On Oct. 12, Columbia Banking System (NASDAQ:COLB) and Umpqua Holdings (NASDAQ:UMPQ) announced that the two smaller regional banks were joining hands to form a $50-billion-asset bank in California, Idaho, Nevada, Oregon, and Washington. Investors panned the deal, sending shares of Columbia, the buyer in the deal, down more than 14% on the day of the announcement. Shares of Umpqua, which received a nearly 13% premium from its price the day before the announcement, also fell nearly 5% with its shares tied to Columbia.
Let's take a look at why investors were so shaken by the deal.
It's a very odd deal structure
Initially, the deal looks like a merger of equals (MOE), where two banks try to gain scale and spread a larger revenue pool over a smaller expense space, while gaining the ability to further invest in their technology. Like other announced bank MOEs over the past year, the two banks will split up the branding; Columbia Banking Systems will become the holding company, but Umpqua will maintain the brand of the subsidiary bank. Clint Stein, the CEO of Columbia, will become CEO of the combined entity, and the board of directors will be split, with seven members from each bank.
However, the Columbia-Umpqua merger may not actually be a MOE because Columbia paid a premium for Umpqua. Columbia previously traded at 184% tangible book value, or TBV (what a bank would be worth if it were liquidated). It purchased Umpqua in an all-stock deal for $5.1 billion, valuing Umpqua at 189% TBV. In other bank MOEs, there is usually not a premium given to the technical seller because it's in both parties' interest to make the deal more financially compelling, as most stakeholders from each bank are continuing on with the new institution, rather than one side being bought out. Additionally, Columbia has only $18 billion in assets and Umpqua has roughly $30 billion in assets, so Umpqua shareholders will hold 68% of outstanding shares when the deal closes.
The financial structure of the deal also presents some downside, especially for Columbia shareholders. The $5.1 billion purchase price will dilute Columbia's TBV per share by nearly 6% (TBV typically influences a bank's share price). Management expects the bank to earn back that dilution in roughly 2.6 years, which these days is considered too long of a time period by many investors.
Another potential issue is increased regulatory scrutiny of large bank deals. Recently, First Citizens BancShares, a regional bank based in North Carolina, and CIT Group, based in St. Louis, announced that they were extending their merger agreement by five months because the Federal Reserve still hasn't signed off on their $2.2 billion deal, which would create a nearly $110 billion asset bank.
Stein all but said that there is currently more regulatory scrutiny at the Fed level:
Yes, there's a backlog right now, as I said, on approvals of this nature. So we expect that it will be a longer approval process in what we just went through with our Bank of Commerce Holdings approval that went very quickly. And that's why we're anticipating a mid-2022 close for this.
Merits of the deal
There are, of course, merits to the deal and the potential for it to be successful. Columbia expects the deal to boost its earnings per share by 23% in 2023, largely from expected cost savings equivalent to 12.5% of the combined bank's expense base, which is a good amount of cost savings. This also doesn't factor in potential revenue synergies, some of which Stein sees in mortgage banking and through Columbia's healthcare lending platform.
The deal also creates a strong deposit base, which is arguably one of the most important metrics that bank investors watch. Together, the new bank will have 44% of its deposits coming from non-interest-bearing sources, meaning the bank doesn't pay any interest on these deposits. The pro forma bank's cost of deposits will be just 0.08%, which is strong.
Management also expects the combined bank to be able to generate a 15% return on average tangible common equity (the technical rate of return on shareholders' equity minus intangible assets and goodwill), and a 1.3% return on average assets, which measures how well the company uses its assets to generate a profit. Both are key metrics for bank investors and both are better than what either bank has been generating on its own, at least in the current low-rate environment.
Can the Columbia-Umpqua Merger work?
This deal is not completely done for. If management at the combined bank can hit its promised financial metrics, including cost savings; avoid significant deposit attrition; and find some real revenue synergies, then this bank will be better long term and likely also be able to develop superior technology.
But I do see a lot of the same execution risk that might be seen in a MOE. There is the cultural aspect of combining these two banks, their management teams, and different brands into one stronger entity. Then there is achieving the revenue synergies that investors will ultimately want to see to make this deal worth it. And of course the added regulatory scrutiny does not help matters, not that one should think this deal won't close. With all of these factors, it's understandable that some investors don't view the reward to be worth the risk.