.
Resurgent COVID-19 infections do remain a risk factor for businesses in sectors like hotels, restaurants, and entertainment, but vaccination rates in FMBI’s footprint are better than average and that may help some.
Betting On Scale
I was one of those who thought it was much more likely that First Midwestern would continue to use M&A to grow, consolidating smaller banks in and near the bank’s core operating footprint to drive scale and cost-effectively acquire customers and deposits. I thought the ultimate end-game would be a sale to a larger bank, but I didn’t expect a merger of equals as a near-term strategy.
The combination with Old National makes some sense, as the two banks have very similar loan and deposit make-ups. First Midwestern has been heavily focused on the Chicago metro area (around 90% of deposits) for some time and on Milwaukee to a much lesser extent, and Chicago was a clear gap in the Old National footprint … though it has also been a market that Old National has said in the past (under different leadership) that it didn’t really want to enter.
Relatively speaking, I see First Midwestern as the somewhat more aggressive of the two, and I like the investments that FMBI has made into its commercial lending platform over the last five or so years, including an enhanced presence in areas like asset-based lending, structured finance, and specialty sector lending (like ag and healthcare).
Given a lack of overlap, cost synergies in the merger of equals will be modest, but Old National can nevertheless look to leverage its lower deposit/loan ratio to help drive loan growth, while also leveraging First Midwestern’s commercial lending platform over a wider geographic range (including markets like Minneapolis and Indianapolis). The two companies can also see longer-term efficiencies from unified tech spending, with the companies having the opportunity to cherry-pick the best offerings of each at the beginning.
Combined, I expect long-term core earnings growth in the mid-single-digits from Old National and First Midwestern. I am now valuing First Midwestern based upon my valuation estimates for the combined entities and the share exchange rate (1.1336 ONB shares for each FMBI share). Between PE, discounted core earnings, and pro forma ROTCE-price/tangible book, I believe First Midwest shares should trade for around $21 to $23.25, with double-digit long-term price appreciation from this level.
Within those results, I assume a long-term core sustainable growth rate around 5% and a sub-10% ROE, but that will be heavily influenced by the bank’s post-merger capital return priorities. I’m also using a 12x forward EPS multiple for Old National earnings that is a little below long-term norms, but maybe not out of line given the risks of a merger of equals for two banks that have never done such a large transaction.
The Bottom Line
I recently wrote that I considered Old National a borderline call given the value I saw but also the challenges in integrating the deal. Given that First Midwest would be my preferred holding if the deal were to fall apart for some reason and that shares are slightly cheaper, this would be my preferred play on the Old National – First Midwest combination, but I don’t want to pretend that there’s a large difference. In any case, I do think the Street is a little too down on this deal, but I also understand the need to prove that the integration will go smoothly and that this will be a case where “1 + 1” leads to at least a little more than “2”.
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