Listen: Street Talk | Episode 135: Takeaway from AOBA: Heavy dose of optimism as the deal window is open

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Nathan Stovall

I'm Nathan Stovall, -- and on this episode, we're talking about the annual Acquire or Be acquire Conference that took place earlier this week in Phoenix. The conference attracts more than 1,700 bankers, advisers, investors and vendors and featured many presentations from the advisory community and one session from Y truly about the fundamental environment. But more specifically, most of the discussions were around the outlook for bank M&A and capital raising activity. The conference also generates hundreds of conversations and predictions from those in attendance. And ultimately, I came away feeling optimistic about 2025. But the question is whether that optimism will translate into actual action. Coming back on my show to talk about that question and share their takeaways from the event is Jeff Davis, Managing Director at Mercer Capital. Jeff, thanks for being on the show.

Jeff Davis

Thanks for the invite, Nathan.

Nathan Stovall

So Jeff, I imagine this was not your first AOBA. I know you were at least there last year. At a high level, what were your big takeaways from the event? Did you share my view that it felt quite a bit more optimistic than we felt in some time?

Jeff Davis

I did. And let me also note that for those who haven't been, Bank Director does a fabulous job with this conference. We're down to, what, 4,500 banks and outwardly, the -- most of the content is about M&A, but it covers a lot of other aspects of banks from fintech, the stock performance and data analytics and the like. But as -- so 1,700 was this year's attendance, plus or minus. And my first one was probably 2014, thereabouts, so maybe 10 in a row and my colleagues, Andy and Jay have probably gone back to 2009 or 2010. It seems as though it gets bigger each year, even though the number of banking institutions has contracted. So to your question, Nathan, yes, there was a lot of optimism, maybe even a ton of optimism. There are many sessions that for -- if you haven't been, there are many more sessions than you could ever possibly sit in on. I did sit in on one session by some bank corporate securities attorneys -- and they were much more measured in terms of implications for a pickup in M&A. But aside from that and maybe some other comments, it was -- it's probably the most optimistic I can remember in terms of attending this conference on the outlook for M&A going back to 2017 and 2018. Of course, as we look back, those were close to the peak in the last cycle, at least as it relates to pricing, but I don't think that's where we are today.

Nathan Stovall

That's an interesting marker, though, and leads into a follow-up there, which is we've been waiting for this pickup for some time. The headwinds have been well known, whether that's punitive interest rate marks on the deals that leave little equity in the targets, valuations under pressure, concerns about credit, et cetera, et cetera. But now we've got lower marks, feeling better on credit and better valuations. Certainly, you're going to get some folks up there putting a good face on the environment. But again, it did feel more optimistic. How confident did the advisory community seem to you? And maybe said even a little bit differently, did it feel like to you, the way that they were talking about it, and I did hear this from a few people that they're really seeing pipelines build already or that they expect that to happen this year?

Jeff Davis

As a group, yes, there -- the adviser community is optimistic and should be. If we think about what impacts deal activity and what supports it and what holds it back is in terms of what supports it where we stand today is stock prices are up. substantial -- for most publicly traded institutions are up anywhere from, let's call it, 5% to 10% to 35%, 40% over the last year. Obviously, earnings did not grow that much. And so multiples have expanded. So buyers have stronger acquisition currencies to work with to the extent we're talking about consideration that consists of the buyers' common shares to be paid to the sellers. Secondly, Nathan, the earnings story for 2025 is materially better than it was a year ago. And let's hold the thought, let's come back and talk about the beginning of 2023. As we look to 2025 is let's use KBW's numbers and Tom showed and he had a slide in terms of -- based upon the KBW analyst estimates is about 6% EPS growth projected for 2025 and 12% for 2026.

Now I would put a lot more money on 2025 than I would on 2026 as things like SIVB can cause the industry to go awry in earnings with it. But in any event, earnings growth is the mother's milk for share performance. And we have a situation where that translates not only for the buyers with the improved stock prices or acquisition currencies, but for the sellers or would be sellers, the earnings outlook for the coming year for most, not all, but for most is getting better. Some will be -- it may be dramatically better perhaps because of substantial restructuring of the bond portfolio last year. For many, it's a story of incremental change, but the incrementals are going in the favorable direction to the extent the cost of funds is going to ease, and we certainly saw that in the fourth quarter, and we'll see it in the first quarter, and I think it will diminish from there. Cost of funds eases. At the same time, floating rate loans have already repriced, may not have been fully reflected in fourth quarter earnings, but that is playing through or will quickly play through the balance sheet, while at the same time, fixed rate loans made at very low coupons in 2020, 2021 and even 2022, same for bonds that were purchased at low coupons will roll off and new loans are being made at higher yields, bonds are being purchased at higher yields, not quite as high as it could have been purchased maybe last spring. But in any event, the NIMs will be better. So it's a much better setup on fundamentals, plus credit is I don't know if it's surprising or not.

This is a -- it continues to be a very good credit cycle, though NPAs and classifieds continue to sort of grind higher, maybe towards normal. We don't know if they'll go through that in the coming year. But fundamentals are -- the backdrop is positive. The regulatory change is going to be positive, whether it's going to be dramatic, I think it's going to be -- it's probably going to be a little bit more blurry versus someone speaking into a mic versus actual policy changes. And the one fly in the ointment out there, Nathan, is the one that has existed for the last 2 years, and that is the fair value marks. They are generally not as punitive as they were a year ago and at least as it relates to fixed rate assets and having to mark-to-market on the rate aspect of marking the balance sheet to market. But as we saw in the fall, an increase in rates works against fair value marks. So all else equal, the marks are a tad more challenging today than they were, say, in September when the Fed did its first rate hike, but assets that were originated a couple of years ago, each quarter we go, we're 1 quarter closer to maturities. It's a very good setup. And we'll see how it plays out, but it's the best setup we've had since probably 2017 or 2018.

Nathan Stovall

Well, one of the last things you mentioned is one of the reasons why we've seen capital required and a lot of deals with the few deals that have come through, those marks are still punitive. So call the -- they leave them targets capital light or even capital thin in some cases. There has been capital there. But one of the things I felt like I heard many presenters say, the capital is there. Capital was available and that would seem to make sense. Valuations better, fundamental environment, much better, and you laid that out pretty well. Do you get the sense that the capital markets are officially open? And maybe even a second follow-up in there is -- if they are, is it still expensive?

Jeff Davis

The capital markets are open. And to your point, the question is what does it cost and cost being a function of how much of a discount to market and how much ownership dilution existing shareholders will take. All else equal, the more compelling a capital raise is for a strategic combination, all else equal, the discount or I don't want to call it a penalty, but the discount to market is going to be less, all else equal. And Nathan, that's going to be a function of the institutional investors who are brought over the wall to look at funding a capital raise. But I think also what's driving the capital raise, Nathan, is the regulatory overlay is an expectation that minimum capital levels that are not low are going to be part of the pro forma organization day 1, not a year down the road or 2 years down the road when the company retains capital through earnings and builds capital through our fair value marks of marking a bond from -- or a fixed rate loan from par to 85 and then accreting the 15-point discount into earnings over 3 years or something, the regulators, at least in terms of meeting a threshold and let's work with the 10% common equity Tier 1 ratio of having that on day 1. So the common raises have been necessary in some instances to make sure day 1 capital is sufficient. And then also, we've got the issue on reducing CRE to CRE as a percent of capital. It's a case-by-case situation, but if it's compelling and the backdrop on the sector is good like it is today, I assume the discount is not going to be punitive.

Nathan Stovall

Yes. And on the former, so regulators effectively want flat capital day 1 pro forma. If you've got a big CRE book, maybe more. And on the latter, to your point, if there's big earnings accretion, then we're going to be even more supportive of the deal, we're willing to price it higher. Is it kind of that simple from the investment community?

Jeff Davis

All else equal, yes. If there's -- all else equal, if there's a chunk of earnings or capital to be realized over the next year or 2, it doesn't have anything to do with franchise value, but it does, from a flavor perspective, fits in with the genre of margin of safety and margin of safety being institution is going to accrete a lot of capital. So the capital ratios will build, particularly if we're not going to see a lot of loan growth the next year or 2. And then also margin of safety from, if you will, from -- there's some underlying earnings there for a given quarterly earnings release. So if we're in any other industry and focused on cash flow, investors would look past that, but that's not the case with the commercial banks.

Nathan Stovall

No, no. Well, so we talked about lots of reason for optimism. I love how you frame it, best setup we've had in a long time, '16 or '17. I did talk with some folks who weren't quite as enthusiastic and maybe that's not even the right way to frame it. I think that they're kind of more in a wait and see. They feel good about things, but call them, they want the proof to be out there, perhaps given what's happened in the last 5 years and are hesitant maybe to say that there's a huge change out there that the fundamental environment is dramatically different. You mentioned one of the sessions you had seemed a little bit less optimistic. Do you think some of the headwinds that we talked about are out there are still in place? Do you think it's reasonable to have a little bit of hesitation at least in the near term to say that we'll see a big change?

Jeff Davis

Sure. But look, if -- let's say, let's have 2 outcomes if we've got a binomial outcome. Let's say, one is the market decides inflation is -- not only is it not sort of sticky at 3%, it's headed back to 4, and that sends the 5-year and the 10-year to the mid-5s or even the high 5s. We're dealing with our fair value mark issue in spades immediately. That's going to be a wet blanket on deal activity. And if that happens, then also the stock prices are going to probably go down, all else equal. And so multiples come in and then it's harder to negotiate a deal vis-a-vis seller expectations and the like. So -- but look, we could get the reverse, Nathan. Let's say, I don't know, the next -- over the next 4, 6 weeks, the 10-year is around 450 and the 5-year is 420 or whatever. Let's say both those come in 40 bps for whatever reason, and stock prices leg up another 10%, 15%. That is going to be a backdrop for a pickup in deal announcement. Does it happen? I don't know. Tomorrow is always uncertain. From an investor standpoint, you can't control that, and you're not really asking from an investor standpoint, but let me just sort of note the obvious. The only thing an investor can control absolutely -- well, there are 2 things. One is price paid -- so it matters not to overpay and then timing of the exit. You can't even -- you don't even know what the exit price is going to be. You can say I'm going to hold something for 2, 3, 4 years. So that's -- the scenario I'll lay out there may be better for investors in terms of forward returns on the stocks will be better, but that's a depression on M&A activity. I have no idea what's going to play out, but we know the backdrop is good today, absent credit becoming a really material issue, which it hasn't yet and absent rates taking another leg up like they did in the fall.

Nathan Stovall

Sure. Well let's assume for a moment that we don't have that. We don't have something that really torpedoes the fundamental environment. You laid out really well where it is and how much more favorable it is. And something that came up in a number of discussions I had is that we have the chance really for a period of almost normalcy. We're talking about it being really positive, but earnings fell the last 2 years. You had '22 and '21 still being very much in COVID and then obviously '29 of it. So you really haven't had a normal period since '19. And now you have that on one side, maybe a period of normalcy for the first time in a while and capital available. And I've kind of been making the case that that leads to optionality that hasn't been available for the group 4, 5, 6 years. Do you agree with that? Do you think that, that is significantly different, that could arm a management team to do a lot of things that they probably couldn't have pursued?

Jeff Davis

Well, it's easier to get it done. The management teams have to be careful to retain investor confidence and the like. But it's -- and it's -- I don't know, maybe it's always like this every decade, but it's -- if you think about what we've gone through the last -- if we go back 20 years, 25 years from 9/11 to the financial crisis to COVID to -- they blew up the money supply by 40% on the back of the shutdown, the inflation is -- I don't know, maybe the anomaly was the '90s, a golden age for investing in banks. But the setup is good. But Nathan, if you and I had this -- if we were doing this in January of '23, we would be concerned about funding and we would be concerned about rate marks, but we wouldn't be concerned about both like we would be in 60 or 80 days on the backside of Silicon Valley and Signature failing and then First Republic failing in early May. So things change, but the backdrop is very good right now. If we went back to 2016 -- well, let's just go back to the election in 2016. Trump was a surprise winner and bank stocks were up 25%, something like that. to pick your index from the day after the election through mid-January, end of January 2017. And the stocks factored in a lot of positive things that were going to happen. One, the Fed at the time was getting off their 0 rate interest rate policy that they had kept in place forever and began to gradually raise rates. But fair value marks were not an issue because the Fed went slow. They hadn't blown up the money supply by 40% back then and the belly of the curve in the long end gradually moved higher. Corporate tax reform was anticipated but not assured. Washington was kicking around lower rates. It seems like they were talking about 23% to 25% when the tax bill actually came through, the number was 21% -- but -- so the market was discounting lower corporate tax rates, putting some probability assessment that, that would happen. Credit was fine, new regulators in who are going to ease up on post '08, Dodd-Frank regs and the like. All those things played out beautifully in 2017. I had a couple of transactions I was working on at that time, and the deals were negotiated in the late summer of 2016, into the early fall. But when they were announced late in the year or early 2017, it was it was -- the pricing was radically different because the buyer stock prices had moved up, but the number of shares had not. In this cycle, the big move really started back in July, continuing through, I don't know, early December. We haven't seen the really big pickup in M&A activity like we saw in 2017, but I think it will occur, the backdrops there. Let me go on to just note as we talk or I'm referencing 2017, 2018, the stocks lead earnings, that is that the stocks aren't going to get it exactly right, but the stocks are anticipating what the earnings trajectory is going to be. So in 2023. They were sequentially lower earnings off 2021, not a disaster, but sequentially lower on tighter margins. And going back to 2017, 2018, the earnings, 2019 was above 2018 generally, but the stocks peaked out by first part of 2018. Not coincidentally, M&A multiples peaked out then. I think our S&P -- or can I say SNL, our S&L industry metrics would show the average tangible book multiple was 1.75, and we've bottomed out the last 2 years at 1.2, 1.25, something like that. So a 5- or 6-year period of contracting margins back to your original question. The setup is for a pickup in M&A activity and the setup is for M&A multiples to expand and catch up, if you will, with the expansion in public market multiples that have occurred the last 6 months.

Nathan Stovall

You wrote about exactly that recently with the idea of will the banks deliver? Will there be follow-through to that expansion? I can't remember if you show me story, but that's kind of what I read after going through and I thought it was a great piece. I've talked to some big CFOs who've expressed a similar thing where they're feeling good, but they're a little bit nervous, can we actually deliver. How do you think about that in terms of a risk or opportunity in the group? I mean, I guess the risk would be that the numbers come up short and that valuations sell off. Is there an opportunity though where this group has not delivered for a couple of years or it's been volatile that if they actually do deliver that maybe they get further multiple expansion? How do you think about it?

Jeff Davis

Can the group get another turn or 2 on earnings, another turn or 2 on the multiple? Sure. Two things have to happen. One is analysts or let's just say, investor earnings expectations, let's go with Tom's numbers, 6% for this year, and I'll take 1/3 of his -- of KBW's 12% for 2026. Let's just go with 8%. Can the group do well and see multiples expand a little bit from here? The answer is yes. But that is also going to assume, Nathan, that the environment remains quiet, that is interest rates are stable. and maybe even favorable to the extent that the Fed pulls down or cut short rates a little bit, 25, 50 basis points and takes a little bit more off funding cost. It also would assume that there are no big credit issues and it absolutely would have assumed that there's nothing like SVB to that post that I wrote about that you're referencing. Going back to 2000, bank stocks, and I know this is ancient history, but -- and it was a little bit different then. But in a sense, the broader market is a similar setup. In the late '90s, dot-com was the AI of the era of that era was sucking capital away from traditional value stocks, retail, industrial, REIT insurance companies, banks, retailers. And then also pulling capital was large cap growth. So something like Coca-Cola, everyone in the emerging market behind the iron curtain in China and elsewhere that had never been able to buy sugar water had access to it. Coke was trading at something crazy like 50x good earnings, not depressed earnings, 50x good earnings at the peak in '99. It was a miserable stock for 10 years or so, 8 years as the multiple contracted. But once the bubble pop on the dot-coms and the large cap growth in March of 2000, and that bubble unwound through sort of a series of contractions. It took the market 18, 20 months to find a bottom. But within the first 3 or 4 months, banks and value stocks more generally had had a great run because capital left the nosebleed valuations and often companies that had no earnings or maybe even very little in revenues. And the capital was redeployed into dividend-paying stocks, which included banks. If tech blows up here, that -- I guess it depends on why it blows up if investors just want out would be probably be favorable for banks and other value stocks if it were to have a material issue because China has made quantum leaps or something happens in the tech ecosystem that might be more nuanced for banks. But we can have a favorable setup also from for these stocks that do not exist in a vacuum as they compete for capital with other sectors. other sectors are incredibly rich, they may become a source of funds for banks.

Nathan Stovall

And we even saw a brief bit of that earlier this week with a bit of a sector rotation out of the AI tech names and the value. So I mean I think that's an interesting strategy to give a leg even beyond the fundamentals. Well, in closing, something else that came up from some folks, but I kind of posed it myself was this idea, you mentioned it several times. We don't know what tomorrow holds. You went back over the last decade and laid it out perfectly in our times of where we have these fits and starts, which is to say there's been windows. And so if we think we've got a window open now and most seem to agree that's where it is, you shouldn't just do something just to do it. But if you're considering it, whether it's a deal or a capital raise, do you have to think about trying to hit that window now? And is it reasonable to say, you know what, this might not be open that long?

Jeff Davis

Well, certainly, if I'm a PNC or someone of that ilk and I've got an or USB, and I know they've made comments that not M&A for now as they digest their last large one. But to the extent I'm a PNC and I have an interest in a Truist or Regions, First Horizon, yes, there is a limited window because the head of -- as the regulatory -- as we have the changes at the OCC, the FDIC, the Feds, that's a more slow-moving body as it relates to regulatory change, just given how the how the appointments work there. But in any event, the Trump administration is going to be much more agreeable to M&A generally, in general and as it relates to banks, if nothing else, of getting deals approved faster and getting them approved. And they're going to be in office for 4 years, and it will take Nathan, what, a year for many of the agency heads to be put in place and another year for policy changes, maybe the policy changes really get underway over the next 6, 9 months. But in any event, you've got it -- the larger you are, the tighter the window is. That's less true for small institutions who want to do M&A, really, it's more about the backdrop is good with access to capital and stock price is up.

Nathan Stovall

Well, I think that's a great place to leave it. wind at our back for a first time in a while. So thank you, Jeff, for sharing your thoughts on the event and just your view of the space in general. I love having you on.

Jeff Davis

Thanks, Nathan.