The market has met several noteworthy mergers of equals (MOEs) in the banking industry with skepticism this year, questioning whether the deals will really provide more value long-term than each of the banks could have created on their own. An MOE in banking is when two institutions, usually around the same size in terms of assets, merge with the intention of building a new bank that really takes large parts of each institution and their various business lines. A traditional acquisition is more about one bank buying a smaller bank to take advantage of costs saves and maybe a new revenue opportunity or two.
In April, BancorpSouth and Cadence Bancorporation said they would partner to create a $44 billion asset bank in the South. About a week later, Webster Financial and Sterling Bancorp said they would join hands in another MOE that would create a $63 billion asset bank in the Northeast. Both BancorpSouth and Webster, the technical buyers in the deal, have seen their stock prices slide since announcing the MOEs.
It's certainly fair for investors to question the game-changing deals, because these banks are more or less altering their strategies fairly significantly, so they may see it as a pretty big gamble. But to understand how these MOEs can work, let's look at Truist Financial (NYSE:TFC), the product of one of the largest-ever MOEs, and see if we can glean some insights on these complex deals.
How the Truist deal is going
In February 2019, the $226 billion asset BB&T Bank in North Carolina and the $216 billion asset SunTrust Bank in Atlanta announced they would partner in a MOE that would create the sixth-largest bank in the U.S. Although BB&T was technically the buyer in the deal, the new entity would have a new name: Truist. It was the largest bank deal announced in more than a decade.
How was that intended to play out? Truist was going to have a best-in-class adjusted efficiency ratio (expenses expressed as a percentage of revenue, so lower is better) of 51% and a return on tangible common equity (ROTCE) of 22%. The two banks also said the deal would immediately grow BB&T's tangible book value, or the value of a bank's tangible assets, by 6% upon the closing of the deal at the end of 2019.
And the deal was also supposed to be accretive to BB&T's and SunTrust's earnings per share (EPS) by 13% and 9%, respectively, at the end of 2021, based on estimates. That means that each of their earnings would be that much higher as a combined entity than what they would have been on a stand-alone basis. Part of achieving these metrics would involve eliminating $1.6 billion, or roughly 12.5%, of the company's total combined expenses.
At the end of the first quarter of this year, Truist had grown total assets to more than $517 billion. The bank reported a 16.4% ROTCE and reported an adjusted efficiency ratio of just under 57%. At the end of last year, the company had cut $640 million in expenses, and plans to reach $1.04 billion by the end of this year. It then plans to reach the total $1.6 billion in expense cuts by the end of 2022, which is on schedule. Given where Truist's efficiency ratio and ROTCE are trending, it does seem like the bank could be at or near its planned targets once the cost savings are achieved.
However, the promised EPS accretion for each bank does not look like it will materialize this year. Back in 2019, management based the 13% and 9% accretion numbers on Truist generating $5.59 EPS this year. Analysts on average are currently projecting Truist to generate EPS of $4.62, with a high estimate of $5. The estimates could certainly be off, and I'm sure neither management team had the pandemic in mind when they made these projections in 2019.
At the end of the first quarter, tangible book value per share at Truist had fallen slightly from where it was when the deal closed in 2019 after the immediate 6% growth. One could probably argue that both banks on their own could have grown tangible book value per share by more than 6% since 2019, but with 22% ROTCE expected in the future, the bank is positioning for faster tangible book growth long term.
Investing in technology
If you haven't heard it already, one of the top reasons cited for bank mergers and acquisitions is to free up more capital in order to further invest and build out digital capabilities. Some of the larger banks in the country, like JPMorgan Chase, now regularly spend in excess of $10 billion or $11 billion a year on technology.
From the start, Truist pledged to invest in technology as part of its $1.5 billion one-time merger costs. The bank also plans to open an innovation and technology center in Charlotte, North Carolina, to drive digital transformation. Initially, the bank said it had specifically set aside about $100 million just for new technology investment outside of cybersecurity, mobile capabilities, and automation.
But those costs have significantly ramped up. Following the fourth quarter of 2020, management at Truist said merger-related costs would increase from $1.5 billion to $2.1 billion, and the bank would spend an additional $1.8 billion on incremental operating expenses that included investments in digital capabilities and the bank's tech platforms. These are all one-time costs that will not be in the bank's run rate following 2022.
While it's hard to know all of the tech capabilities the bank is investing in, management said on an earnings call in January that the bank is building new loan origination platforms that will create better client experiences and lead to more loan applications. Seeing expenses increase like this can spook investors, but Truist CEO Daryl Bible said, "We believe it was for the right reasons and makes all the sense that it's going to help our clients and really produce good performance for our company going forward."
The market seems pleased -- now
Although not yet done with all of the merger work, Truist appears to be on a good path to hitting its future profitability and efficiency goals. It is building a strong bank in growing markets with lots of revenue diversity, and the market appears to be pleased. Prior to the merger, BB&T traded around 230% of tangible book value, while SunTrust traded at 165% of tangible book value. At recent prices, Truist traded around 262% tangible book value.
While the deal that created Truist is much larger than the BancorpSouth-Cadence and Webster-Sterling deals, it does give us a road map for the trajectory of MOEs. They are chaotic and messy at times, and not every projection will be hit, but they can ultimately create a stronger-performing bank better positioned to compete once finished. While MOEs are perhaps a bigger risk than making a standard smaller acquisition, I think given what we know about the banking industry and the need to scale and invest in digital capabilities, the deals should be looked at optimistically.