The wave of regional bank consolidation continued recently with the announcement that BancorpSouth (BXS -0.69%) and Cadence Bancorporation (CADE) plan to join hands in a merger of equals. The deal will create a $44-billion-asset bank in the South with a presence in Texas, Georgia, Mississippi, and Alabama. Cadence had been rumored to be contemplating a sale, but the merger of equals component creates an interesting dynamic, and the market so far has not exactly taken to the deal. Let's see what the merger means for shareholders and if it will work out long-term.
A wonky deal
Unlike a typical sale, a merger of equals means that Cadence is not just getting bought out, but that it will essentially play a big role in the bank moving forward, which complicates things. For instance, BancorpSouth is technically the buyer in the all-stock deal, and will exchange 0.7 shares for each Cadence share. But then Cadence, which is flush with excess capital, will also pay its shareholders a special dividend of $1.25 per share. In total, the deal is valued at $23.83 per Cadence share, or roughly $3 billion.
Even though BancorpSouth is technically the surviving entity, the combined bank will continue under the Cadence Bank brand, although Cadence plans to rebrand to "honor the history of both brands." Additionally, the board of directors will grow to a whopping 20 people, with 11 board members from BancorpSouth and nine members from Cadence. Ultimately, management expects to reduce the size of the large board eventually.
The deal will create the fifth-largest bank headquartered in the Southeast and bring together two very large commercial lenders, with 35% of BancorpSouth's loan book in commercial real estate and 64% of Cadence's loan portfolio in other commercial loans. The combined bank will have 73% of its loan book in commercial loans. The big commercial base also brings a strong deposit base, with 31% of the combined bank's deposits in no-cost and sticky non-interest-bearing deposits, and roughly 97% in core deposits. The combined bank will also have more than a quarter of its operating revenue from fee-based sources such as insurance and wealth management, investment advisory, and trust businesses.
The market's initial doubt
Initially, the market slammed the deal, sending BancorpSouth shares down some 6% on April 12, the day the deal was announced. Shares have since recovered, but are still down a bit from their previous levels.
I was somewhat surprised to see such an adverse reaction because the deal does present attractive financials. For one, it is accretive to BancorpSouth's tangible book value (equity minus intangible assets and goodwill). That essentially means its tangible equity with Cadence attached will grow right away. A lot of deals dilute tangible book value initially, so investors are usually more receptive to deals that are immediately accretive.
Additionally, the deal is expected to be accretive to both BancorpSouth's and Cadence's earnings per share by 17%, once again meaning that the combined bank's earnings in 2022 will exceed each of the bank's earnings on a stand-alone basis by 17%. Management also expects the deal to result in profitability metrics that put the new bank in the top quartile among its national peer group, while also creating a more efficient expense base.
So what might be the market's concerns? Well, Cadence has had some credit issues in recent years. Nearly 18% of its total loan portfolio is also tied to the restaurant and hotel sectors, both of which ran into trouble during the coronavirus pandemic. Nonperforming loans (those that are in danger of going into default) as a percentage of total loans peaked at 1.64% last year, which was high even last year for a bank. However, Cadence managed to hold net charge-offs (debt unlikely to be collected and a good indicator of actual losses) steady during 2020 and saw improvement later in the year.
So, there certainly may be some anxiety from BancorpSouth investors about jumping into bed with Cadence, given these past issues. But it does seem like management is sensitive to this. As part of the deal, there is a gross credit mark on Cadence's loan portfolio of roughly 3.75% excluding Paycheck Protection Program loans. That, as one analyst thought following the deal described, is "stretching reasonable."
At the end of the fourth quarter of 2020, Cadence had a total allowance for potential loan losses equivalent to roughly 2.89% of its total loan book. That number does not even factor in all the additional stimulus that has been injected into the economy since December and the higher growth projections for the U.S. economy. So the fact that management significantly increased reserves for Cadence's loan book after the economic situation significantly improved should make investors feel a lot better.
The deal has a lot of potential
If you're a BancorpSouth shareholder, one thing to be happy about is that you got into the attractive Texas banking market for a good price that didn't dilute your equity. With the deal valued at $23.83 per share, BancorpSouth is essentially buying Cadence for 151% tangible book value.
That's a great price considering that Cadence is in Texas, and the high bank valuations right now. If Cadence had just sold itself, I imagine it would have been much more expensive. Still, keep a close eye on credit quality. Right now, all of the money from stimulus in the economy is going to keep borrowers healthy. But when interest rates rise, likely in 2023 or 2024, that could reveal some bad loans. However, given what we know right now, management seems to have taken an extremely cautious approach to Cadence's loan book, and it's hard to argue against banks getting bigger right now.