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.