Great Western Bancorp (GWB) based in South Dakota surprised many investors recently by announcing that it had agreed to sell to First Interstate Bancsystem (FIBK -0.53%) based in Montana, a deal that will create a $32 billion asset institution. The sale was surprising because Great Western had only hired a new CEO at the start of 2020, which usually indicates the bank is not interested in selling in the near term. But with credit issues to work through and a challenging revenue environment for banks, it looks like management and the board think it's the right time to sell.
With First Interstate Bancsystem adding another $13 billion in assets to its operation and becoming one of the largest banks in the region, let's take a look at how Great Western adds to the bank and whether First Interstate is still a buy.
How Great Western adds to First Interstate
First Interstate is traditionally a strong-performing bank stock. Prior to the acquisition announcement, the bank traded at more than 200% to tangible book value (TBV), which is a bank's equity minus goodwill and intangible assets, and represents what a bank would be worth if it were immediately liquidated. That's a strong valuation. Since the acquisition announcement, however, First Interstate's stock is down about 9%.
While the stock is down, I do think the financials look pretty good on the deal, which is an all-stock transaction valued at $2 billion. The deal will immediately boost First Interstate's TBV and then also boost the bank's earnings per share by 20% in 2023, a number that could prove conservative. First Interstate CEO Kevin Riley on a conference call following the acquisition announcement noted that in their modeling, management used a pre-provision net revenue number for Great Western that is 15% below what the Street is forecasting for the bank in 2023.
First Interstate plans to cut 21% of Great Western's expense base, a number that analysts on the conference call seemed to think was conservative. However, Riley pointed out that there is minimal branch overlap in the deal and that Great Western already has a pretty efficient expense base. In fact, with the addition of Great Western and the 21% cost savings, First Interstate will be able to reduce its efficiency ratio, a measure of a bank's expenses expressed as a percentage of revenue (lower is better), down from the high 50s percentile to 53%.
The deal will also give First Interstate a presence in Omaha, Nebraska and Des Moines, Iowa, while beefing up the bank's presence in South Dakota. While revenue synergies are not modeled into the assumptions, First Interstate did list several areas it sees opportunities in, including further credit card penetration across Great Western's customer base, wealth management, treasury solutions, and extending indirect lending across Great Western's footprint. Riley also said that over the long term, he thinks the new Great Western markets will be able to generate the same mid- to high-single-digit organic loan growth that First Interstate is targeting in its own footprint.
Great Western's credit issues
Analysts spent most of the conference call questioning executives on Great Western's credit issues. The bank ran into trouble with its agriculture and hotel loan portfolio exposure once the pandemic hit and has been de-risking its loan portfolio ever since.
At the end of June of this year, Great Western still had $612 million of loans that were classified or on non-accrual status, meaning they were in danger of going into default or already late on payments. Non-accrual loans made up 2.48% of total loans, which is very high, and the bank has been selling off some of its hotel loans at a discount. First Interstate is taking a 3.75% credit mark against Great Western's loan portfolio, which represents a 20% mark on the $1.2 billion of Great Western loans that First Interstate purchased but considers to be of deteriorating quality.
Riley said no one should assume that the combined bank will run down the entire $1.2 billion of impacted loans, and the somewhat good news is that Great Western has been de-risking its loan portfolio for more than a year now and has made some progress. Also, the bank seems to have taken a conservative approach on credit. On Great Western's most recent earnings call, Chief Credit Officer Steve Yose said, "we do not see significant loss in our non-accrual book."
Great Western CEO Mark Borrecco also noted that although non-accrual loans remain elevated, if there was significant improvement and decrease in the non-accrual book, it would likely mean losses were accelerating. Management also seemed to feel confident about taking minimal losses on their troubled agricultural loans. But they added that until money is in the bank, they planned to be very conservative about how they reserve for their hotel and hospitality loan book over the next six months.
Is First Interstate a Buy?
While the deal caught many off guard, the financials behind First Interstate's acquisition of Great Western are certainly compelling. I think there is a very strong likelihood this acquisition works out long term. However, I would likely advise waiting another quarter or two to see how the problem loans at Great Western pan out. Some bank executives have recently reported a softening on consumer spend in the hotel, lodging, and airline sectors in Q3 due to the delta variant.
Management at First Interstate and Great Western do appear to be thinking the right way about the problem loans in Great Western's loan book, but the problem loans still need to be worked through and the world remains full of uncertainty right now.