Bank of Montreal's (NYSE: BMO ) acquisition of troubled regional bank Marshall & Ilsley (NYSE: MI ) is sure to stoke the fire of many investors and especially those who are bullish on the banking sector. I can already see all the headlines touting "cheap" regional banks that are being targeted by some of the larger, more capital-rich banks. I am not one of those bulls, but many of my Foolish peers are. In fact, if you listened to Matt Koppenheffer, you might have held your nose and bought some shares of M&I as he recommended it just a day before it was taken out. While it was quite a timely call, Matt made the additional caveat, "nota bene, for investors that go this route, I strongly suggest that these are made as smaller positions and are grouped with other similarly beaten-down stocks."
I recently read through Ben Graham's legendary value investing book The Intelligent Investor, and it reminded me that sometimes investors have to be advantageous and take chances on undervalued stocks that are being underappreciated by investors. Marshall & Ilsley was certainly underappreciated, but it had earned the dubious distinction through years of bad loans and mismanagement. The company's credit rating was recently downgraded to junk status, and its earnings or losses are still atrocious. In its most recent quarter, Marshall & Ilsley reported a net loss of $169.2 million, which is better than during the same period in 2009 in which the bank lost $248.4 million, but it's hardly anything to get excited about.
Many believe that if the Bank of Montreal is willing to take on such an ugly balance sheet, investors should be allocating money to more financially sound regional banks that may also be takeout targets, but I'm not so sure.
Banking on the future
For many Marshall & Ilsley investors, the implied $7.75 sale price in the all-stock deal will still come at a significant loss. Shares of the bank traded well above this value for a good part of 2010 and in April briefly traded above $10. While the loss for some investors won't feel as bad as it did for those who held shares in Wilmington Trust (NYSE: WL ) before it was taken under by M&T Bank (NYSE: MTB ) , it helps put the "premium" Bank of Montreal paid into perspective.
It's not that these banks won't perhaps one day be accretive to earnings for the acquirers, but the deals seem more like necessary bailouts for stability; whereas I believe the more financially sound regional banks would be unwilling to be acquired at such low valuations.
For example, below is a list of valuations as of Thursday's close before the acquisition for some of the banks that are being mentioned as potential takeout targets now that M&A might be heating up in the sector.
Price / Tangible Book Value
|Marshall & Ilsley||0.52|
|KeyCorp (NYSE: KEY )||0.96|
|Regions Financial (NYSE: RF )||0.98|
|SunTrust (NYSE: STI )||1.07|
|First Horizon National||1.26|
|Fifth Third Bancorp||1.43|
More deals coming?
Even though many investors might believe these valuations are on the cheap in general, Marshall & Ilsley was valued at less than half of nearly every bank on the list. The acquisition price of $7.75 only values the troubled bank at a 0.70 price/tangible book, which is still significantly below its peers.
In addition, Bank of Montreal announced that it will mark down Marshall & Ilsley's portfolio by a whopping $4.7 billion, which accounts for about 12% of its loans outstanding. This will definitely put a scare into banks on the acquisition trail as it speaks to the still unknown quality of many outstanding loans. This surprised many, including some analysts at Oppenheimer who estimated the bank's loan losses would be about half that much. If the economy continues to stay weak over the next year and asset quality doesn't improve, it is possible that this markdown still won't be sufficient enough.
It is definitely a positive that we are starting to see some acquisitions in the banking sector. However, I don't think that necessarily makes the banks that are listed good investments. For one, buying a company because it is an acquisition candidate is a pure guessing game based on hope, and hope is no investment strategy. While some of these banks may have "cleaner" balance sheets than Marshall & Ilsley, many have yet to pay back TARP funds, have some similar troubled assets, yet trade at a much richer valuation than Marshall & Ilsley. So get ready for the bank deal hype. Just don't be too excited to buy it.