Insights

We lost a lot in 2020, but we are getting a lot of it back in 2021. One bit of good news apparent in fourth quarter earnings calls is the coming return of the bank merger and merger premium. Connecting the dots to create a portfolio of likely acquisitions should be a fun and profitable exercise this year.

One inevitable force over the last 35 years has been the consolidation of US banks from 15,000 in 1985 to 4000 today:

Yet like many changes last year this cycle took a break. Instead of the typical 80-100 depository mergers each quarter we saw less than half that many last year.

Bank CEOs never stopped thinking about how mergers could solve their problems, and the reasons to merge are as apparent today as ever. Indeed the reasons are so many and so inevitable that we could expect the sector made up for lost time and a merger basket to outperform the market in 2021.

What is so pressing?

• Buyers need to boost margins, and mergers allow this (via loan marks). Enterprise (EFSC) CEO Lally:

• Buyers are more confident on the loans they are acquiring. Old National Bank (ONB) CEO Ryan:

• Buyers want to improve earnings and efficiency, which well-executed mergers achieve. Bear in mind this means buyers often pay 18x earnings but get 12x earnings.

• Both sides of the deal typically shower themselves in shareholder money.

• Arbitrage: Buyers on Nasdaq and in ETFs typically have a 20-40% higher multiple than OTC-listed banks. (No table here but I have run numbers).

• Broader buyer pool: Credit Unions and mutuals are also out buying, as Standard Bank (STND) shareholders learned:

• Sellers know they need scale to help pay for technology (below, JPM CEO Dimon)

• Sellers may be offered more for their bank today than they can achieve through 3+ years of business as usual.

It would not be a surprise to see 50% more mergers this year than in a typical year.

How to profit from this? A few recommendations;

a) Figure out what buyers want – typically demand deposits but can also include urban centers of loan demand

b) Sunbelt generally beats rust belt. Florida and Texas in particular are in constant demand.

c) How much does the board own? More is better

d) Is there a shareholder hero involved? Some include Joe Stilwell, Abbott Cooper, or Ken Lehman…

Ongoing levels of competition and regulation for small banks are nasty; combining forces appears as necessary as ever.

Many years ago I attended a dinner with a group of bank investors, including a good friend later profiled in the movie The Big Short. The topic of Fifth Third came up. Fifth Third had recently sold its payments business to scrounge up capital and my friend blurted out “FIFTH THIRD – WORST BANK EVER! WORST BANK EVER!!”

Brainstorming incompetence Fifth Third has gotten on its feet and it’s time for an update. News of a $130 million fine to Deutsche Bank on Friday brought up a thought that culminated in the twitter survey below – what’s the worst large bank in America? The survey focused on a few of the usual suspects:

It’s a dirty job exposing incompetence, but someone has to do it This exercise is not for spite and there are excellent people working at all of the contenders for this dubious honor. Usually, these banks are just the culmination of many strategy errors compounded. Given the sellside and media both profit from the businesses they cover, however, it’s up to bloggers and investors to dig into the underbelly of value destruction. If we do a good job, maybe we will rotate capital away from unfulfilled careers, sad shareholders, and generally wasted opportunity. The world can become a better place. With that said…

The contestants:

Regions (RF): a warm up – The survey respondents above got it right – Regions is not the worst. Yes, the company habitually mistreats depositors with innovative nickel and dime fees, and has a history of bad mergers and recession blowups. If you bought shares in 1996 at $17.75… you would still be able to buy shares at $17.75 today. With that said, Regions’ financial metrics are nothing to be ashamed of, with a 54% efficiency ratio, 38% of revenues from fees, margin over 3% and 18% ROTCE in the third quarter.

Wells Fargo (WF): getting closer – Cheating customers, scaling back the wrong business lines, competing on price, keeping two corporate cultures and missing spread revenue guidance like night follows day – this is Wells Fargo. Still, this is not the worst. 2.1% margin, 80% efficient (the non-recurrings are recurring), 5% ROE in 3Q can still be undercut. Moreover, Wells is deeply ashamed of its position and is taking steps to mitigate.

HSBC North America (parent HBC): serious contender –

You would try to exit too if you checked these boxes:

1. Lost money 4 of the last 5 years.
2. Structurally unprofitable – 1.9% expenses / assets and margin under 1% make losses the rule rather than the exception.
3. The bank carries $70bn in cash and $70bn in money market deposits. HSBC does this by keeping branches but competing on price for retail and private banking deposits. At least they recognize that this does not make sense.

HSBC is $260 billion in assets but is still lighting money on fire – the size of this fire makes burning man look modest! Still, management is taking steps to extinguish the flames. Who else can compete?…

Mistubishi UFJ

Mitsubishi is looking to be all things to all clients:

Not yet determined to focus resources, management has created a small-scale Bank of America, with trailing market share and notable inefficiency. Why? First, the bank’s 2.2% margin, while low for the US, looks fantastic by Japanese standards, where under 1% is standard. However, the bank cannot seem to avoid overspending, as show below.

For combining a 75% efficiency, 2% margin, and breakeven profitability on an ongoing basis, Mitsubishi, lacking the self-awareness of HSBC, has given us a Jets vs Jaguars competition. But do they win the lottery pick? We will leave things suspended where they are. After all, we’ve hit the 3 minute mark on this blog and we haven’t touched Deutsche. Also, there’s no point in raising the dander of PR executives in an organization that thinks nothing of spending millions on low return projects!

2021 is going to be less awful in more ways than you expect. It will be the year banks finally begin to figure out how to make customers’ online experience good, while saving money in the process.

The issue is as simple as converting to the cloud. You’ve probably done it by moving from Microsoft Exchange Server email or ditching an adobe download. Yet this hasn’t happened in banking, because almost all banks under $50bn have been scared to change legacy systems, resulting in the picture below:

Changing data storage providers is hard, but money talks. A number of banks have finally figured out that moving their data to cloud data storage can potentially:

• Save 50-75% vs. the cost of legacy systems
• Make it easier to merge, because no contract cancellation fees (which routinely run several million dollars)
• Improve security due to constant upgrades vs daily batching
• Allow easy integration of new features in weeks – no more hiring QTWO or other software engineers to duct-tape together a PPP application or deposit product that doesn’t fit Jack Henry’s template. This affects everything from loan applications to online experience to money transfers. It mostly affects small banks, and won’t happen overnight, but just making the change is like flipping a switch for improving internal processes.

To quote a CEO of a $500 million bank I spoke with last week “It’s a competitive disadvantage to stick with Jack Henry”

What do all those bullet points above mean?

1. If you own bank shares in a converting institution, expect your bank to drop 1-3% more to the bottom line in coming years.
2. Because the customer experience will be far better, regional banks will have an easier time keeping customers that might go to JP Morgan or Chime.
3. If you bank with a small bank, many of you will waste less time on needless nonsense in late 2021 and beyond.
4. Banks that continue to nickel and dime will merge or lose share (Regions, Key, Wells etc)

Who are the cloud providers? Neocova, FinXact, Finacle and Temenos are a few. The legacy providers may create their own product as well. Whether Fiserv et al will be nimble with disruption like Adobe, or resistant like Blockbuster Video, remains to be seen.

Despite headlines to the contrary, small taking share from big is a theme we will see plenty of in 2021, from ecommerce (Shopify) to challenger banks (Chime) to payment systems (Square).

We may even see some of it in investment management. After a decade of mutual funds losing share for charging too much for too little, Vanguard and Blackrock have become Goliaths. So far so good for the little guy saving on fees while avoiding underperformance, but what does the increasing dominance of passive mean? Let’s look at an example of how little guys can increasingly benefit from this growth of the passive fund “Goliath”.

This past Friday was an odd day in markets, and in particularly for the smaller companies in the Russell 2000 index. The Russell 2000 is filled with little banks, because unlike most sectors, there are so many – about 800 banks have tickers. A number of them, most close to $1 billion in assets, began soaring and plunging with 30 minutes to go before the market closed. None of them released news and there was nothing special taking place in the broader economy. Yet we saw First Western (MYFW), a bank that oversees a number of investment advisors, move 15%+ on meaningful volume:

Professional Holdings, which has a mortgage on a Trump property next to Mar a Lago, took a ride:

A little bank in Knoxville got nailed:

As did one on the coast of Maine:

Notice also the big trade at the beginning of the day for each of these companies.

What happened was both the Russell and S&P indices executed a quarterly rebalance.

There is now enough passive money in products lined up with these indices that 4 times a year, we can expect 20, 30 or even 50 little banks will take a ride on the Goliath rollercoaster, as State Street, Vanguard and Blackrock do their best to adjust allocations due to companies coming in and out of indices.

There is a science to this trend, and some firms predict adjustments, yet it still catches investors off guard. This is because:

a) Some ETFs are more organized about changes than others (note that some buy or sell stock on the open and some, in desperation, on the close).

b) Every year there are fewer dollars going to Davids taking the other side of these trades, and more dollars to the passive Goliaths.

c) These trades are often too small for many money managers to care about – perfect for little guys.

Little guys therefore need to keep slingshot handy for the money in these strange trades. This coming summer’s reconstitution stands to be the biggest roller coaster yet.

The Tech angle to Bank Upside

As we venture through a “dark winter”, there are no sure things in bank investing, but a wrinkle has emerged of late in finding outsized winners. The double and triple opportunities are not all credit-recovery plays like in past cycles, rather the market’s love for fintech is also generating upside in banks helping develop technology. Given that tech analysts typically don’t look at banks and vice versa, close study can bring about happy returns.

The traditional way to find bank doubles: We’ve seen 100%+ moves recently in banks including Cadence (CADE), Texas Capital (TCBI), Berkshire Hills (BHLB) among other traditional credit plays. It seems with the recent vaccine rally however that the number of remaining opportunities here are relatively slim.

The new funnel – tech plays: Fintech isn’t just coding and selling – there has to be a place to hold the deposits migrating away from megabanks, and unless that money is uninsured (meaning, in a 2008 event, poof gone), a smaller bank is involved.

To be clear, we want to ignore banks like Regions that are happy to be “fintech partners”, getting a tiny scrape and basically being used like a cardboard container by a more innovative group of coders and tech bros. Instead we care about the banks that want to own the spread revenue and the technology. They may have picked up some outstanding talent, or have a management team committed to innovation. We will nickname these the “Bank Tech Doubles” or “BTDs”.

Who are some BTDs? The most prominent recent examples are Silicon Valley Bank (SIVB), Silvergate Bank (SI), and Live Oak Bank (LOB).

Live Oak Bank (LOB, actually a triple off lows). Live Oak pays an army of developers to find ways to bank more easily. Its affiliated Finxact technology ran circles around the competition in PPP funding, and Live Oak was involved in several recent multi-bagger fintech investments.

Silvergate Bank (SI), another triple. Silvergate came up with a means to help fund crypto exchanges, as well as to lend against crypto assets. They claim they have the controls in place to monitor collateral.

Silicon Valley Bank (SIVB), “only” a double from the lows… SIVB is much larger and older than the others, and derives much of its value from warrants associated with its technology loan portfolio. It actually saw extreme margin decline during its rally because of a heavy liquidity position.

Who’s next? Some emerging “BTDs” don’t trade often or we are still doing research, so this is a wide angle lens, but a few places to look are:

1. Banks sharing fees with “challenger banks” that include Chime, Aspiration and Current. Chime and others like it are “finance” apps that look like a bank but don’t actually hold a charter. This segment of the market is exploding. There is big money in sharing the fees these challenger banks generate on debit card swipes or typical monthly fees. A lot of banks take deposits for these “app banks” but few have the technology to ensure card compliance – this is where value lies, but only a few banks do this and they are typically under $10 billion in assets.

2. Banks developing a mobile product to meet a need. We all know that banking technology is typically weak at best, painful at worst. This is because most small to medium sized banks typically use 3 old-school, IBM-style data storage providers that clog innovation (Jack Henry, Fiserv and FIS). Lately a few cloud-based data processors have come to market to replace the legacy bottlenecks, and this will result in a ramp of new and better customer features, from payments to security to ease of use. There are at least 10-15 banks with the potential to monetize this angle.

3. Banks working with crypto. In addition to Silvergate above, a few of these include Metropolitan Bank (MCB) in New York and MVB (MVBF) in West Virginia. There are puts and takes in each situation and the value of these crypto deposits will vary with interest rates, competition, and the crypto assets themselves.

(Whether the individual stocks mentioned above are appropriate for readers depends on his or her risk tolerance and objectives)