On December 1, 2018, Eagle Bancorp (Nasdaq:EGBN) was the target of a “short and distort” scam run by an anonymous blogger that sent its stock down to $49.95, nearly 25% lower than the previous day’s close of $66.15. Like a proud bird of prey, Eagle responded quickly and firmly, denying the allegations and rebutting the claims made by the anonymous blogger. Pulling no punches, Eagle’s CEO Ronald Paul hit the nail on the head, calling the short and distorters “shrewd scumbags.” After this strong response, Eagle stock rebounded on the next trading day following the anonymous blog posting, rising over 14% to $57.10.
Since then, however, Eagle management has largely refused to publicly address either the anonymous blog post or any of the—in my view—scurrilous allegations contained therein and the stock has failed to get back to its pre-short and distort attack levels, despite any deterioration (as far as I can tell) in Eagle’s financial results, condition or prospects.
Below is a Bloomberg chart comparing Eagle’s stock price to the Nasdaq Bank Index from the day prior to the anonymous blog post to June 18.
Unfortunately, I think that the allegations made by the anonymous blogger have had a lasting impact on Eagle’s stock price—not because they are remotely true or accurate—but because that they have created a shadow of doubt that Eagle and its management have yet to conclusively dispel. In other words, I think that at this point, the prolonged malaise in Eagle’s stock prices is largely due to Eagle’s failure to aggressively defend itself and remove any lingering doubts created by the short and distort attack.
Shortly after the anonymous blog post, I attended an investor lunch with Eagle’s senior management team and the fighting spirit present in their initial reactions seemed to have largely dissipated. Instead of outlining further aggressive responses intent on decisively rebutting the inconsistent and vague allegations made in the anonymous blog post, Eagle management took the position that investors would have to rely on negative assurance. More specifically, Eagle management essentially indicated that, to the extent there were no disclosures any instances of fraud, self-dealing or other illegalities or bad acts relating to the conduct alleged in the anonymous blog posts, that was because there was nothing to disclose. My recollection is that Eagle management provided no time period for these disclosure—to the extent that any were required—to be made and merely said that investors would have to rely on the absence of disclosures as evidence that Eagle had nothing to disclose.
I am not sure what caused Eagle management’s change in tone. Given management’s substantial stock holdings, I would assume they would be as irate as anyone and bent on removing any clouds that might be having a negative impact on the stock price. My guess, however, is that they received some very defensive advice—advice more focused on avoiding providing grist for the plaintiffs’ lawyers mill rather than recapturing the lost value in the stock.
Since then, Eagle has released earnings twice and filed both its 10-K for 2017 and its 10-Q for the first quarter of 2018 and I have yet to find any problematic disclosures reasonably related to the “facts” alleged in the anonymous blog post. Based on Eagle’s construct of negative assurance, the lack of disclosure after that period of time and intervening fillings, should give investors comfort that the anonymous blogger’s claims were baseless and should have no negative impact on Eagle’s stock price.
Negative assurance, however, is cold comfort, particularly when Eagle’s stock continues to tread water. Rather, investors need a more definitive “all clear” signal—it is time for Eagle to stop being a turkey and conclusively and directly lay the anonymous blogger’s claims to rest for once and all.
As I have previously pointed out to both the company and other stockholders, National Bankshares (Nasdaq:NKSH) has too much capital.
Obviously, all banks need a certain amount of capital and having a little extra, particularly if a bank has strong growth prospects, is generally pretty desirable. However, with capital, just like many other things, more of a good thing is not necessarily better and too much of a good thing can be bad. When a bank has more extra capital than it needs to support reasonably achievable future growth, that excess capital becomes a drag on returns. In addition, to the extent that the market does not believe that a bank is likely to deploy its excess capital in a reasonable time frame, it becomes a drag on valuation.
From a corporate finance perspective, there is obviously a cost of equity, or a level of return on equity that stockholders expect in return for putting capital at risk. Having more equity doesn’t lower its theoretical cost, but it does lower the return on that equity (where return on equity is earnings divided by equity, more equity means lower returns). As a result, over capitalized banks, like National Bankshares (who reported a return on average equity for 1Q18 of 8.85%, despite, according to Bloomberg, having a cost of equity of 9.0%), often fail to “earn” their cost of equity.
As a matter of stewardship, hoarding excess capital is hardly either optimal or admirable. Stockpiling capital beyond that which is reasonably required (by regulators, as a buffer thereon and to support realistic growth) benefits no one, least of all stockholders, and to the extent that it cannot be deployed, should be returned.
Leaving aside banks with either strong growth prospects or anticipated near term losses, why would a bank operate with capital levels well in excess of accepted norms? There could be a number of reasons, none of which are particularly compelling.
Perhaps a management team views excessive capital levels as a mark of achievement, particularly if the capital is generated through retained earnings. Strong and sustained earnings are obviously a good thing, but should then be either reinvested in the business or distributed to stockholders. Taking a miserly approach to earnings and hoarding them as underutilized and excessive capital benefits no one and reflects negatively on the management team that was so successful in originally producing the earnings.
Maybe a management team has some nebulous and ill-defined dread of an economic downturn or other potential events or circumstances that might cause significant credit issues. Conservative views on credit and risk taking are obviously pretty common in banking and not necessarily a bad thing, but those views are better expressed through modifying underwriting standards and other business practices to reflect low risk tolerances and appetites as well as robust (to the extent permitted by auditors) loan loss reserves. A large “catch all” capital buffer in excess of current norms is just an excuse for poor and/or lazy risk management.
Of course, a management team might be holding out hopes of future opportunities to deploy capital, whether through organic growth or acquisitions. Clearly, in an ideal world, banks with significant levels of excess capital would be able to find new or greater avenues for growth—acquisition targets, new business lines, geographic expansion, greater market penetration, etc—but management teams should be realistic in their assessment of their prospects. Rarely does a bank with a history negligible growth and no recent acquisitions reverse those trends (successfully) overnight. Rather, banks with more capital than growth opportunities should heed Jamie Dimon’s advice and return the excess to stockholders who can put it to a “higher and better use.”
However, I think that there is another reason why a bank might operate with excessive capital levels that is both less likely to be acknowledged and significantly less defensible—to deter potential suitors. Significant amounts of excess capital not only mask the true earnings power of a bank, but it can also provide a convenient obstacle to a sale. Conventional wisdom holds that acquirers will not pay a premium on excess capital, on the theory that each dollar of excess capital is properly worth one dollar, so it is harder for a buyer to pay a meaningful premium for a bank that has a large amount of excess capital.
However, given the significant expansion of many banks’ price to tangible book value (“TBV”) multiples, particularly since the fall of 2016, the merger math for buying an overcapitalized bank has gotten significantly better. Since most overcapitalized banks trade a lower price to TBV multiple (because they have a lot of tangible book value) relative to would be acquirers, such deals could be expected to accretive to tangible book value. While I am not a big fan of judging bank mergers by whether they are accretive or dilutive to TBV (and if dilutive, how long it will take the acquirer to “earn back” the dilution), it is clearly important to the broader market.
Turning back to National Bankshares, as of June 12, 2018, they are trading for around 1.8x TBV. Given that there are a number of obvious buyers trading north of 2.5x TBV, I would imagine that many of these potential buyers might be able to pay a market standard premium for National Bankshares and still be able to announce to investors that the transaction is accretive to tangible book value. I would also imagine that any buyer would also then, after the closing, use National Bankshares’ excess capital to buy back their own stock, likely improving earnings per share, return on equity and, presumably, their own stock price.
One of the interesting characteristics of banks is that, unlike other types of businesses, taking a publicly traded bank private is not really an option. Because banks are so highly leveraged to begin with, it is generally impossible to further leverage them in order for someone to buy out all their stock. In addition, as a general matter, once an investor exceeds certain ownership thresholds, they become subject to regulation by the Federal Reserve, which comes with its own issues and burdens.
All that is to say, once a bank goes public, it stays public until it is acquired.
Occasionally a public bank holding company will go bankrupt or delist from an exchange, but since (i) the former is involuntary, (ii) the latter doesn’t really get rid of public stockholders and (iii) neither are particularly common, I’ll leave those alternatives out of the scope of this post.
Going public has clear consequences. Perhaps the most obvious is having public stockholders. Going public also comes with various obligations and expectations, whether explicit or implicit, clear or less so. Public banks very clearly must comply with the rules and regulations of the SEC and/or other regulatory bodies. Less clear and more implicit obligations include things like interacting and engaging with public stockholders (both current and prospective), caring about the stock price and taking reasonable steps aimed at increasing the stock price and stockholder value and generally displaying some level of accountability to those public stockholders.
Obviously, most banks both accept these consequences and embrace these obligations and expectations. Even if only out of self-interest, management is usually incentivized to try to increase the stock price, whether through improving results and profitability, optimizing capital or otherwise. Management will also engage with current and prospective investors as a way of generating demand for the stock, hopefully increasing its value. Whether or not there is actual accountability, management will give the impression of accountability, if only to create the impression that any missteps or errors that might have caused a decrease in the stock price will not happen again.
Some publicly traded banks, however, rather than accepting the consequences of having gone public and unable to reverse the decision, have opted for a different path. Rather than acceding to the expectations for public companies, they have adopted the mantra of Melville’s enigmatic scrivener, preferring not to.
These reticent public banks tend to have little or no research analyst coverage, shun investor outreach and generally tend to fall between the cracks. In many cases, their initial public offering is a hazy memory—the reasons for it now unclear and the underwriters who made assurances regarding research coverage faded into the mist. For some, this type of effective rejection of their status as a public company is likely intentional, as management teams seek to actively avoid negative research coverage, fly under the radar of activists and keep potential short sellers in the dark and worried about unexpected catalysts. For others, however, it is merely the end result of indifferent performance, unappealing growth prospects, unambitious management and a compliant board.
Having effectively escaped the spotlight many publicly traded banks find themselves in, these ophans, who also tend to have fairly diffuse stockholder bases, can do things and allow conditions to exist that would, for their less bashful peers, attract significant attention and comment from the investor and research community—such as summarily firing a CEO’s heir apparent without cause or allowing capital to build to excessive and inefficient levels.
While these banks’ fate is unclear, they should take note of Bartleby’s end—he starved to death, preferring not to eat.
Following Roaring Blue Lion’s most recent misstep in their proxy contest with HomeStreet (Nasdaq:HMST), I was hoping to be able to write that, while winning this battle (like so many before it), HomeStreet had lost the war (albeit more due to the fact that the obvious and predictable shortcomings of its business model can no longer be ignored rather than Roaring Blue Lion’s powers of persuasion). Unfortunately, not only did HomeStreet win all the battles, but it seems like they also won the war.
Obviously, as John Blutarsky once pointed out, it wasn’t over when the Germans bombed Pearl Harbor, so Roaring Blue Lion could (and should) immediately start to agitate for a sale, but they might not have the vision and fortitude you only get from seven years of college.
Roaring Blue Lion’s failure, however, is our opportunity and serves as a good object lesson with respect to a few fundamental points that I think are critical to successful activism with banks.
First, stock selection is key. Obviously, there needs to be both (i) some amount of underperformance and (ii) some clear root cause or causes for that underperformance, but there also has to be some sort of reasonably achievable fix and some inherent franchise value. As to the latter, the extent of HomeStreet’s inherent franchise value is uncertain at best and, as to the former, my sense is that most investors viewed fixing HomeStreet’s business model as a near impossible task and certainly not anything likely to result in a near term increase in stockholder value.
Second, have a clear and compelling message/value proposition. Some obvious examples of this are asking a bank with limited prospects (and for whom there are a number of capable and willing buyers) to sell, asking a bank with way too much capital to return it to stockholders, et cetera. In the case of Roaring Blue Lion, not only was the message not all that clear—they did not offer much in the way of specifics for mitigating HomeStreet’s dependence on mortgage and speeding the buildout of the commercial and consumer business—but it also wasn’t particularly compelling. Even if Roaring Blue Lion was able to put some directors on HomeStreet’s board, it is extremely unclear as to (i) whether Roaring Blue Lion’s directors would have had any ability to mitigate the effects of HomeStreet’s overdependence on mortgage and speed the buildout of the commercial and consumer business, (ii) whether that type of radical transformation is even possible and, even to the extent it was successful, (iii) what the actual benefits to stockholders would be and when they might be realized.
Finally, execution and professionalism matter. Without rehashing all the gory details, executing on its activist strategy was clearly a challenge for Roaring Blue Lion. Even if Roaring Blue Lion had delivered on the two points above (which they did not), my sense is that their seemingly limitless ability to find and then step on a procedural landmine would have severely hampered their ability to successfully agitate for any changes that would enhance stockholder value.
Leaving Roaring Blue Lion’s misadventure with HomeStreet aside, the banking sector remains ripe for activism. The keys to success, in my opinion, are (i) picking a bank that has real franchise value (ii) that is not fully reflected in its current stock price (iii) where there is a relatively uncomplicated fix (iv) that would create immediate value for all stockholders.
Here is some advice for my friends at large regional banks: with respect to tangible book value (TBV) dilution in acquisitions, heed the prescript (here slightly paraphrased) of Benjamin Jowett and never apologize, never explain.
If you are not familiar with the concept of TBV dilution and its earnback period in bank mergers and acquisitions, you will get no explanation here beyond the following:
First, focusing on TBV accretion or dilution in an acquisition is an extremely defensive way to look at and evaluate the merits of a bank acquisition. I don’t recall exactly when this fixation took hold, but it is properly viewed as a remnant of the financial crisis and its immediate aftermath when bank earnings were essentially non-existent and preservation of capital was paramount. To the extent that TBV dilution was ever a particularly useful metric, that time has passed—this is an expansionary, not defensive period for banks and bank acquisitions should primarily be judged on earnings accretion or dilution and strategic merit. Given the recent earnings performance and prospects for most banks, capital preservation and generation is not the issue—rather it is capital deployment or return.
Second, the desire to limit TBV dilution earnback periods to less than five years has been perhaps the single biggest impediment to bank M&A during the last five years. Put extremely simply, it is hard for a bank to buy another bank that has a larger price to tangible book multiple without incurring tangible book value dilution. One of my biggest gripes about this metric is that it makes it really hard for banks with lots of capital (usually raised for them to be able to buy other banks) to buy banks that are more leveraged. Since there is no normalizing capital levels in calculating TBV dilution, a buyer with lots of capital is more likely to have a lower price to TBV multiple (because the denominator is higher) than a target that is more highly leveraged (because the denominator is lower). This problem is particularly acute when the target is private, since private banks tend to be more highly leveraged than public banks (because, among other reasons, they do not have public stockholders who might be concerned about prospective capital raises).
Finally, not only is it a metric that, due to reliance on forecasts and a lack of a truly standard method of calculation, is easily manipulated, but it is also almost impossible to look back and determine whether the actual impact was close to what was predicted, particularly if the buyer has done any subsequent acquisitions.
So, to put my above advice to regional banks in more specific terms: stop including TBV dilution and earnback calculations in merger related investor presentations. Blunt advice, yes, but my reasons are as follows:
First, going off price to TBV multiples, most larger regional banks trade at a discount to the smaller banks they might want to acquire. This is almost inevitably going to lead to TBV dilution in excess of “accepted” levels. A perfect example of this can be seen in Fifth Third’s (NASDAQ:FITB) recently announced acquisition of MB Financial (NASDAQ:MBFI). I don’t really see this valuation gap closing any time soon, so this will continue to be an issue, even in transactions that are otherwise very attractive and well thought out. Put differently, I don’t think that there is going to be any getting around larger amounts of TBV dilution in these types of deals than investors and research analyst are used to seeing, so regional bank acquirers may be faced with three choices: (i) don’t do the deal, (ii) get beat up for “long” TBV dilution earnback periods or (iii) ignore the metric all together. For otherwise attractive deals, (iii) would seem to be the best alternative.
Second, and this will sound cynical, I think investors and research analysts generally only care about TBV dilution and earnback periods because they think they are supposed to. By including these metrics in investor presentations, banks are endorsing their importance and ratifying their utility, both of which I think are negligible at best. To the extent that investors really care, they can do the math themselves.
Finally, and a corollary to the point above, I think trying to explain why TBV dilution and earnback is not particularly relevant or that a particular transaction might compare favorably to other alternatives, such as buying back stock, with respect to TBV dilution, is, frankly, somewhat of a waste of time. Not only do such explanations inherently give credence to the notion that TBV dilution remains an important consideration, but an acquisitive bank’s time and energy would be better spent on demonstrating the attractiveness of a particular deal (earnings accretion, strategic value, etc.) than comparing that specific use of capital to hypothetical alternatives.
Rather than just wait for this fixation on TBV dilution to finally fade from view, banks who have negotiated, structured and priced acquisitions that are financially and strategically sound should simply choose to ignore this holdover from the immediate aftermath of the Financial Crisis.
Since responding to Roaring Blue Lion’s request for a board seat by giving them the Heisman, HomeStreet (Nasdaq:HMST) has added two directors.
In January, HomeStreet added Mark Patterson to fill a newly created vacancy and then, yesterday, announced that Sandra Cavanaugh would join the board on May 24, the next regularly scheduled board meeting and the date of their annual meeting (and denouement of their current proxy contest with Roaring Blue Lion).
While neither Mr. Paterson or Ms. Cavanaugh seem to have any particular qualifications that would help HomeStreet address its obvious challenges, they certainly appear qualified enough in a general sense to be directors and I assume they will exercise their duties responsibly and with care. However, taken in tandem, there is something a little too cute about these appointments.
Specifically, each previously worked for a large HomeStreet stockholder. Mr. Patterson worked for NWQ Investment Management Co. LLC until his retirement in 2014 and Ms. Cavanaugh worked for Russell Investments until 2016.
This is a look at HomeStreet’s largest stockholders:
Both Mr. Patterson and Ms. Cavanaugh are several years removed from their employment by NWQ and Russell, respectively, and while Mr. Patterson seemed to be involved in NWQ’s investments in bank stocks, Ms. Cavanaugh seems to have spent her career focused on distribution. There is no claim or disclosure that I could find that either Mr. Patterson or Ms. Cavanaugh were appointed pursuant to any agreement or understanding with (or even with the knowledge of) any stockholder.
Does it seem like Mr. Patterson and Ms. Cavanaugh are (or would be) qualified additions to HomeStreet’s board? Sure.
Does it seem a little too coincidental that both worked for large stockholders of HomeStreet? Kind of.
Does it feel like this is an attempt to give the impression that HomeStreet’s board, management and strategy has the imprimatur of two of its largest stockholders leading up to a contested director election? Yeah, it sort of does.
I guess we will find out next week if that is actually the case.
Two proxy advisors have weighed in on Roaring Blue Lion’s proxy fight with HomeStreet (Nasdaq:HMST), with Glass Lewis recommending that shareholders vote for HomeStreet’s nominees and ISS recommending that shareholders vote against one of HomeStreet’s nominees.
I don’t have access to either Glass Lewis’ or ISS’ report, so I don’t know the full extent of either of their recommendations or rationales therefor, but one comment from Glass Lewis’ report (quoted in HomeStreet’s synopsis thereof) stood out.
Per HomeStreet’s quote of the Glass Lewis report “We believe differences in the Company’s performance and valuation relative to peers can partially be attributed to differences in business mix and the Company’s relatively high exposure to the mortgage industry.”
That, to quote the immortal F. Ross Johnson, is a “blinding glimpse of the obvious.”
What is odd about the above quote from the Glass Lewis report—and why HomeStreet would choose to highlight it—is that I don’t think anyone would disagree with its accuracy. I don’t know the context for the quote, but the key issue of contention is not whether HomeStreet’s “high exposure to the mortgage industry,” is the cause of its lackluster performance and paltry valuation (hint: it is), but what, if any, should be the repercussions of the decisions (and execution thereof) that left HomeStreet’s financial results, condition and prospects so at risk in the event of a (completely predictable) downturn in the mortgage business.
Given that it is pretty well understood that the mortgage business slows as interest rates rise, as well as the well telegraphed path of Fed rate hikes, it should have been (and was) obvious a while ago that a “high exposure to the mortgage industry” was not going to be a desirable thing. The real issue at hand is whether current HomeStreet management did (or is capable of doing) enough to build out other business lines to offset the very predictable weakness in mortgage.
Not to beat a dead horse on this one, but rather than spending a lot of time trying to figure out whether HomeStreet’s management is on the right path to minimizing the reliance on mortgage or whether the more aggressive measures proposed by Roaring Blue Lion are the better option, I think all parties involved should focus on finding a partner for whom HomeStreet’s mortgage business will compliment larger and more established commercial and/or consumer businesses. It seems pretty clear to me that the public market has a pretty gloomy outlook on HomeStreet’s ability to exercise adequate self- help—the time has come for HomeStreet to test its value in the private market.
Disclaimer: I used to spend a lot of time on the golf course trying to get business. I would guess that when I was an investment banker, the most consistently productive use of my time was taking clients (or would be clients) to play golf. Whether that was the most productive use of those clients’ time—and what that says about my skills or value add as an investment banker—is question for another day.
More than just a confession of my questionable investment banking prowess, my point is that I am a big believer in the utility of golf for building business relationships. In any type of sales position (and investment banking is 98% a sales position), it is essential to have some type of hook for connecting and bonding with clients and for me, and a lot of others, it was golf. Right or wrong, I generally view customer golf as an entirely legitimate and worthwhile part of business.
I also generally think that the expenses for customer golf are properly viewed as business expenses and, if someone takes a potential customer to play golf, they should be reimbursed for those expenses in the same way their firm would reimburse them for any other type of client entertainment.
However, what with it being proxy season, the practice of many small banks of paying for country club memberships for their named executive officers really rubs me the wrong way.
Before getting into why this gives me such a rash, let’s look at one bank’s justification for this practice. From Old Second’s (Nasdaq:OSBC) most recent proxy statement:
“We do provide country club memberships to certain executives and managers in the ordinary course of business to give them the opportunity to bring in and recruit new business opportunities. These individuals are eligible to use the club membership for their own personal use.”
“Okay,” you say, “seems reasonable enough—so what is the problem with that?”
Actually, I have a number of problems with that and none of them have to do with the actual expense, which is usually immaterial.
For starters, it just seems pretty bush league. To elaborate a little, it seems completely out of touch with current views on corporate governance and executive compensation. I don’t totally buy into all the various best practices or policies put forth by sundry investor advocacy groups, but this quote from the Council of Institutional Investors’ Policies on Corporate Governance seems like a pretty good articulation of current thinking on this topic:
“Company perquisites blur the line between personal and business expense. Executive, not companies should be responsible for paying personal expenses—particularly those that average employees routinely shoulder, such as family and personal travel, financial planning, club memberships and other dues.”
Like I said, I don’t totally agree with a lot of the current thinking on corporate governance out there, but this just seems like a pretty easy one for banks to adhere to in the spirit of minimizing potential points of contention with investor groups, proxy advisors, etc.
Paying for named executive officers’ country club memberships also seems pretty anachronistic. Like I said above, I am a believer in golf’s utility for business, but the notion that a country club membership should be so important to developing business relationships that it should be specifically paid for by a bank seems dated at best. Not to put too fine a point on it, but if a bank or bank CEO really thinks a country club is the best place to look for (or use to entertain) business prospects, they are probably missing more business than they are getting and might want to start thinking about broadening their horizons just a little.
More than anything, however, paying for country club memberships for named executive officers is, to me, basically rent seeking (consciously or not) by those named executive officers and part of the larger issue of many small bank management teams thinking of themselves (and their boards allowing to think of themselves) as employees rather than owners.
I think that most bank CEOs are paid pretty fairly (if not generously) and banks, like other public companies, take up a lot of space in their proxy statements with an extensive discussion of executive compensation. In particular, there is usually a lot of benchmarking, peer analysis and the like, which I view as primarily intended to make (what I consider) the very subjective decision of what to pay (primarily) the CEO as objective seeming as possible. I generally think that that a lot of the metrics, targets and peers are chosen in order to rationalize paying (primarily) the CEO what he wants to be paid. Nevertheless, it is still a process that has at least the appearance of some rigor and allows the board to colorably claim that they are paying the CEO what he is worth.
I may be a little cynical about the whole process, but I get it. What I don’t get is why, after going through all that analysis and justification, then throw in the costs of a country club membership?
I might be wrong, but I think there is a very significant qualitative difference between (i) a bank paying a CEO’s country club dues and (ii) a bank paying a CEO a little more and letting him (and it is usually him) pick up his own country club dues. In the first instance, the CEO is probably completely indifferent as to cost and where the cost/benefit analysis comes out, while in the second, even though the money is essentially coming from the same place, the CEO is probably significantly more attuned to cost and, in particular, whether the benefits justify the cost. More to the point, I think it is fair to say that people are more likely to pay close attention to such matters when it comes out of their own P&L.
In the case of Old Second, I doubt that their CEO, Jim Eccher, thinks of the bank’s P&L in the same way he thinks of his own. Not to pick on Old Second and Jim Eccher for this (since it is not egregious as far as many small banks go), but I would generally consider Mr. Eccher’s stock ownership as relatively de minimis given that he has been CEO of Old Second’s holding company since 2015 and CEO of Old Second’s bank since 2003. Based on Old Second’s proxy, Mr. Eccher made approximately $1 million in total compensation in 2017, but (using a stock price of $14.50 a share) only owns around $2.2 million in Old Second stock. Again, I don’t think that the numbers in Mr. Eccher’s case are over the top on a relative basis, but definitely reflect a mindset that is all too pervasive among many bank management teams—specifically, that wealth creation comes from job preservation, which may or may not align with, result in or be a function of, maximizing stockholder value.
What is egregious, however, is that while the US Treasury, and by implication, US taxpayers were losing money on their Financial Crisis era investment in Old Second, Old Second maintained its practice of paying for management’s country clubs.
Like many banks during the Financial Crisis, Old Second received a capital infusion from the US Treasury pursuant to TARP. Unlike with most banks that participated in TARP, the US Treasury took a significant loss on its investment in Old Second, primarily due to Old Second’s persistently poor asset quality and financial performance. However, using 2013, the year that the US Treasury sold its Old Second preferred stock at a steep discount, as an example, Old Second paid, per its proxy statement, in excess of $27,000 for country club dues for its named executive officers, even as Old Second continued to lose money, largely due to soured real estate loans.
Old Second (and other small bank) stockholders might want to take a mulligan on allowing this practice continue.
Turning back to a favorite topic of this blog—Roaring Blue Lion’s activist campaign against HomeStreet (Nasdaq:HMST)—I am going to predict that, by the time all this is said and done, HomeStreet is really going to regret not just giving Roaring Blue Lion a board seat when they asked for it last year.
“Wait”—a faithful reader of this blog might say—“you’ve been pretty critical of Roaring Blue Lion in the past—so what has changed?”
The answer is that a number of things have changed.
To begin with, HomeStreet’s first quarter earnings were a bit of a disaster and starkly illustrated how dire the situation has become for HomeStreet’s mortgage business. Per HomeStreet’s CEO on their earnings call:
“In the first quarter of 2018, we met many challenges. The limited supply of new and resale housing has become acute and has now become a nationwide phenomenon with many markets experiencing the lowest historic levels of new and resale housing ever observed. The yield curve has flattened considerably to near historic lows. We have experienced higher levels of negative convexity in our servicing portfolio and the debt capital market experienced periods of extreme volatility during the quarter. Additionally, lower industry loan volumes substantially increased price competition in the quarter. These challenges meaningfully reduced our profit margins, mortgage loan volume, and mortgage servicing income in the first quarter, making a quarter that already reflects seasonally low volume more difficult, and driving an operating loss from the mortgage banking segment in the quarter, despite significant restructuring and cost reductions last year.”
My translation: “(i) not enough people are buying houses, (ii) even when we make mortgage loans, we don’t make enough money on them and (iii) mortgage servicing rights haven’t actually turned out to be much of a hedge against the impact of rising rates on our mortgage business. In addition, since mortgage is such an incredibly competitive business, now that there is not as much of it to go around, pricing is brutal. Given that the first quarter is usually pretty bad for mortgage anyhow because of seasonal home buying patterns, we really took it on the chin, even after cutting the business to the bone last year.”
Secondly, as HomeStreet’s stockholder meeting approaches, the dueling appeals to stockholders and proxy advisors are starting to come fast and furious and, in Roaring Blue Lion’s case, with significantly more polish and focus. I don’t know if Roaring Blue Lion brought in some new advisors or were just playing rope-a-dope in the early rounds of this contest, but they have definitely stepped up their game in the last week or two.
Both HomeStreet and Roaring Blue Lion have made presentations to ISS followed by a rebuttal presentation from HomeStreet, that was re-rebutted in turn by Roaring Blue Lion.
Based on this flurry of activity, a few things are pretty clear.
First, HomeStreet’s business strategy is not working. Their attempts to diversify away from mortgage and into commercial and consumer banking, while well-intentioned, have not been nearly enough to cushion the negative impact that higher interest rates have had on their mortgage business.
One of the issues that generally everyone has with the mortgage business is its volatility—there are periods of boom and periods of bust. I appreciate that HomeStreet tried to mitigate the boom/bust nature of mortgage by building out other business lines, but, based on their own materials, my conclusion is that the investment in commercial and consumer is not really panning out. When mortgage was booming, the investment in commercial and consumer banking was a drag on earnings and now that mortgage is bust, those businesses don’t generate enough earnings to offset the impact of the precipitous decline in the mortgage business.
The result is a pretty low performing bank that, left to its own devices, has two paths to (self) improvement. The first path, which is out of its control, is that the mortgage market improves significantly. The second is redoubling their efforts to build out commercial and consumer. Put succinctly, their options are hope and hard work (and more expense) and neither path has a guaranteed outcome. In comparison, the steps suggested by Roaring Blue Lion—sell HomeStreet’s mortgage servicing rights, scale back on mortgage, cut costs in the consumer business and focus more on the commercial business—seem to offer the possibility of great stockholder value than what is currently on offer.
Obviously, however, the quickest and surest way to maximize stockholder value is for HomeStreet to pursue a sale, but neither side is talking about that, yet anyway . . .
Second, HomeStreet is spending an incredible amount of time, energy and money on their battle with Roaring Blue Lion, all of which could clearly be better spent on trying to deal with the challenges in their business (or, as far as I am concerned, extolling the virtues of their business to potential suitors).
Third, I am relatively confident that Roaring Blue Lion will come out as the winner in this. My guess is that either they manage to secure enough votes to defeat the two HomeStreet directors who are up for election or HomeStreet decides to follow the first rule of holes and settles this by giving Roaring Blue Lion a board seat.
While I may be relatively confident that Roaring Blue Lion will come out as the winner, I am really confident in declaring HomeStreet (really its board and management) the loser. Not only has all this (including their own presentation materials) laid bare the fundamental flaws in their business—namely their over-dependence on mortgage and their inability to get their commercial and consumer banking business to scale before mortgage tanked—but the fight with Roaring Blue Lion is clear evidence of misplaced priorities.
I appreciate how HomeStreet’s management and board might have resented Roaring Blue Lion’s demand for a board seat. However, it would have been a lot easier, all things considered, to have just given them a board seat and avoid a costly and distracting proxy fight at what has turned out to be an incredibly inopportune time, particularly since Roaring Blue Lion’s influence once on the board could have easily been muted.
I guess it could be worse (at least for HomeStreet’s management)—Roaring Blue Lion could finally realize that the best path to really maximize stockholder value is through a sale . . .
I want to make two points.
The first is that, in my opinion, this is a great time to be running a bank. I don’t want to wax too Panglossian, but the economy is growing, banks are generally seeing an immediate positive impact from tax reform, industry wide asset quality is fantastic, the regulatory environment is significantly more constructive than it has been in years, unemployment is dropping, core deposits are gaining in value—the list just goes on.
However, as Abe Lincoln once said, “this too shall pass.”
While current conditions are generally positive for most of the banking industry, that is not going to stay that way forever. Rising rates obviously cut both ways and, once the Fed stops raising rates and deposit betas catch up with loan betas, it will be all too apparent who has been swimming without a bathing suit (to paraphrase another folksy American hero). Technology will inevitably reshape the competitive landscape for banks and there will be a bigger run rate of expenses associated with cybersecurity. Loan growth will not be shared proportionally by all. Banks will have to grapple with CECL, which will be a costly headache for many. Finally, while I do not anticipate anything close to the credit issues experienced by banks during the financial crisis, asset quality has a lot more room to get worse than to get better.
None of that makes me a bear on banks—or, more accurately, none of that makes me a bear on some banks. I think the real impact of changing conditions will be that the banking sector will become even more clearly divided into the haves and the have nots, with the haves getting their disproportionate share of the benefits of economic growth, rising interest rates, implementation and adoption of technology, etc. All these benefits should be reflected in their results and stock price multiples, allowing these winners to be even more aggressive in making investments in their business, whether through acquisitions, hiring, spend on technology, whatever. You can already see the trajectory of this by looking names like Western Alliance (NYSE:WAL), Pinnacle (Nasdaq:PNFP), ServisFirst (Nasdaq:SFBS) and Bank of the Ozarks (Nasdaq:OZRK).
For others, things could be a little tougher.
This leads me to my second point. If you are not currently in, or soon to join, the haves category, now would be a pretty good time to think about selling. Put another way, if you are a bank and are not taking full advantage of this great climate for banks, I think it is going to be pretty hard to play catch up and the best route to maximizing stockholder value is probably finding a partner.
To put this into context, I was reading the Proxy Statement for MidSouth (NYSE:MSL) and came across this statement:
“Our aim is very simple – we want to achieve long-term, sustainable, above-average financial performance as measured against our peers. That is our stated goal and it will take time to get there, with an initial milestone of achieving peer levels of profitability at lower levels of risk within three years.”
I have a ton of respect for the board at MidSouth. They have faced a lot of tough issues head on and made some hard decisions without flinching. Their transparency and forthrightness are truly commendable. I also think they are completely serious about maximizing stockholder value. Unfortunately, I don’t think a three year journey to peer levels of profitability is the way to do it.
As an aside, I do think these guys are straight shooters—three years is a long time, but if feels about right in terms of the length of time to accomplish all that they are trying to do. I think other banks facing similar turnaround situations are probably less candid about how long and how difficult the process is likely to be.
Being straight shooters, though, MidSouth basically points out all the issues with embarking on this path in their proxy statement: the costs of significant investments in risk management infrastructure, the need to retool their business model, the costs of building out operating infrastructure, the challenges of attracting and retaining talented individuals, etc. More importantly, MidSouth acknowledges perhaps the most overarching concern of all--execution risk, which I don’t think is ever properly estimated in turnarounds. Finally, MidSouth points out perhaps the biggest issue to stockholders:
“These activities will not deliver much in the way of positive financial performance in 2018 . . .”
While I think that both the goals and intent of MidSouth’s board are laudable, I also think they should refresh their recollection of this statement from their 2017 Annual Shareholder Meeting Presentation:
“Independence is earned and not a God-given right.”
I am confident that many other banks would be interested in partnering with MidSouth. They have a valuable deposit franchise and an increasingly liquid balance sheet that would prove very attractive to banks in need of additional deposit funding. In addition, it is often easiest to deal with credit issues in the context of an acquisition—purchase accounting would offer an acquirer the opportunity to wipe the problem asset slate clean (and potentially provide for additional earnings down the road). Finally, as with almost all acquisitions, there is the likelihood of significant cost saves.
I can only hope that the MidSouth board (1) is not rebuffing bona fide overtures from banks capable of executing a transaction, whether made directly or through their intermediaries, (2) is fully informed as to the value MidSouth might obtain for stockholders in a sale transaction and (3) carefully and faithfully weighs the value that could be obtained in a sale against the value of remaining independent, after taking into account all risks associated with either path.
Going back to my first two points, I think it is pretty clear that MidSouth is not currently taking full advantage of the current excellent climate for banks. I don’t think that the current board and management team is at fault for that and I think that they are trying to make the best out of a tough situation. However, I think it would make more find a strong partner now, and allow MidSouth stockholders to fully reap the benefits of this great environment, rather than wait three years to see whether a tough turn around will be successful and hope that economic conditions will remain as supportive as today.
I took a break from earnings to check in and see what was going on with the proxy fight between HomeStreet (Nasdaq:HMST) and Roaring Blue Lion. Unfortunately, for all you fans of this type of thing, the answer is not a lot.
Having, quite frankly, whiffed in their attempts to put forward two candidates for election for director, Roaring Blue Lion is now soliciting proxies against HomeStreet’s slate of directors.
I don’t really have a dog in this fight. I think the best thing for HomeStreet stockholders would be for the company to pursue a sale, maybe with Banner (Nasdaq:BANR), who clearly needs to do some type of deal to get well north of the $10 billion in assets threshold and rationalize their capital and expense base. For some reason, however, Roaring Blue Lion is not raising this topic, despite the fact that it would most likely garner the exact type of attention and excitement from stockholders that their current efforts sorely lack.
Anyway, I have three general thoughts (or buckets of thoughts) on the current situation.
First, why wouldn’t HomeStreet just give Roaring Blue Lion a board seat? I started thinking about this a while back. Based on HomeStreet’s proxy statement, Roaring Blue Lion is one of their biggest stockholders, with close to 6% of the shares. I am sure that HomeStreet probably considers Roaring Blue Lion to be a nuisance, but to give them a board seat doesn’t seem like a massive concession. For a company that is struggling with some pretty serious business challenges, it would also seem to make sense to try to (or at least appear to try to) work with large stockholders.
Right now, HomeStreet has nine directors. If they added two other directors, giving Chuck Griege, Roaring Blue Lion’s main guy, a board seat and adding another independent director, that would make Mr. Griege one director out of eleven, plus he would then be an insider and they could have him sign a standstill agreement, all of which would really limit his ability to cause mischief. In addition, they could make sure to schedule board meetings, retreats and the like to make sure that he attended in person. My general view of human nature is that people are pretty social beings and it is pretty hard to consistently be a nuisance with a group of people once personal bonds are established, particularly if they are a more or less collegial group.
Unfortunately, however, after reading the chronology of events in Roaring Blue Lion’s proxy materials, the only sensible conclusion is that HomeStreet considers Roaring Blue Lion not only a massive nuisance, but an irredeemable one at that. Obviously, those types of considerations should not impact corporate governance issues, but, it is what it is.
Second, speaking of corporate governance, as a tactical matter, Roaring Blue Lion should put much more emphasis on HomeStreet’s corporate governance shortcomings. Personally, I am much more concerned with how a company is managed than how it is governed, but there is some pretty low hanging fruit that Roaring Blue Lion could go after, like a classified board, no director resignation policy, no separation of Chairman and CEO role and no proxy access. In addition, it looks like the stock ownership by HomeStreet officers and directors is a little light and there are no guidelines (at least that I could find) for minimum stock ownership by senior executives. This last point is something I actually do care about. When executives do not have a meaningful amount of “skin in the game,” it is pretty easy to come to the conclusion that job preservation, not increasing stockholder value is the prime motivator.
Like I said, I think good management is more important than good governance, but (metaphor stacking alert) if someone had an axe to grind, it would all be grist for the mill. Roaring Blue Lion does mention some of these points, but given the attention that many institutional investors give to corporate governance issues, I would be pounding the table on this point if I wanted support for a proxy solicitation.
Third, just what is the point of all this? If I read Roaring Blue Lion’s proxy materials, it seems like they are upset about a $500,000 SEC fine and the events that gave rise to that fine and want the three HomeStreet directors up for election to be “accountable” for that, as well as the how HomeStreet’s stock has underperformed over the past five years. Sure—I would like directors to be accountable for poor stock price performance and the fine is not great—but, if you are going to go the effort of a proxy solicitation, it feels like it should be a “go big or go home” type of effort.
Roaring Blue Lion does raise a few specific things that new directors (presumably that would be appointed if the directors up for re-election are not so elected), all of which seem pretty reasonable. Per Roaring Blue Lion:
“We believe there also may be opportunities for HomeStreet to create more value for shareholders. New Board members could assist in the evaluation of these alternatives, which include (1) monetizing the single family mortgage serving rights and using the proceeds to repurchase stock; (2) restructuring the mortgage origination business by reducing loan originations and targeting an improved efficiency ratio; (3) restructuring the commercial banking business by reducing expenses; (4) realigning executive compensation programs to de-emphasize production volume and focus on profitability; and (5) instituting better corporate governance, including eliminating the staggered Board and separating the Chairman and CEO roles.”
Reasonable? Sure, why not? All these points are probably worth consideration, but I don’t know that I would consider them to be “going big.” Referring to Roaring Blue Lion’s alternatives by number, I guess (1) could result in near term stockholder value, though I would need to understand the numbers involved to figure out how much I cared. I am pretty sure HomeStreet is already working on (2) and (3). With respect to (4), quite frankly, my reaction is “whatever”—I would rather focus on making sure that management had enough stock so that they thought like owners, rather than employees. On (5), I would prefer a non-staggered board, but don’t really care about the separation of Chairman and CEO—at the end of the day, each director has one vote, so what does it really matter?
What is lacking from all of this is the type of thing that I really do care about—a clear path to increasing stockholder value within a reasonable timeframe and with minimal execution risk. Given HomeStreet’s mortgage dependent business model and the difficulties in changing that model, I think that path points in the direction of partnering with someone. Ideally, HomeStreet would find a partner where the mortgage business is a small enough part of the combined business so that the earnings from that business get a “bank”, not “mortgage” multiple and where there are significant opportunities for cost savings and economies of scale. That, to me, is worth a proxy fight.
Maybe one of the most hoary adages in banking is that “banks are sold, not bought.” I think the common understanding of this old chestnut is that, as a general matter, (a) a bank’s decision whether and when to sell is a decision that is uniquely and solely the provenance of the selling bank (and, in reality, often the selling bank CEO) and (b) that any attempts to force or hasten that decision are likely to be unsuccessful. Taking a page from Missy Elliot, I think it is time that confident bank CEOs take that conventional wisdom and “flip it and reverse it.”
A perfect example would be Pinnacle Financial Partners (Nasdaq:PNFP). On their earnings call on Tuesday, Pinnacle’s CEO Terry Turner (who I consider to be one of the absolute best in the business) said “I believe banks are sold, they’re not bought, which is just another way of saying that you have to buy it when they are for sale.” While he was saying this in the context of explaining that (a) Pinnacle didn’t really have any need to do any acquisitions because its organic growth prospects were so strong and (b) they would always have plenty of deal opportunities to look at—both of which I agree with wholeheartedly—I don’t think Pinnacle has to wait for a bank to be for sale to be able to buy it.
Part of this is due to Pinnacle’s strong currency, which theoretically would allow them to pay enough to get someone otherwise not interested to sell. Part of it is their unique culture, which would make it an attractive place for people to work, taking some of the sting out of an unsolicited approach. However, I think the biggest reason why Pinnacle would be excellent at buying banks (rather than waiting for them to sell) is what I consider to be the cornerstone of their success to date: their relentless focus on identifying, recruiting, motivating and retaining the best bankers in their markets.
Basically, I think it would be pretty easy, especially given the expansion of their footprint as a result of the BNC transaction, for Pinnacle to identify a deposit rich franchise (likely in a more rural area) and pursue a transaction with them, whether or not they are for sale, and combine that transaction with a lift out (for lack of a better term) of some talented bankers in that market or just use the deposits to fund loans in their high growth urban markets.
Indeed, this is essentially the template that Pinnacle used when it entered the Memphis market, combining the acquisition of (in my mind) an ok banking franchise with a lift out of a good sized team of experienced bankers from the dominant regional bank in the market.
While I generally prefer the organic part of the Pinnacle story, their impressive loan growth has made their ability to grow deposits at both an acceptable pace and cost a little bit of an issue. I am generally pretty confident that Pinnacle will be able to address this issue—I think that Terry Turner is tremendous at both managing and motivating—but (even discounting any misplaced modesty and recognizing that he was somewhat trying to minimize the importance of M&A to Pinnacle’s strategy or prospects), he is selling his ability to buy banks (rather than wait for them to sell) short and may want to turn those abilities towards securing additional low cost, sticky deposits.
There was a lot more than spring in the air at the end of last week—late in day on Friday, there was a public report that FCB (NYSE:FCB) was looking for a buyer. Rumors that this bank or that bank is for sale or looking for a buyer are nothing new, but I was a little disappointed and chagrined that FCB was so publicly rumored to be selling (although I wasn’t particularly surprised). I think it is a pretty acknowledged fact that there is a subset of banks that are frequently the subject of sale rumors, and, unfortunately, as far as I am concerned, FCB gets lumped into this group.
To make it clear, I think that most rumors that any particular bank is looking for a buyer are probably made up of equal parts of speculation, wishful thinking and gossip. I have touched on this before, but I think it is fair to say that there is a widespread expectation among all those that follow the banking industry (investors, research analysts, investment bankers, lawyers, reporters etc.) that at some point (and hopefully soon), the floodgates will open and massive waves of consolidation will reshape the banking industry landscape. Unfortunately, however, those floodgates haven’t opened yet and, in the meantime, there is a lot of speculating who might be open to selling, hoping that some of these deals come to pass and gossiping about any possible signs of incipient M&A activity.
Nevertheless, these type of rumors are always swirling around and often formalized into “likely seller” lists published by research analysts and the like that read more like a tout sheet at the track than financial analysis. Not surprisingly, a lot of the same banks show up pretty consistently on these lists, which I think reflects how frequently people speculate that they might be for sale and, in turn, makes them frequent subjects of rumors that a sale process is underway.
Leaving aside FCB for the moment, I would say that a lot of the banks that are the subject of these rumors—let’s call them the bridesmaids—have actually been for sale for a number of years. That is not to say that there have been active sale processes going on for all that time (although I would expect that there are pretty regular soft market checks)—rather, there has been a continual expectation that the bank will be sold in the near term. I think this expectation comes from two sources that feed on each other and, on balance, likely diminishes (rather than enhances) the likelihood of any sale at any type of premium to market prices.
The first, and most important, source of these expectations is the management and the board. Anyone with any reasonable amount of familiarity with bank stocks knows that there are a decent handful of banks out there that were built to sell—usually with more emphasis on the “sell” and less on the “build”—and are now looking for an exit. These banks may not come out and explicitly say that is the goal, but the “body language” of management is pretty clear. Also, they are frequently the subject of takeover speculation, whether on “likely sellers” lists or talked about in the market.
One consequence of these management and board expectations is lack of investment in the bank’s business. Some of this is intentional, as necessary or desirable expenses are pushed off in hopes that they will be borne by a buyer after a sale. Some is less directly intentional, such as when a bank chases businesses that might result in immediate earnings but no real franchise value or fails to critically assess businesses or markets it is in and should exit or others that it is not in and should enter. Some is probably completely unintentional, such as when a bridesmaid cannot hire talented individuals who see no upside to going to work for a bank that might be sold to a competitor at any moment.
Feeding off management and board expectations of a sale are investors, who I think are generally pretty astute at recognizing a bridesmaid when they see one. As I mentioned in an earlier post, I would argue that the more that investors think the sale of a particular bank is likely, the more that expected sale premium gets built into the bank’s stock price. The stock price then just seems to trade based on what the market expects that a buyer might be able to pay for the bridesmaid, taking into constraints around earnings and tangible book value dilution.
As a total aside, thankfully, tangible book value dilution in bank M&A is becoming less of a concern as investors and research analysts become more focused on earnings. I’ll probably address it in another post, but I think it is a metric that represents an incredibly defensive view of bank stocks. It also fails to take into account different levels of capital and, more importantly, why banks might have different levels of capital.
My opinion is that these two sets of expectations reinforce each other. At the most superficial level, my sense is that the management and board of a bridesmaid would be likely to sense that stockholders too are expecting a sale and don’t want to diminish that expectation for fear that any such diminished expectations would result in a corresponding diminution of the takeout premium baked into their stock price. At a more profound level, if you take the view that stock price and valuation multiples are a gauge for investors’ satisfaction with management performance, valuation multiples that are inflated because they assume a yet to be received takeover premium can easily be conflated with valuation multiples that reflect excellent management performance.
Put another way, if I am the CEO of a bridesmaid, it is pretty easy for me to ignore any potential looming issues in my business if my stock price represents a full valuation—why would I want to take on tough decisions if my stock price basically tells me that investors are happy with the status quo?
Unfortunately, none of this probably makes a sale more likely. Buyers generally have to pay a premium to get a deal done and that gets hard if a bridesmaid’s stock price already fully reflects that expected premium. Additionally, the perpetual state of being for sale usually diminishes, rather than enhances, franchise value, with predicable results for chances of a successful exit. At some point, one might expect, these bridesmaids’ chickens will come home to roost in the form of either a no premium sale or a “take under” on the one hand or some tough sledding as management has to confront some real business issues on the other hand, but who knows? Maybe the Canadians will buy one or all of them.
Notwithstanding the recent news stories about FCB, I would put them in a different category than the bridesmaids. Sure, they have a couple of attributes that make people confuse them with the bridesmaids—they started out as a “blind pool”, a general perception that the board was playing a trade and, now that the trade has paid off, is interested in an exit, and frequent rumors that they are exploring a sale—but there is one extremely important difference: they are actually building a franchise. I think it was a stroke of genius for FCB to hire Kent Ellert as CEO—he is a super capable guy and well on his way to creating a core deposit funded, commercially oriented, pure play Florida powerhouse. He has done a great job on the loan side and is working hard to continue to improve the deposit mix, which is always a challenge.
Their biggest issue, however, is shedding the image of a bridesmaid. I think that their stock trades too much based on what someone could pay for them rather than what they are worth. For most banks, that would be a good thing rather than a bad thing, but I think FCB’s expected take out price puts a ceiling on, rather than a floor under, their stock price.
Again, in contrast to a lot of banks out there, I think that FCB could create a lot more stockholder value in the long run by focusing on its own growth path. Maybe they exit down the road if some of the larger regionals’ valuations ever improves to the point that they could pay a substantial premium for (what should then be a much larger and more profitable) FCB, but for the foreseeable future, I think the real opportunity for FCB is to just keep executing on doing what it is doing.
My hope is that the FCB board will take such steps as it can to help FCB be seen as other than a bridesmaid, which might include remixing the board somewhat to add more Florida-centric business types. I don’t think that there is anything wrong with any of the current directors—it looks like they are all extremely sophisticated and oriented 100% towards stockholder value and I am guessing that a lot of them have substantial Florida connections—but my gut feeling is that a lot of investors, rightly or wrongly, see the board as playing out a trade. Adding some well-established, well-connected Florida business types might not make any difference in terms of the performance of the board (which I think is quite strong) but may be useful in terms of sending a signal to the market.
In addition, the FCB board could indirectly address these rumors through some type of strong statement in connection with FCB’s upcoming earnings release. Obviously, most of the time, it is not in a bank’s best interest to comment on market rumors—and, for all I know, they could actually be in the process of selling themselves—but, some type of reiteration of their commitment to pursuing current opportunities for growth might be warranted.
While I generally like it when a bank stock is being undervalued by the market, I really love it when a bank stock is being undervalued by the market and there is a catalyst on the horizon that I think will make the market revalue that bank stock higher. It’s great to be right in picking stocks that are undervalued, but it is profitable to pick those where there is a good chance that the market will soon realize its mistake. Ideally, the catalyst is something pretty objective actually occurring, like oil prices going up or the results of an investigation. In that type of situation, there is a fact that has changed, which provides a reason or excuse for the market to reconsider its view of a stock.
The absence of any change in facts or circumstances, however, is a trickier situation, particularly when the market seems to be expecting something bad to happen. In such a case, the non-occurrence of the expected bad thing, presumably, doesn’t mean that the bad thing won’t happen, it just means that it hasn’t happened yet.
While I recognize the logic of that type of thinking as applied to many cases where the market expects a bank’s results to stumble, in some circumstances, it might be better to listen for the dog that doesn’t bark in the night.
A perfect example of this is Bank of the Ozarks (Nasdaq:OZRK). Despite its uncanny record of stellar results, it still, in my mind, is significantly undervalued by the market. A large part of the reason for that is what I would call a rich man’s problem—it is just too consistently, too profitable for many to believe that its model is sustainable. Along those lines, it was the target of a, in my mind, very uninformed and unsophisticated public attack a few years ago, which probably first really dented the performance of the stock that had, prior to that, been somewhat of a market darling.
If I had to list the common bear case arguments against Bank of the Ozarks, I would say that the three biggest are credit, growth and funding. I won’t go into Bank of the Ozarks differentiated business model—their recent management comments from their earnings release yesterday do a great job telling their story—but the executive summary of the bear case is that (1) their construction loans will blow up,(2) they will not be able to continue to make construction loans at rapid pace and/or (3) they will run out of deposit funding.
None of these expected bad things has, so far, come to pass. The real question is how many successive quarters of bad things not happening does it take for the market to grasp “the significance of the silence of the dog”?
P.S. Releasing management comments along with the earnings release is a great practice that I hope other banks adopt.
You know what tastes great together (other than chocolate and peanut butter)? The combination of an asset generation engine that produces a lot of high yielding loans and a liquid balance sheet funded by low cost, sticky deposits. While there are a number of banks that fall into one or the other of these categories and may have been patiently waiting to find their complimentary opposite, there is no reason why this natural pairing should not happen more frequently—just like in the classic Reese’s commercial, this combination could easily occur more spontaneously and without any elaborate or lengthy courtship.
Asset generators (i.e., banks that grow loans substantially faster than deposits) buying deposit rich franchises with low loan to deposit ratios is nothing new. Capital One’s 2005 acquisition of Hibernia is a classic (and perhaps most the extreme) example of, and template for, this type of transaction. In its quintessential formulation, a bank with a national lending business that generates lots of high yielding loans significantly faster than it can gather deposits buys a bank in a slower growth market with lots of sticky, low cost deposits that is “under-loaned.” Mixing my metaphors (obviously I have dessert on my mind), the cherry on top of this sundae is that the CEO of the acquired bank remains to run the legacy banking operations. Ideally, the end result is a bank that can grow high yielding loans at a rapid pace funded by a deep well of low cost deposits.
Great combination, right? Unfortunately, there is one glaring issue with this model—traditionally, for a deal to occur, a deposit franchise has to (finally) decide to sell, the timing of which can obviously be hard to predict or rely upon. However, instead of waiting in the wings for an aging CEO to finally cash in his chips or hoping that an elaborate and oblique courtship conducted through intermediaries bears fruit, there is significantly simpler and more direct option for confident asset generators: make a public and unsolicited bid.
I mentioned in an earlier post that I think one of the reasons why public unsolicited bids were so rare in banking is because of the general “clubbiness” of the industry (I have some thoughts on why that exists that I will share in a later post) in general and, in particular, the concern that by making such a bid, a potential buyer, if unsuccessful will have prejudiced itself in the event that the bank later decides to put itself up for sale. I think that both the general and particular concern are much less of an issue for an asset generator with a national lending business because, almost by definition, the CEOs and boards of those type of institutions are less likely to be bound by, or troubled by the breach of, any of the more parochial conventions regarding combinations prevalent in any particular markets. In addition, such asset generators, since they are probably largely indifferent as to the geographical location of a deposit franchise, can easily treat these opportunities like the proverbial bus—if missed, another will appear.
Further, many of the characteristics that would make any particular deposit franchise a perfect target for an asset generator—low loan to deposit ratio, slow growth market, etc.—probably also mean that the target has earnings issues and difficulty in providing acceptable (current or future) returns to stockholders. In such a case, a properly priced (i.e., not a “low-ball”) bid should prove attractive to both stockholders and the target’s board of directors—particularly if the latter is both informed as to, and being candid about, the target’s prospects as a stand alone entity.
Finally, with respect to those asset generators who would need local management to run a deposit franchise, an unsolicited bid (again, if properly priced) could conceivably be a blessing in disguise—not only could the CEO get a premium for his stock and retain his job, but it also might be a way for him to solve his growth and profitability issues without ever actually admitting they exist.
In terms of likely candidates for either side of this type of delicious combination, there are a number of obvious choices. On the asset generator side, Triumph Bancorp (Nasdaq: TBK) has a clear familiarity with this model, as does Bank of the Ozarks (Nasdaq:OZRK), though their success with their “spin-up” branches and the sheer size of their funding needs, combined with their enviable asset betas, may signal a move towards the more predictable route of just paying up for deposits in a targeted fashion. On the deposit franchise side, almost any publicly traded bank in California’s Central Valley would be a good choice, as would a bank like MidSouth (NYSE:MSL) that has a good deposit franchise, but is experiencing earnings challenges due to the decision to drastically limit exposure to a particular industry.
While the idea of a public unsolicited bid may have its clearest application in bringing together two banks that effectively represent opposite sides of a balance sheet, some banks with slightly more traditional loan and deposit makeups may also want to consider more aggressive methods of securing deposit funding, particularly as the tide goes out with respect to deposit costs and the quality of deposit franchises.
Lastly, as potential bidders contemplate this step, they should be mindful that there is no time like the present, as rising rates and increased emphasis on core deposits may narrow the valuation multiple advantage that many strong asset generators now have compared to deposit franchises. Taking a wait and see approach to acquiring a deposit franchise may significantly limit an asset generator’s options and will almost certainly make the transaction more expensive.
We’ve all been there. You’ve really got a busy day tomorrow, but your best bud is throwing a party and he says it’s going to be great. You figure you’ll swing by, check it out and follow the two drink rule—no problem. Only thing is, the party is great and one thing just leads to another. Next thing you know, it’s really late, the two drink rule was dismissed as more of a guideline and you already know that tomorrow is going to be a struggle. You’re also pretty sure that decision to go for tacos at two in the morning is something you are going to regret. Not a pretty picture.
Sometimes it feels like the right thing to do, but staying too late at the party almost never works out. Unfortunately, looking across the banking landscape, there are a number of banks that raised excess capital coming out of the financial crisis that have done just that and now have some tough decisions to make. In most cases, both the original plan that was pitched to investors and the intentions of the management team were sound. Taking advantage of the disruption caused by the financial crisis, the blueprint was pretty simple—find a small and/or troubled bank, over- or re-capitalize it, clean it up if necessary, try to make a few acquisitions, take advantage of some low hanging fruit in terms of deposit and loan generation and then sell for a nice multiple. In a number of cases, this plan was executed to perfection while, in other instances, the outcome was less than optimal. However, there are a number of examples out there of management teams that, despite solid to excellent execution of the first few steps of the plan, have failed to deliver on the most important step: the sale.
So what happened? It varies from case to case. In some instances, management teams may have been just cutting it a little too fine by holding off potential buyers until some perceived optimum level of profitability and/or scale was achieved. In other cases, unforeseen developments, such as regulatory, credit or other issues, pushed out the timing of a potential sale. Some were never able to deploy their excess capital, creating a drag on returns. Occasionally, management teams just start to get a little too comfortable with their jobs to make good on their understanding with their investors. Others are some combination of any or all of the above.
As anyone who has modeled these re- or over-capitalization type of investments can attest, the real returns are made on the exit and most investors are looking to exit in a sale. Sure, given the expansion in bank multiples and the general rotation into bank stocks since the Trump election, a lot of investors who backed these type of plays have the opportunity to sell into the open market at attractive valuations. However, given the choice between the two, most large investors would probably rather get their liquidity all at once at a premium to prevailing market prices (i.e., in a sale) rather than dribble shares out into the market or sell in a block trade or secondary offering at potentially a significant discount to the market price.
If you are wondering why these management teams can’t just rectify the situation now, I would offer a number of reasons. First, and perhaps more importantly, there might not be any buyers. As I noted in an earlier post, the pool of potential buyers is not as deep as one might expect. Based on reviewing the “background to the merger” section in a random sampling of merger proxies, it is clear that, even in broadly marketed auction proceedings, it is difficult to get more than one real bid. A corollary to the observation that the buyer pool for any given bank may be pretty shallow is that banks that might have been potential buyers may, once our subject bank starts seriously thinking about selling, no longer be interested. Again, this could be for a variety of reasons--regulatory issues, a move away from M&A as a core strategy or even because the potential buyer itself was bought.
Of course, the actions taken by our subject bank may also impact its ability to find a buyer (or a buyer willing to pay the price sought by our subject bank), though they would probably still be better off pursuing a sale, even if at a lower premium. Perhaps the subject bank has grown into that $10 billionish in assets range and become a “tweener”—a little too big for many of the serial acquirers out there to comfortably take on, but not big enough to move the needle for those large regional banks who may be returning to the M&A arena. Perhaps, more concerningly, our subject bank may have grown to that size with the assumption that a takeout was on the horizon—theoretically eliminating the need to make (as well as to take the hit to earnings from) necessary investments in infrastructure—and are now facing a meaningful expense ramp to catch up (particularly if they can’t find a suitable target in order to jump over the $10 billion in assets threshold). Or, in order to show rapid earnings growth, they may have relied upon earnings streams that are either unreliable (such as small acquisitions where current capital is traded for later earnings when purchased loans are aggressively marked down to generate higher yields in future periods) or would garner a lower multiple in a sum of the parts analysis (such as mortgage warehouse). Maybe, while the party was rocking, our subject bank failed to adequately develop a true core deposit franchise and now, in a rising rate environment, is potentially looking at higher than peer deposit betas.
So what are our subject bank’s options now? Obviously, they can remain independent and take their medicine, as applicable, in terms of higher expenses and/or earnings and funding challenges, but such a course of action would probably result in lower multiples and a bit of a slog for management, particularly as most of the anticipated industry wide catalysts for expected earnings growth (e.g., tax cuts and rising rates) have either happened and/or are pretty well baked into stock prices.. Alternatively, they could try to find a “merger of equals” partner and effectively sell for no premium. Or they could abandon any remaining pretense of coyness and market themselves widely in hopes that a bid representing some reasonable premium appears.
It’s never good to stay too late at the party.
As any good cowboy can tell you, it doesn’t matter if you get bucked off, the name of the game is getting back on the horse that threw you. This is exactly the opportunity currently presented to Roaring Blue Lion in its squabble with Homestreet (Nasdaq:HMST). While I have been pretty critical of Roaring Blue Lion’s attempts at a proxy contest at Homestreet, I think there is a chance for Roaring Blue Lion to salvage its broader campaign. With respect to the proxy contest, I just don’t think Homstreet’s issues will be solved by adding two new directors. Unlike Roaring Blue Lion, I think the best answer for Homestreet is not to work harder at transforming from a mortgage dominated institution to one more focused on commercial lending, but something much simpler and easy to execute: sell.
Nevertheless, I like seeing a little drama in the banking world, so I was disappointed (though not terribly surprised) to see that Roaring Blue Lion’s recent appeal to the courts was stymied. For anyone interested, Roaring Blue Lion’s putative director nominees had, with respect to their director nomination forms, among other things, violated one of the cardinal rules of all unprepared test takers: don’t leave anything blank. Without getting further into the details, it appears that Roaring Blue Lion’s proxy fight is stillborn.
Despite this not-unexpected setback, Roaring Blue Lion still has an opportunity to make its case to HomeStreet stockholders--one that I like a little better than a proxy contest--a withhold the vote campaign. At its essence, Roaring Blue Lion’s complaint with HomeStreet seems to be that they just don’t think that management has been doing a good job running the company. I personally don’t really see how electing two directors, who may or may not have the type of experience one would think is necessary to address the business issues at Homestreet, actually creates any value or augurs any likelihood of meaningful change—it seems more an indictment of the record of HomeStreet’s board and management in operating the business and an expression of no confidence in their ability to do so in the future. If that is the case, a withhold the vote campaign, if thoughtfully run, would have essentially the same impact as a proxy contest, but without all those confusing rules and forms.
As a tactical matter, Roaring Blue Lion should combine a withhold the vote campaign with a campaign urging Homestreet to adopt a director resignation policy. Director resignation policies have been widely adopted and are a cornerstone of good corporate governance for many stockholder advocacy groups, so this measure—to the extent not already included in Homestreet’s charter or by-laws—should receive widespread support.
There is a lot going on in this post, so please bear with me. First, I think that it is time for Banc of California (NYSE:BANC) to sell itself, not because of the recent disclosure of losses related to a fraudulent loan, but because of the bigger issue of whether they can execute on their planned transformation. Second, I think that someone should make a public, unsolicited bid for Banc of California.
Banc of California has been a pretty controversial name for a while: among other things, it has experienced disagreements with activist investors, eyebrow raising stadium naming deals, scurrilous blog posts, an SEC probe and CEO resignation, more agitation by activist investors and even “palace intrigue.” The end result of all this is a new CEO, a revamped board and enhanced corporate governance policies and a comprehensive new business strategy—all great stuff that makes a lot of sense in theory, if not totally in practice. One of the big knocks on Banc of California under Steve Sugarman’s leadership was that he ran it kind of like a hedge fund—he bought and sold loan pools, etc. and had a big and pretty opaque securities book—and the current strategy, designed to continue the transformation to a commercial bank that had actually begun under Sugarman, seems intended (to some degree) to be a direct repudiation of the perceived risk taking of prior leadership. Instead, the plan going forward seems to be to transform Banc of California into a regular way, nuts and bolts commercial bank focused on business loans and funded by core deposits. I get it—I generally like those models, though I don’t understand why, given Doug Bowers’ previous leadership at Square 1, they are not trying to build out a technology bank, which are great sources of cheap deposits—I just think it is really hard to do.
Even when a major change in a bank’s strategy is well thought out, which Banc of California’s seems to be, there are obvious challenges. Execution risk is always an issue. Fraud can, and does, occur at any bank, and I don’t think the loss they just disclosed on a fraudulent loan necessarily reflects systemic weakness in its underwriting processes, but it is also pretty easy to come to the conclusion that mistakes can be made in attempting to rapidly grow commercial loans (if that is what it was—I don’t think the nature of the fraudulent credit has been disclosed).
Aside from execution risk, I think the biggest challenge in with a major revamp to a bank’s strategy is the near term replacement of earnings. When a bank exits a business line (in this case by exiting lease finance and selling associated assets, selling loan pools, exiting mortgage and selling related assets and remixing the securities portfolio), they give up the earnings associated with those businesses. They may get cash in return for whatever is sold and may be justifiably confident in the future earnings stream from whatever businesses they are going to enter or emphasize as part of the strategy shift, but they are still likely to have to deal with an earnings shortfall in the near term. Compounding the earnings shortfall is added expense of adding new bankers, etc. to implement the new strategy.
I would also distinguish between the type of major strategy shift that is gradual in nature and may have some type of short term earnings bridge built into the plan and the type that is being executed by Banc of California. As I said, I understand what Banc of California is trying to accomplish, but I am generally skeptical when a bank tries to dramatically and suddenly shift its strategy in reaction to some failure (in this case, broadly speaking, the perceived failure of Steve Sugarman’s leadership and vision) of the previous business model. In the latter case, I think it is best to just stabilize the bank as best as the board can, look for a buyer who can take out costs and take advantage of whatever desirable attributes (deposits, markets, whatever) that remain, and try to avoid being anchored by any pre-business model failure stock price. I don’t think this is unique to Banc of California. There are a number of banks in similar situations—MidSouth (NYSE:MSL) comes immediately to mind—who should look for a partner rather than taking on the challenge of replacing potential earnings lost to due to a change in strategy on their own. One additional advantage to dealing with these issues through a sale is that an acquirer may be more likely to take one large restructuring charge at the time of a transaction and eat all the costs of the transformation at once and in a way that might get more of a pass from analysts and investors.
Nonetheless, Banc of California seems to be moving aggressively to execute on their shift in business model. Just by taking a look at their investor deck outlining their strategy change and steps taken to date, you can see that they have made a lot of new hires and have a lot of new initiatives underway. While it is great that the new management team and revamped board are not letting the moss grow beneath their feet, these actions likely diminish the prospect of a near term sale.
Unlike a lot of bank boards, I doubt that the board at Banc of California has any commitment to independence for its own sake. Given its makeup--a private equity guy focused on banks, an activist investor focused on banks, a former bank CEO who successfully sold a bank, etc—I would assume that the board of Banc of California is particularly focused on maximizing stockholder value. However, given the expense and effort involved in selecting and hiring a new CEO, overhauling the rest of the management team, hiring new lenders and everything else associated with the change in strategy, I would assume that they are committed to the path they are currently on, unless something better comes along.
Before getting into why I think someone should make a public, unsolicited bid for Banc of California, it might make sense to consider why such things, which are not uncommon at all in the rest of the business world, are so rare in the banking industry. There are some possible reasons—the general opacity of bank assets, concerns about retaining management, regulatory issues, etc.—but I think, at the end of the day, it is because banking is a very clubby industry and almost no CEO that I know of wants to be on bad terms with the guy down the street, even if they are fierce competitors. A corollary of this is that acquisitive CEOs don’t want to prejudice themselves in the event that a bank later decides to sell itself. My sense is that most acquisitive CEOs just tend to let it be known, directly or indirectly, that they would be interested to the extent the target bank ever considers selling and do not force the issue. There are few examples of unsolicited overtures having a happy ending for the instigator and at least one where the ending was clearly not what the instigator intended.
As a total aside, I would not be surprised if, in this rising rate environment, there appeared a few unsolicited bids for banks with low deposit costs and liquid balance sheets, particularly where management has tried, but failed, to get their banks “loaned up” enough to make decent returns. I could pretty easily see some of the banks in California’s Central Valley become prey for faster growing asset generators with high multiples, whether from the California coast or elsewhere, who can better deploy excess liquidity.
Turning back to Banc of California, I think that a public, unsolicited bid could count as something better coming along and prompt serious consideration by its board. To be sure, a “low ball” bid would not be successful, but, at the same time, were an in-market player that could offer significant cost saves and effectively de-risk Banc of California’s strategy change make a bid with a modest premium, I don’t think that such a bid could be rejected out of hand.
As for why a public bid, rather than the discreet approach more widely favored in the banking industry, I think the answer is simple—a public bid is hard to ignore. I don’t think that the Banc of California board would take the ostrich like approach that some other boards might if confronted with a privately made unsolicited bid and reject it out of hand or after comparing it to expected future performance without taking into account the risks associated with attaining that future performance, but all the same, making the bid public would probably result in a more rigorous decision making process.
In addition, I think some of the circumstances that might otherwise give a potential bidder pause are not relevant here. First, as noted, I think the Banc of California board falls squarely in the “maximize stockholder value” camp (as opposed to the “independence for non-economic reasons” camp) and is comprised of sophisticated individuals who understand that unsolicited bids are part of business. They might not be overjoyed to be on the receiving end of a public, unsolicited bid but I have no doubt that they (i) would take advantage of such a bid to extract maximum value for Banc of California stockholders and (ii) not take it personally and attempt to find another suitor primarily to spite the original bidder or, to the extent the bid does not result in a transaction, exclude the original bidder from any potential sale process down the road.
In terms of some of the other factors that might give a potential bidder pause, asset quality should not be an issue as I would have expected a new CEO to diligence credit pretty thoroughly before taking the job, though the recent fraud certainly gives rise to questions about risk controls, etc. Also, with regard to management, while the new CEO has probably done a pretty good job with the hand he was dealt, I would not expect him to be such a critical part of the business (just because of his short tenure, not any shortfalls in his ability) that losing him or his senior team would materially jeopardize the value of the business to an acquirer.
Whether a bid emerges or not, who knows, but given the need for constant earnings growth, the unsolicited bid should become part of the playbook for acquisitive banks going forward.
 I don’t know if it was the intent, but it wouldn’t be out of the question to argue that the former CEO Steve Sugarman had already begun the transformation Banc of California is now attempt to execute, but in a slower and more deliberate fashion and using the assets that the bank has since jettisoned as an earnings bridge.
 Based on a recent summary on the M&A market prepared by one of the top investment banking boutiques, there were 134 hostile M&A deals globally in 2017, representing $523bln in aggregate deal volume.
I’ve got a guilty secret: I kind of like it when Aurelius Value issues one of their “research reports” on a bank. I’ll give you two reasons why I like it and then explain why I feel guilty.
For anyone unfamiliar with Aurelius Value, they are, as far as I can tell, an anonymous short seller that periodically issues “research reports” (also known as “blog posts”) regarding banks and other companies whose stock they have shorted. The reports are pretty sensational—I have only looked at the ones involving banks, but I am going to guess that other companies are treated similarly—and generally have the effect of driving down the subject company’s stock price. Once the stock price tanks, presumably, Aurelius Value covers its short positions and, I would guess, makes a quick and substantial profit.
My first reason for (kind of) liking it when Aurelius Value issues a research report is commercial: It is pretty clear from looking at what happened to the stock prices of both Banc of California (NYSE:BANC) and Eagle Bancorp (NASDAQ:EGBN) following Aurelius Value’s first posts on each that their “research” has the desired effect. Obviously, for anyone who has somewhat of a value or contrarian bent, big drops in a stock price can create opportunities.
My second reason, however, is aesthetic: I appreciate the artistry of Aurelius Value’s work. Having given considerable study to two of Aurelius Value’s masterworks (its initial posts on Banc of California and Eagle), I consider Aurelius Value to be the Georges Seurat of short sellers. From up close, each of these posts just seems to be a bunch of relatively random allegations that, even if taken as true, don’t necessarily demonstrate that the bank will, or is reasonably likely to, suffer any losses related to the allegations made in the post. Even after repeated readings, I still can’t quite figure out what bad things were supposed to be going on at Banc of California—I mean “control” by “notorious criminals” sure sounds pretty awful, but I couldn’t actually find any specific accusations of bank fraud or other criminal behavior. Similarly, there don’t seem to be any specific allegations that the loans referenced in the Eagle post will go bad or cause any losses or other actual economic damage to the bank. However, when viewed at a distance, a distinctly negative picture appears from each post, presumably designed to destroy confidence in the subject bank.
More so than any other type of company, banks depend on confidence—they are highly leveraged, their assets are opaque at best to outsiders and the memories of the financial crisis (the massive recapitalization of the sector as a whole since then notwithstanding) are still vivid—and, when investors see a picture that causes them to loose confidence in a bank, they head for the exits post haste. The beauty of this method is that Aurelius Value doesn’t have to present any detailed accusations (which could later be proved false) of specific wrong doing that is or could reasonably be expected to cause material harm to a bank’s results, condition or prospects. Rather, they can just make a bunch of salacious allegations, intimate that bad things could be happening and then let investors conflate the two in their minds, all to the detriment of the bank’s stock price.
Despite liking the commercial opportunities presented by, and the artistry of, Aurelius Value’s work, I feel guilty because what they are doing is, in my mind, wrong and should be stopped. Whether Aurelius Value’s actions should be the subject of investigation by the SEC or the appropriate criminal authorities is beyond me, but the banks that are subject to these attacks should vigorously defend themselves.
I can guess some reasons why a bank might decline to fight back against Aurelius Value—not wanting to dignify or expend time and resources defending frivolous claims, concern over potential shareholder litigation and a desire to avoid providing grist for the plaintiffs’ lawyers’ mill, etc.—but I think that is the wrong approach. I also think it is the wrong approach to imply that investors should be comfortable with negative assurances—i.e., to the extent that there are no disclosures by the company of any adverse event, fact or circumstance related to Aurelius Value’s posts, then there was nothing to disclose—also known as the “dog that didn’t bark in the night” approach. Rather, banks subject to Aurelius Value’s attacks should proactively respond, preferably seeking counsel from advisors whose reaction is to go on the offensive, rather than retreat behind the walls of non-responsiveness.
 According to the Los Angeles Times, Aurelius Value has admitted that they cannot prove the allegations made in the initial Banc of California post, but “believes [they] are possible.”
 Talk about bad timing—right after I wrote this, Banc of California disclosed a significant loss due to a fraudulent loan. However, as far as I can tell, the loss was unrelated to anything in any of Aurelius Value’s reports.
Recently at an investor conference, the CEO of a bank was walking me and a couple other investors through their investor deck. We got to a page that showed deposit share in their market and how that had been changed by M&A over time (its a pretty standard type of page that you see fairly frequently). They operate in an attractive market where there has been a lot of consolidation. The page showed what I (and, I am going to guess, the other investors) already knew: out of market banks had bought a lot of the banks in their market and they were one of the few remaining banks that was more or less entirely based in that market and the only one that is publicly traded. The CEO’s commentary on this page was something along the lines of “as you can see, we have a lot of scarcity value.” He didn’t wink when he said it, but he might as well have.
I don’t think that I am telling any secrets when I say that, for many people, a significant component of investing in small cap banks is a play on consolidation. More than anything else, consolidation of the still very fragmented US banking landscape has been the industry’s defining trend for close to forty years. Obviously, for the biggest banks, consolidation has effectively reached its end state, but there are still more than 5500 FDIC insured banks in the United States, most of which are pretty small. In the Russell 2000 Index, which is basically the public small cap market, there are over 250 banks. In other words, despite the tremendous amount of consolidation that has already occurred in the US banking industry, this is a trend that still has a lot of room to run.
I think it is fair to say that anyone who has spent any time looking at or investing in small cap banks is well aware of this dynamic. I also think that it is fair to say that, for a lot of people, part of the decision of whether to buy the stock of a particular small cap bank is whether or not the investor thinks there is a reasonable chance that the bank will be acquired within a reasonable timeframe. Based on that, my view is that there is some amount of takeover premium that is already baked into the price of most small cap banks. Put another way, I think that investors’ collective expectations that a particular small cap bank will sell is generally reflected (to a greater or lesser degree) in that bank’s stock price, which can explain why some banks trade at higher multiples than their historical or expected results might suggest.
Now when this bank CEO told me that his bank had “scarcity value,” what I understood (taken together with the investor deck slide) him to mean was that they were the only publicly traded bank left in an attractive market that could be bought as a pure play on that market. I don’t think that interpretation is much of a stretch. Basically, my view was that this guy was saying “buy stock in my bank because we will have the opportunity to sell the bank at a big premium.”
I have three problems with this.
First, I think it is kind of a bush league move. Generally people at bank investor conferences have a pretty decent understanding of industry dynamics. They also generally have access to the service that used to be known as SNL and have a pretty decent understanding of what banks in what markets might have “scarcity value.” Obviously, it would be tremendously useful to investors to know whether or not a particular bank is considering selling in the near term (and a lot of time at investor conferences is spent dancing around that issue, with investors never actually asking the question and management teams studiously avoiding answering the unasked question), but it is not particularly useful for a management team to hint that, were they to sell, their bank might command a premium. Which leads me to my second problem.
My view is that, when a bank management team spends a lot of time talking about their bank’s “scarcity value,” it is done to intentionally increase investors’ collective expectation that the bank will sell in the near to medium term. I also think that bank management teams understand that those expectations are reflected in their stock price and by increasing those expectations, any takeover premium baked into their stock price will be increased as well. My problem is that, to the extent the takeover premium that is baked into a bank’s stock price is increased, it most likely decreases the actual premium that an acquirer might pay, which is why it is not particularly uncommon for banks that have been the subject of widespread takeover speculation to be bought at a nominal premium (or even a discount) to their stock price the day before the acquisition is announced. Put another way, investor expectations that a bank will sell (which can be fueled by management teams talking about scarcity value), can lead to stock prices and valuation multiples that are not only in excess of what a buyer might play but may also unsupported by the bank’s fundamentals or prospects.
That is why, in my experience, the bank CEOs who are actually likely to sell in the nearish term tend to keep it pretty close to the vest. I think this type of CEO (who may have already sold a bank or two and are usually pretty canny) avoids or downplays discussion of “scarcity value” or other signifiers that a sale is likely for two reasons. First, they want to minimize any implied takeover premium in their stock because they are still getting stock as part of their compensation and would, naturally, rather have that takeover premium baked into their stock price at the time they sell their stock (i.e., when they sell the bank), not when they buy it (i.e., when they receive stock or stock option grants). Second, these CEOs want to avoid the issue of “outkicking their coverage”—they don’t want any implied takeover premiums to inflate their stock price and valuation multiples beyond what a buyer might reasonably pay, thereby jeopardizing any possible sale.
This leads me to my third problem: the existence of “scarcity value” is only relevant to me if (i) I think a bank is actually going to sell and (ii) there is a buyer for it. Dealing with the issue of buyers first (which I will probably elaborate on further in a future post), there is not an obvious buyer for every bank. Even when one or more obvious buyers exist, it may be the case that, when the target bank is ready to sell, one or more (or all) of those obvious buyers will not actually be able to buy the target bank for any number of reasons (regulatory time out, their priorities have changed, they themselves have been bought, etc.).
More importantly, I think that “scarcity value” only really means something if the management team is thinking of (or is open to thinking of) selling the bank. To the extent that management is not thinking of (or is open to thinking of) selling the bank (particularly if they are committed to remaining independent), I think it is pretty bush league for a management team to, intentionally or not (and I think in most cases it is pretty intentional), talk about “scarcity value” and try to inflate their stock price with an implied takeover premium. Unfortunately, despite the fact the he highlighted his bank’s “scarcity value,” nothing else would suggest that this particular bank CEO is likely to sell (or even entertain a discussion on the topic), so whether or not this particular bank has any scarcity value would seem to be an entirely theoretical question.