Reaction to Virginia Deal Signals Shift in M&A Attitudes

A stock-price drop is rarely good news, but in the case of Union First Market Bankshares (UBSH) it very well could be.

The Richmond, Va., company's $445 million agreement to buy StellarOne (STEL) in Charlottesville would create the largest community bank based in the state, boost earnings by double digits, strip 32% of StellarOne's costs and put the overcapitalized Union First's cash to constructive use.

The downside of the all-stock deal announced Monday is the dilution to the $4.1 billion-asset Union First's tangible book value, which it says would take five years to restore. In the last few years investors have shown a strong preference for deals that have earn-back periods of two to three years, and they have punished the stock of buyers who announce a lengthier timeline.

Union First's stock fell 1.3%, to $19.76, on Monday — a hit, for sure, but a much gentler one that some of its peers have absorbed.

"I feel like it is healthy to see a quasi-merger of equals with a long payback and to see the stock pretty much holding OK," says Chris Marinac, an analyst at FIG Partners. "It is important because this is the type of deal we expect to be replicated."

Analysts will be following the stock closely over the next few weeks to see how it performs.

"It is early and is only one deal, but this could be the start of the market lightening up on the fear of tangible book value dilution," Marinac says.

Recent examples of bank stocks that were punished for long earn-back periods include Columbia Banking System (COLB), which announced in September that it would acquire West Coast Bancorp, and Park Sterling (PSTB), which said in May 2012 that it was buying Citizens South Bank. The stocks of Columbia and Park Sterling have since surpassed their pre-deal values after taking hits initially.

The possible attitude change fits into a larger shift in the way investors are valuing banks and M&A in the sector. For the last several years stock prices have been tied to tangible book value, but bank stocks are beginning to trade off earnings, observers say. With Union First promising a "double-digit" earnings accretion, that might explain the softer reaction to the earn-back in Union First's agreement.

"When banks were not making much money a couple of years ago, investors rightly looked at tangible book value for a metric," says Jeff K. Davis, managing director of financial institutions for Mercer Capital. "Investors are much more focused on earnings now."

However, Davis cautioned that investors need to consider the "totality of the deal," because tangible book value still matters.

"I never thought they should focus solely on book dilution and conversely, they shouldn't solely focus on earnings accretion," Davis says. "It is important in banking for folks to never get too far away from the importance of tangible common equity, because that is what is levered."

Union First Chief Executive G. William Beale says the earnings accretion, a planned share buyback in connection with the deal and a 20% internal rate of return are outweighing the longer earn-back period.

However, attributing the first-day stock performance purely to metrics shortchanges the strategic benefits of the deal, he says. At $7.1 billion in assets, the combined company would be the largest community bank headquartered in Virginia, excluding Capital One Financial.

"You can't discount the strategic nature of this one," Beale said in an interview.

During a conference call on Monday, Beale repeatedly touted the scale and competitive edge the combined entity would have because of its size. He said it was a negotiated transaction that stemmed from both banks trying to figure out how to become more efficient.

"As the boards of both banks went through their strategic planning process and looked at the operating environment that we are in today and appears to be before us, as well as the economic environment, it seemed to make sense that to both parties that you would need scale to operate better," Beale said. "Both groups were working on initiatives to improve their efficiency ratio, improve operating numbers, and I think both boards realized at the same time that the best way to deliver that shareholder value was really to combine."

The deal, which carries the third largest price tag in 2013, comes at a time when dealmaking has slowed. Although dealmakers say there are a lot of merger discussions, few result in an actual agreement.

"I would say it is a combination of persistence and timing," Beale says. "To do this, you just have to keep working at it."