In the face of economic uncertainty, normalizing bank industry credit quality and a lack of M&A activity, a merger of equals was the most attractive opportunity for Orrstown Financial Services Inc. and Codorus Valley Bancorp Inc.
The two Pennsylvania-based banks are coming together in a merger of equals (MOE) that should generate a 1.5% return on average assets and 20% return on average tangible common equity with a 49% efficiency ratio by 2025, according to an investor presentation on the deal. It is also expected to bolster earnings per share by 46% in 2025.
The combination comes after Codorus Valley faced investor activism and credit quality struggles in recent years.
"We had an opportunity to evaluate many of the questions or concerns that other bankers might have," Orrstown President and CEO Tom Quinn Jr. said in an interview. "The numbers were far more compelling than any other opportunity."
The Street was also sold on the combination, with Codorus Valley's stock price rising 16.6% the day after the announcement and Orrstown's increasing 8.1%. Those gains continued during the week of the announcement, with Codorus Valley's stock price closing the week up 24.4% from its stock price before the announcement and Orrstown's rising 18.8%.
"I think the market actually really liked it, contrary to what we've seen in other MOEs," Kauffman said.
The positive reaction came despite a tangible book value dilution of about 21% with a 2.6-year earnback period, compared to dilution of just 0.7% with an earnback period of 0.3 year, excluding accumulated other comprehensive income and rate marks.
"Given positive initial stock reaction, we feel that investors are more understanding of the math [with] these types of transactions," Piper Sandler analyst Casey Whitman wrote in a note on the deal. "We think this deal makes sense for both sides with a combined company that has greater scale and a better profitability profile from cost saves, with optionality going forward."
Orrstown and Codorus Valley are not the only community banks that see the long-term value of pairing up in an MOE-type transaction. Six such deals have been announced so far in the year, the most since 2020.
Managing risk
Still, the deal comes with potential risks.
Codorus Valley has faced credit quality struggles, with nonperforming assets (NPAs) as a percentage of assets and net charge-offs (NCOs) as a percentage of average loans "more volatile for [Codorus Valley] than peers" over the last five years, Stephens analyst Matt Breese wrote in a note.
Piper Sandler's Whitman also pointed to credit as a potential integration risk for the deal as credit quality normalizes.
"We recognize that with any MOE there can be significant integration risk, and trading into and through the close can be choppy (especially when paired with potential credit normalization)," Whitman wrote.
The company's recent dealings with activist investor Driver Management Co. LLC, which urged the bank to sell and launched a proxy battle with director nominations before striking a cooperation agreement,
But Codorus Valley and Orrstown do not see credit quality as a risk, particularly because the former tackled many of its legacy credit problems in recent years, Codorus Valley's Kauffman said.
Codorus Valley's NPAs made up 0.36% of its assets at Sept. 30, compared to 1.84% in the second quarter of 2021 — the ratio's highest point since the beginning of 2020. Its NCOs to average loans also improved to negative 0.15% in the third quarter from 2.04% in the first quarter of 2020.
Moreover, the banks conducted a detailed due diligence process that determined they both have "pretty robust" credit management and monitoring practices, Kauffman said.
Additionally, the prior activist campaign had "nothing" to do with Codorus Valley's decision to pursue a transaction, Kauffman said. Codorus Valley entered a cooperation agreement with Driver Management in April 2022, but ultimately terminated it in October in light of the activist investor's diminished position in the company. Driver Management did not respond to a request for comment on this story.
"That was an agreeable and amicable departure, so it had really nothing to do with this at all," Kauffman said.
Long-term value
Codorus Valley and Orrstown believe the long-term benefits and value from the combination outweigh the risks identified by analysts.
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One particular aspect of the deal was the companies' combined footprint in attractive markets, executives said. They see the opportunity for revenue growth in markets where the respective banks have yet to make significant investments on their own, such as Baltimore.
"The opportunity to try to double down in some of those markets really is an opportunity to grow the franchise," Codorus Valley's Kauffman said.
The companies are also eager to bring a broader suite of lending products to their clients. Specifically, Codorus Valley specializes in agricultural lending and is a preferred Small Business Administration lender, while Orrstown has a focus on middle-market lending.
"It's a perfect fit," Orrstown's Quinn said. "It really fits like a jigsaw puzzle."
The combined company's larger lending limit will also help to bolster those lending lines, they said. The merged company will have nearly $5.3 billion in assets based on Orrstown's $3.05 billion in assets at the end of the third quarter and $2.19 billion for Codorus Valley, according to S&P Global Market Intelligence data.
The post-merger company will also have a significant wealth management arm, with pro forma combined assets under management of $2.7 billion. The wealth management business will make up 42% of the combined company's pro forma noninterest income, according to the investor presentation.
With their combined scale, the company will be able to better recruit talent.
"The ability to recruit top lending talent has been, in our view, a core competency at Orrstown and we believe the combined franchise operating at ~$5.4B+ should be in position to attract even more talent and compete with larger peers on a more complete basis," Hovde analyst David Bishop wrote in a note on the deal.
"Additional scale in the Wealth Management segment may also imply the ability to attract high quality personnel and clients over time," Bishop wrote.